G-Squared Partners: LLC vs. Corporation: What Is Better for a Small Business?

You’re eager to get your new business off the ground and lay the groundwork for success. You’ve got a concept, a mission, and the passion to make it happen. That’s the exciting part. But before you get too far ahead of yourself in terms of acquiring clients, rolling out your product or service, and reaping returns, there’s a critical step that should never be overlooked: choosing your business’s legal entity.

Sure, this aspect of entrepreneurship may seem tedious and uninteresting — but if you fail to address it, you risk immense legal liability and jeopardize your own (and your family’s) financial well-being. This is one of the most hazardous decisions you can make as an entrepreneur. 

As soon as you’ve resolved to start a business, you should determine whether the new company will be an LLC (Limited Liability Company), S-Corporation, or C-Corporation. (Sole Proprietorship is an option, but not recommended). Under federal income tax laws, each of these has specific guidelines, so knowing which is right for you is key to setting up your business finances. 

Yes, the details can be complicated. This is not always an easy or clear decision, as each option bears its own pros and cons depending on a number of factors that characterize your line of business and your goals for the future. Regardless, it’s a serious decision and one that you can’t afford to ignore or put off. 

What are the four types of business legal entities? 

There are four types of legal entities a business can classify itself as. A limited liability company (LLC), C Corporation, S Corporation, or what is called sole proprietorship. 

Understanding Your Options

Maybe you have some preconceived notions about the various categories of legal entities, or perhaps you don’t know have the slightest clue about any of them. Either way, it’s important to understand that you’re not choosing a legal entity based on the size of your company. The selection process should be structured around the following considerations: 

• Taxes
• Liability
• Fundraising Needs
• Administrative/Maintenance Costs
• Exit Strategies

Your optimal course of action is to consult with a legal and/or financial expert to discuss your business goals and requirements. An expert can help you pick the option that fits your business’s unique needs and protects you as an owner. 

If you decide to get started on your own, however, there are some key indicators that you can use to make the most sound decision for your entrepreneurial journey. Keep these options in mind as you prepare to make a final selection of legal entities: 

Option 1: LLC

This is the most common legal structure business owners choose. It is simple, straightforward, and gives the business owner complete managerial control. A business owner is not legally required to be a US citizen, nor a permanent resident of the US, providing business owners with greater flexibility. 

Pros of an LLC: 

• You have the option of pass-through taxable income, which enables you to avoid a corporate tax return. With the pass-through taxable income, the owner pays the taxes for their business’ profits on his or her individual tax return.
  
  • There is no residency requirement, meaning business owners are not required to be U.S. citizens or permanent U.S. residents.
    
  • Because the business owner bears the majority of the responsibility for the company, there is limited liability for members, managing members, and employees.

 Cons of an LLC: 

• You cannot issue stock shares to attract investors. An alternative, however, is issuing membership units, similar to giving partners a piece of the financial pie.
  
  • Venture capitalists and investors do not like to invest in LLCs, because they are flow-through entities.
    
  • There is an inconsistency of LLC treatment from state to state. Depending on what state you’re operating in, registration fees and taxes will differ.
    
  • Your earnings can be subject to self-employment tax.

Option 2: C Corporation

C Corporations are the most common and traditional type of corporation in the U.S.

Pros of a C Corporation: 

• C Corporations limit liability for directors, officers, shareholders, and employees.
  
  • The business perpetually exists after owners leave or pass away.
    
  • They have higher credibility in the eyes of suppliers and lenders.
    
  • There is high growth potential because there is no limit to the amount of stock you can sell.
    
  • C Corporations have no shareholder limit, but must file with the SEC under the Securities Exchange Act of 1934 when assets reach $10 million and the securities are “held of record” by either 2,000 persons, or 500 persons who are not accredited investors.

Cons of a C Corporation: 

• Double taxation is one of the biggest drawbacks for C Corporations. Earnings are taxed at the company level and again at the shareholder level when a company distributes a dividend.
  
