When it comes to establishing your business, a crucial part of the process is deciding exactly what kind of business you’re starting. There is a list of different types of businesses that all share an expansive Venn diagram of similarities and differences. Because of the similarities, a lot of people treat the terms as interchangeable, but because of distinct differences, the government treats them differently. So, if you find yourself deciding if you want your business to be a limited liability company (LLC) or if you want to incorporate, here’s what you should know:
When choosing between an LLC or incorporating, you should know that there are similarities between the two. The most important similarity is that both offer limited liability protections for owners. This means that in typical circumstances, shareholders are not liable for the debts and obligations of their company. Contrast this with businesses classified as sole proprietorships or partnerships in which the owner’s personal assets can be used to pay off the business’ debt.
But now we need to talk about the differences. Corporations and LLCs are taxed differently.
LLCs are known as pass-through tax entity. The company’s income is not taxed at what is known as the entity level, but the entity still completes a tax return. However, income or loss as shown on the return passes through the business to the shareholders or interest holders, which they then report on their individual tax returns.
Corporations are treated as a separate legal entity for income tax reasons. Because of this, corporations pay tax on their earnings. If corporate earnings are distributed to shareholders as dividends, the corporation does not receive an expense deduction, and the dividend income is taxed as regular income to the shareholders.
Let’s look at some of the advantages and disadvantages of forming an LLC. Starting an LLC is much easier than starting a corporation because there is less paperwork to complete and file. Once the LLC is formed, it’s good business practice to establish the roles and responsibilities of the ownership interest (also known as members). LLCs also have the advantage of increased tax flexibility because the members themselves can choose how they’re taxed: as a sole proprietorship, a partnership, or a corporation – LLCs allow the flexibility.
But every advantage brings a disadvantage. An example of which is also associated with taxes: LLC members have to pay a self-employment tax which includes a 12.4% Social Security tax and a 2.9% tax for Medicare. LLCs can also be automatically terminated for tax reasons. This is triggered when a transfer of 50% or more of an LLC’s total interest of profits within a 12-month period. This is known as technical termination.
When it comes to corporations, though, there are benefits. First, there is a certain flexibility to setting up a corporation: do you want an S Corporation or a C Corporation? They can also issue shares of stock to attract investors and have the ability to reduce overall tax liability.
As with LLCs, founding a corporation brings with it its own disadvantages. It is a complex endeavor, requiring a great deal of paperwork and other structural processes. You must elect a board of directors, adopt bylaws, organize annual meetings, and create formal financial statements. There is also the issue of double taxation; because corporations are separate legal entities from their owners, the same income is taxed twice.
So, when you start a new business, should you start an LLC or should you incorporate? Ultimately, there are pros and cons to both choices, so there isn’t a clear-cut answer. If guidance from certified CPAs is what you need, Valor Partners brings the expertise to help you set-up your business and successfully administer your payroll. We look forward to working with you.