Many small businesses will eventually have to move on from partnership or sole proprietorship status. Owners should understand the differences between corporations and LLCs for when that time comes.
There are a number of small distinctions between the two entities that small business owners should understand before deciding which is right for their venture. It might be a good idea to look for some financial tips from a tax expert before making the decision, but for a summary of what the differences are, read the advice below:
1. Legal and tax entities
LLCs and corporations, as well as sole proprietorships and partnerships, are classified as legal entities and as tax entities, according to MyCorporation. Tax entity is the scope through which the IRS views your business, while legal entity is how your businesses is seen by every other institution. When a business becomes a corporation, for tax identity purposes, it will be designated as either an S corporation or a C corporation. LLCs can decide which kind of tax entity they'd like to be taxed as. LLCs have more flexibility in terms of taxation, and can decide on whichever identity works best for their members.
2. Pass through and non pass through taxation
LLCs are pass through entities, Entrepreneur explained. These institutions don't pay income taxes on their profits. Any profit or loss for the business is passed through to the owners and reported on their personal tax returns. Companies can be taxed as S Corporations, which are taxed in a way similar to LLCs. However, normally corporations are non pass through entities. This means that they are considered legally separate from owners. Corporations must submit tax returns and pay income taxes on their profits. This can cause double taxation. This means that the corporation is taxed, and then when owners take out their profits, they will have to report the dividend on their personal tax returns. Double taxation can prove overly expensive for some small businesses.
3. Income shifting
C corporations may be double taxed, but they have the advantage of flexibility in terms of income shifting, compared with pass through entities such as LLCs and S corporations, MyCorporation noted. When pass through entities are taxed, their members pay taxes on their share of the profits. This is true whether the money stays in the business or goes to a personal account. C corporation owners are taxed on the amount they receive as dividends only. C corporation owners that work with an expert can design a financial plan that places them in a lower income tax bracket.
4. Ownership differences
Owners are classified differently depending on their businesses designation as an LLC or corporation, according to Entrepreneur. Corporation owners are categorized as shareholders, while LLC owners are codified as members. This allows LLCs to distribute ownership stake independent of each members' actual contribution to the business. If the owners would like profits to be distributed equally, regardless of individual input, this designation will allow them to do so. For corporations, this kind of profit distribution is more complicated. C corporations can create a unique stock class structure in order to shift earnings in a similar way, but C corporations are also subject to double taxation. S corporations cannot design a similar stock class structure to C corporations, and thus don't have as much flexibility in terms of profit distribution.