Understanding the Differences Between Corporations, LLC's, and Partnerships
Provided by HG.org
Congratulations on your decision to start a new business. The question you may be asking, though, is what kind of business you should form? What is the difference between a corporation, an LLC, and a partnership? Why form one and not another?
In a corporation, the owners are called “shareholders.” The owners of an LLC are called “members.” An LLC has complete freedom to distribute its ownership stake to its members without any regard to a member's capital contribution to an LLC. This becomes important when profits are distributed to each member. Although a certain member may not have invested as much as another member, an LLC's operating agreement may specify that all members receive an equal share of the profits.
A corporation can theoretically do the same by creating a unique stock class structure, but this is limited to C-corps. Unfortunately, a business that wants to be identified as an S-corp to avoid double taxation cannot create a unique stock class structure. As a pre-requisite, an S-corp must have a single class of stocks with its dividends distributed in proportion to a shareholders capital investment. Thus, in order for a corporation to create a unique stock class structure, it must be subject to the double taxation.
The owners of a partnership are, not surprisingly, called “partners.” There is no requirement for a formal written agreement in most jurisdictions when creating a partnership, and the partners of a partnership own all of their company's assets and liabilities personally in proportion to their ownership interest in the company.
We have already touched on this a little, but there are complicated and variable rules regarding taxation among the various business entities. Corporation profits are not subject to Social Security and Medicare taxes. Like a sole proprietorship or a partnership, the salaries and profits of an LLC are subject to self-employment taxes unless the LLC opts to be taxed as a corporation. With a corporation, only salaries (not profits) are subject to such taxes.
An LLC has complete flexibility on how it wants to be taxed whereas a corporation may not. A major disadvantage to the corporate designation (at least for C-corps) is its double taxation implications. A corporation's profit is taxed once (corporate tax), and the dividends its shareholders receive is then taxed again (individual tax). The S-corporation designation does allow flow-through taxation (no corporate tax), but there are certain requirements to qualify as an S-corp that may limit its application for some businesses, particularly those that want to sell shares to raise capital. Depending on the circumstances of a corporation, it may have no choice but to be a C-corp and face double taxation.
An LLC, on the other hand, no matter its structure or organization, can choose how it wants to be taxed. By default, an LLC is treated as a "pass-through" entity (single taxation), but can elect to be taxed as a C-corp or an S-corp (if it qualifies). If a business qualifies as an S-corp, the tax difference between an LLC and S-corp are a bit more nuanced. Both an LLC and an S-corp has flow through taxation (no double taxation). However, an LLC's distribution of profits is subject to an employment tax, whereas an S-corp's dividends are not. With careful planning, a small business can avoid significant employment taxes by electing to become an S-corp. There are a few other reasons (like much more paperwork) that may deter a small business from taking this advantage, but you should consult with either an attorney or an accountant experienced with corporate set-up before making a decision on whether to be taxed as an LLC or S-corp.
Partnerships and sole proprietorships, on the other hand, are taxed directly on the partners' respective incomes. Because all assets and liabilities are considered to be those of the owners themselves, any gains or losses made by the company are taxed directly to the partners in proportion to their ownership interest in the company. There are also fewer deductible business expenses available to partnerships. But, because the taxes are done directly from the partners' own incomes, there is very little additional paperwork.
While corporations must hold regular meetings of the board of directors and shareholders and keep written corporate minutes, members and managers of an LLC need not hold regular meetings, which reduces complications and paperwork. S corporations cannot have more than 100 shareholders. Each shareholder must be an individual who is a U.S. resident or citizen. Also, it is difficult to place shares of an S corporation into a living trust. These restrictions do not apply to LLCs (or C corporations).
Members who are active participants in an LLC's business can deduct operating losses against their regular income to the extent permitted by law. While S corporation shareholders can also deduct operating losses, C corporation shareholders cannot.
Corporations can offer a greater variety of fringe benefit plans than any other business entity. Various retirement, stock option, and employee stock purchase plans are available only for corporations. While sole proprietors, partners, and employees owning more than 2% of an S corporation must pay taxes on fringe benefits (such as group-term life insurance, medical reimbursement plans, medical insurance premiums and parking), shareholder-employees of a C corporation do not have to pay taxes on these benefits.
Partnerships have the least restriction because they have the least advantages. Partnerships need not have meetings, special paperwork, and are not bound by limitations on ownership.
Corporations, LLC's, and partnerships all have unique advantages and disadvantages, and any of them may be a great idea for forming your business depending on your unique situation and legal requirements. Of course, your best bet is to consult with an attorney or accountant who is experienced in setting up different business entities to give you clear guidance on which structure will be best for your particular situation and tax needs.
Read more on this legal issueShareholder Rights Against a Director
Deciding between an LLC and a C Corporation
C Corporation 101 – Everything You Need to Know
Converting an LLC to a C Corporation
Do You Need to Register Your Business Name?
Dangers of Offering Stock in Your Business to Friends and Family
Reasons why You May Prefer an LLC over a Sole Proprietorship
Questions to Pose for Your LLC Agreement
Definition and Benefits of a Limited Liability Company
How to Convert an LLC into a Corporation
Adding a Member to Your LLC
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.