In today's video, we are going to help you decide between an LLC or a corporation. And then we're going to wrap up by talking about which one might be better for you and your online business.
So, one of the number one questions I get from clients who schedule strategy calls with me is, “What can I do, Jim, to protect my online business? How do I do that?”
Well, the answer is actually pretty complicated. But one of the biggest ways to start with protecting your business is to go about setting up some sort of legal structure or legal foundation that you can use to insulate your personal assets from your business assets.
So, when we talk about corporations, for purposes of today's post, I'm talking about what's called a C corporation, not an S corporation. A lot of people get confused.
They think an S corporation is a different type of corporation. It is actually not. It is actually a tax election that people can make, whether they're a C corporation or an LLC or a partnership or whatever you might be. You can elect to be taxed as an S corporation. It is not a separate type of corporation. So, just so you understand.
Difference in Filing LLCs and Filing Corporations
Today, we're talking about C corporations versus LLCs, the differences, and which one I think is going to be better for you. Now, both of these entities are formed at the state level. And it's relatively simple to file both, although the steps can be a little bit more complicated when we're talking about the C corporation, and I'll talk about that here in just a second.
The way that you form a C corporation is you file what are called articles of incorporation, and you're going to file those with the secretary of state where you live. I've talked about this in other videos, I highly recommend filing them where you live, not in some other state, which is very similar to setting up an LLC.
For an LLC, as opposed to filing articles of incorporation, you're going to file what are called articles of organization, and you're going to organize the LLC.
Now, the person that files these documents does not necessarily have to be associated with the legal entity itself. If a third party files your corporate paperwork on your behalf for a corporation, they're called the incorporator. That could be a shareholder. It might be somebody else.
The person who files the articles of organization for the LLC is going to be called the organizer. And again, they can be a member of the LLC or they can be somebody else.
Now, the information that's going to go into both of these documents is very similar. It's going to include the name of the business, and you're going to have to use that unique identifier. So, if it's a corporation, you're going to have to use Inc. or incorporated or Co. as in company.
With an LLC, you're typically going to file the name, comma, LLC, or comma, limited liability company, or comma, LTD, or some other identifier that identifies your business as an LLC.
The other information that's typically going to go into this document is going to be the name and address of the shareholders in the case of a corporation, or the members and the case of an LLC. You're going to include the name and address of the registered agent. You're going to include, if you have one, the address of the principal business location will be included in these documents.
In the case of a corporation, you're also going to include things like the number of shares that are going to be issued, or if there's going to be different classes of shares. You'll want to outline that in the formation document, and those types of things.
So, it does get a little bit more complicated right off the bat when you're dealing with a C corporation than with an LLC, but the processes are basically very similar. You're going to file some documentation with your state, and they're going to file that. They're going to let you know that your corporate paperwork has been accepted, or your LLC paperwork has been accepted, and that your business has been formed.
Corporate Formalities of LLCs vs Corporations
Now, the second major difference that we're going to talk about with regards to corporations versus LLCs are the corporate formalities. I've talked about this in other videos. Basically the corporate formalities are going to be much more complicated and much more stringent when you're dealing with a C corporation than when you're dealing with a limited liability company.
This is one of the main reasons why people are more prone to file limited liability companies than C corporations, especially for small businesses, and that is because there's not as many rules and things that you have to follow in terms of an LLC versus a corporation.
A corporation, the statutory language is typically going to be shall, which means you shall have to do certain things. You shall have bylaws. You shall have annual meetings. And you shall keep track of the minutes for the corporation. You shall, shall, shall do all these things. It's like you've got a parent looking over your shoulder. You shall do this. You shall do that.
Versus an LLC, it's like the nice grandmother. Hey, well, you may want to do this. You may do that. You may do this. But it's not like the parent that's going to be shall, shall, shall. So, that's the main difference in terms of corporate formalities between the C corporation and the LLC.
Now the one caveat I will say about that is LLCs are not required to have an operating agreement. However, I strongly recommend that you put an operating agreement in place for your LLC just to make sure that you're protected in the event something goes wrong and you need that corporate veil protection. You have it if you have an operating agreement. It's going to increase the likelihood that you're not going to have problems.
Related Resource: Need more information about operating agreements? Check this video.
Corporations is to Shareholders as LLCs is to Members
All right. The next major difference between corporations and LLCs is going to come in the form of the ownership, and this is a biggie. In a nutshell, people that own corporations are called shareholders. People that own LLCs are called members. Shareholders own shares. Members own what are called ownership interest, so they'll have a percentage ownership interest in the LLC.
You can have different classes of shareholders for a corporation. And you can have different classes of membership owner interest in LLCs if you want. You have to outline all that in the operating agreement.
For the corporation, different shares, as I said, can have different rights. So, you might have class A shares, class B shares. You could have voting shares. Or you could have non-voting shares. You can have all of these different things. There's a lot of flexibility in terms of what you can do with the shares for a corporation. So, you can do all these same things with an operating agreement that you can do with the class of shares for a corporation.
Now, in both cases, there's not going to be a limit on the number of owners for the business. You can have as many shareholders as you want. You can have as many members as you want with an LLC.
However, if you do decide that you want to elect to be taxed as an S corporation, regardless of which entity you have underlying that, there is a limit to a hundred shareholders for an S-corporation, and those shareholders have to be U.S. citizens or residents.
In regards to the transferability of shares, if you want to sell your shares in a corporation, that's fairly easy. You can sell your shares if you want to, unless there is a restriction in the bylaws that prohibits.