  • It is expensive to file articles of incorporation, in addition to paying state-imposed fees. State fees also differ depending on your state of incorporation.
    
  • There is more government oversight for C Corporations. This is due to complex tax rules and protections preventing owners from being responsible for debts, lawsuits, and other financial obligations.
    
  • You cannot deduct corporate losses, unlike S Corporations, where shareholders can deduct losses on personal tax returns.

Option 3: S Corporation

Subchapter Corporations or S Corporations are similar to C Corporations, with a few simplifications.

Pros of an S Corporation:

• S Corporations limit liability for company directors, officers, shareholders, and employees.
  
• There is an option for pass-through taxes, which can further limit liability for parties other than the owner.
  
• S Corporations avoid double taxation – income being taxed as corporate income and again as dividend income (a situation facing C Corporations). 
  
• You have the availability to sell stock and attract investors. However, this is limited as you still face the issue of flow-through.
  
• The business continues to exist, even after owners leave or pass away.
  
• S Corporations only have to file taxes yearly, unlike C Corporations that have to file quarterly. Shareholders may have to pay quarterly taxes though.

Cons of an S Corporation:

• You must be a legal U.S. citizen and permanent resident.
  
  • You can have no more than 100 shareholders.
    
  • There are formation fees and ongoing fees imposed by some states. You must file Articles of Incorporation, obtain a registered agent for the company, and pay all appropriate fees. And, some states impose ongoing fees that may include annual reports or franchise tax fees.
    
  • You will face closer scrutiny by the IRS. Employees and shareholders can receive distributions as either salaries or dividends. Each option is taxed differently, which leads to the IRS paying closer attention to how distribution occurs.

Option 4: Sole Proprietorship

As the only owner of your business, you may be inclined to consider sole proprietorship, so we feel the need to mention this option. However, sole proprietorships are rarely the right option for businesses, primarily because there is no distinction between the owner and the business. So, while you reap all the profits, you are also responsible for all the debt and financial risk. Instead, consider one of the previous legal structures for your business.

LLC vs. Corporation: Which Is Better for a Small Business? 

Understanding the connection between a business entity and legal liability is the first step toward minimizing your risks, and there is a wealth of information to consider in your selection process. 

• In most cases, it is best to start off as an LLC or S-Corporation because these are most suited to minimize your taxes early on AND provide legal protection.
  
• Think about whether you plan to raise money. If you do, an S-Corporation is likely to be your best bet. If you don’t, it’s more beneficial to form an LLC.
  
• It is very expensive to transition from an LLC to a C-Corporation, so if you have big fundraising goals for your business, look into the S-Corporation option. With this structure, you can more easily move the business to a C-Corporation when the time is right.
  
• When selling a company, it is better to be an LLC or S-Corp due to the single-level tax.

It’s easy to become overwhelmed, confused, and even bored by the options and details associated with choosing a structure for your business. Delving into tax implications or the technicalities of funding requirements and exit strategies may not be high on your list of inspiring business activities. But if there’s only one thing you take away from this article, let it be this: do something.

The truth is it’s better to opt for the “wrong” legal entity than to fail in setting one up at all. Of course, the smartest path is to seek legal and financial counsel before choosing a business structure, but don’t underestimate the importance of taking action. And don’t make the mistake of relying on a sole proprietorship or a partnership, as neither of these options shields you from personal liability if the business cannot satisfy its liabilities. 

Without establishing a legal separation between you and your business, there’s no distinction between what’s at risk financially. Your personal assets are just as vulnerable as your business ones. In the event of a lawsuit, an employee injury, or a loan default, you could be faced with companies, creditors, or individuals coming after your house, your savings, or your other financial valuables.

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Before you choose a legal structure for your business, it is a smart move to consult a financial expert. They have the expertise to advise you on which choice is best for the future of your business. Want to talk to a financial expert about the legal entities available for you to choose from? Schedule a free consultation now.

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