Incorporate or LLC: Which Is Right for Your Small Business?Consider the tax, legal and convenience implications before you decide.
One of the first questions you need to answer when starting a business is how you plan to structure it. Two of the most common legal entities among small businesses are incorporation and LLC. Which is right for you?
Defining the terms
Thankfully, you don’t need to pass the bar to understand the difference between an LLC and a corporation, at least in broad terms.
A corporation — specifically, a C corporation — has three defining characteristics: It is a business entity that is owned by shareholders, controlled by a board of directors (who are elected by the shareholders) and managed by officers who act under the general direction of the board of directors.
Though both the corporation and LLC shield the owner’s assets from creditors, a Limited Liability Company, generally referred to as an LLC, is owned by its members with a much simpler structure and less paperwork.
It’s all about the taxes
The key difference, Andrew Goldberg, a tax attorney, pointed out, is in the tax consequences.
In an LLC, all profits and losses are reflected in the owner’s personal Form 1040 tax return; the business itself does not pay federal income taxes. “The result is that income from an LLC is treated as ordinary income, and losses from an LLC can offset other personal income,” said Goldberg.
Taxation for a C corporation is just the opposite: Income earned by the corporation is taxed twice. First, it’s taxed at the corporate level based on corporate income tax rates, and later, when that income is distributed as dividends to shareholders, it’s taxed at the individual income tax rate. “This double-taxation is the major downside to a C corporation,” said Goldberg.
Your options might be limited
When deciding how to structure your business, you might not have much of a choice. State law is the driving factor. Some states require certain kinds of businesses to structure themselves as specific legal entities.
Mark Figueiredo, an attorney at Structure Law Group, said that in many states, “construction companies and hair salons cannot be an LLC because of the rules relating to their license status.” On the other hand, “real estate holding companies will invariably be LLCs. The rules are fairly complex and vary depending on industry.”
The pros and cons of LLCs
Before you jump to the conclusion an LLC is best, know the pros and cons.
Pro: LLCs are easier to run. “One of the cons of a corporation can be the requirement to observe formal corporate structures like shareholders’ meetings and corporate record-keeping,” said James Johnson of First Venture Legal. Many experts contend an LLC better suits small businesses that have at most a few brick and mortar stores and are located in just one state.
Pro: LLCs may be easier to sell. When it comes time to selling your business, an LLC can be more attractive to the buyer. As Goldberg explained, buyers generally want to purchase the business as an asset “because it can be depreciated and recoup the purchase price over time. If a person buys stock through the purchase of a corporation, he is paying with after-tax dollars and cannot depreciate the purchase price; it’s a more expensive deal for the buyer.”
Con: LLC’s don’t give you a paycheck. With an LLC, there is no paycheck, and you are considered self-employed; this is sometimes a red flag for lenders. “For this reason, I often advise my clients to be a corporation where they can take ongoing paychecks yet still have the benefit of a single level of taxation like an LLC,” said Goldberg.
Con: An LLC causes more transparency than you might like. Goldberg explained, “If there is a single member, there is not a separate tax return. All income and expenses will be reflected on Schedule C of the IRS Form 1040 as if the person was a sole proprietorship. Many people do not like to show all of their business activities on their individual return, and for that reason, they often choose to incorporate.”
Don’t feel compelled to choose one solution based on a perception that it’s the right thing to do, said Frank Natoli, CEO of Lantern Legal.
“Many startups are under the false impression that if they are to be seen as appealing to institutional investors, then they must set up as a C corp. But no one is going to turn down a good deal because of the entity type — that is like not going to a great restaurant because you don’t like its name. Almost all pre-money ventures will start as LLCs today for very pragmatic reasons, and flexibility is at the top of that list.”
The right decision depends on personal factors. John Blake of accounting firm Klatzkin & Company LLP, for example, advises his clients: “If they want good protection, an easier way to raise capital and separate taxation, then incorporating may be the right thing to do. But if they want flexibility and flow-through taxation, then they may want to consider an LLC.”