Oftentimes, in closely held corporations there might be restrictions on who can and can't sell shares. Also, there might be a right of first refusal to other shareholders so that their shares are not diluted if somebody else were to sell their shares to a third party that's not necessarily affiliated with the business.
The same is true with membership interest in LLCs. People are free to sell their membership interest. However, oftentimes, and this could be written into the state statutes, that it's required that there be a majority of members agree to the sale of those membership interests.
Also, if you're looking for your state statute in terms of whether or not you're allowed to transfer your shares or your membership interest of your LLC, oftentimes, as is the case in North Carolina where I live, you're going to need unanimous consent of the members to add a new member.
So, by default, if you wanted to sell to a new member who was not formally part of the LLC, then it would require the unanimous consent of everyone else before that person joined. Unless you have something written into the operating agreement that says otherwise.
You definitely want to make sure if that's going to be an issue, to check your state statute and see whether or not there's any restrictions on the transferability of ownership interests if you're going to go with the LLC. And basically, what that would be called is the state statute. The LLC statute would require consent from all the other members before you can transfer your shares.
Getting Taxed as an LLC vs as a Corporation
Taxes are a big deal when it comes to C corporations versus LLCs. A huge benefit here for LLCs is LLCs can decide how they want to be taxed. LLCs can be taxed as a sole proprietorship, they can be taxed as a partnership, they can be taxed as an S-corporation, or they can be taxed as a C corporation.
C corporations really have one option, and that's they can be taxed as a C corporation, unless they elect to be taxed as an S corporation. For the vast majority of C corporations, people that form those, they're going to be taxed as a C corporation.
Because honestly, if they want to choose the S corporation tax status, it probably would benefit them to form an LLC to begin with. But there's reasons why people form C corporations, and there's a reason why those are around. I don't want to put a blanket statement on everyone here.
So, some of the benefits with regards to C corporations and how they're taxed is there's a lot more flexibility in terms of fringe benefits that can be paid to owners and employees with the C corporation.
However, you have to be aware of something called double taxation. Basically what that means, with a C corporation, the corporation is going to close its books at the end of the year, and it's going to file a tax return. And the tax returns can have its income, less its expenses, including salary paid to owners and employees and everyone else. And then there's going to be a net profit. Right?
Now, that net profit, you're going to pay tax at 21%. That's the current federal tax rate. It might change and frequently it does change. But as of right now, it is 21%. You're going to pay that. And the C corporation is going to pay that directly through its tax return. Okay? In addition, you're going to have to file state tax returns. And then if there's a corporate tax in your state, you're also going to have to pay state income tax as well.
Now, here's where the double taxation comes into play. The corporation has already paid tax on its net profit, but anything that's left over after tax can be distributed to the shareholders as a dividend. And so, when you receive those dividends, as you're well aware if you own stock or mutual funds or anything like that, you have to pay a tax on those dividends, basically income tax on the dividends that you receive.
Now, one of the nice things about corporations is they don't have to declare a dividend and they don't have to pay out the dividends. So, there's a level of tax planning that can go into this. But when you do take that money out in the form of a dividend or profit, you're going to be paying tax on the salary that you receive, and then you're going to be paying tax at the corporate level. And then when you get the dividends from your business, you're going to pay tax on that as well. So, that's what's considered the double taxation. That's what we're talking about.
Contrast that with an LLC. You're not even going to file a tax return if you're taxed as a sole proprietorship, but you're just going to put it on schedule C of your personal tax return. You're going to show your income less your expenses, your net profit, and then that net profit is going to be taxed at your individual tax rate.
Now, you will have to pay a 15.3% self-employment tax on your self-employed earnings. There's no double taxation. You're not going to get taxed twice a year. You're just going to pay one tax, and it's on your personal tax return. If you'd like to be taxed as an S corporation, you'll pay yourself a salary, and then the profit will flow through to you tax-free. Again, no double taxation there.
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Deciding between an LLC or a Corporation
So, that leads us to which one of these entities is going to be better for your online business. And it really comes down to what are your goals? What is it that you're trying to do with your business? Are you trying to grow a huge multinational corporation where you're going to be going public at some point, and you're going to be bringing on a lot of investors and raising capital and looking for venture capital and different things like that?
If you're doing all of those things, a C corporation might be the way to go because it's much easier to bring on lots of shareholders. It's easy. People understand it. And at some point you can take your entity public. And so, that might be a benefit to you if you want to grow this huge corporation. That's fine.
An LLC, on the other hand, is great for small businesses, particularly online businesses who are small, maybe one or two people tops, who are looking for some liability protection in their business. LLCs are easy to manage. There's lots of tax benefits to having an LLC versus a C corporation. And there's a lot of flexibility built in, in terms of the lack of corporate formalities.
Related Resource: Ready to form your LLC? Here is an affiliate link.
Honestly, a C corporation for most small businesses, online businesses, is going to be overkill. It's going to be more than you need. It's like trying to drive your kids to school in a rocket ship. You don't need that much firepower, okay? Is that a terrible analogy? It's like if I needed to get to Charlotte, which is about a two-hour drive from where I live, and instead of just driving there in two hours, I decided to take a Concorde.
Or it's like we're going to Ohio for a little mini vacation here in a couple of weeks. It's about an eight-hour drive. Instead of driving in a car, we decided to take a rocket ship. It's too much horsepower. It's just a lot that you don't need with a C corporation. But your personal circumstances will vary, and you might be in a situation where you really need that C corporation because you do plan on going public someday. Just depends.
If you're interested in starting up your own LLC, and you'd like to know more about how you do that, here's a video that I did right here that talks about how to set up your LLC in very short order.