Choosing the best structure for your business is not something that you do overnight. It takes careful consideration of several factors, most importantly the needs of your business now and in the future. When choosing a business structure, some of the things that you must consider are the setup procedure and cost, personal liability, the ease of raising funds, tax implications, required formalities, and flexibility on your part. As you consider these factors, remember that no single factor leads you to the right choice because most of the time, it is a combination of any of all these factors.
If you are after a business structure that protects the owners of the business from liabilities, two of your best options are the LLC and the C-corporation. In the United States, most large corporations are structured as C-corporations. This type also serves as the basis for many smaller companies in the country. On the other hand, the LLC or “Limited Liability Company” offers both the benefits of partnerships and sole proprietorships. Like the C-corporation, it offers limited liability protection, is easy to form and has certain tax benefits.
While C-corporations and LLCs share some similarities, they differ in terms of tax benefits, management level, ownership, taxation structure, paperwork and records, and a lot more. C-corporations are formed by filing for incorporation and require a board of directors and management. Also, C corporations are taxed twice. On the other hand, LLCs offer limited liability protection that is more superior to the protection provided by C-corporations. In this business structure, it is harder for the law to attach personal property since it is not a corporation but an unincorporated business entity.
Take a look at the characteristics of each business structure:
What is a C-corporation?
Also known as the standard corporation, a C-corporation is considered a legal entity that is owned by shareholders but is apart from its owners. When it comes to business debts, this structure limits the personal liability of each owner or shareholder to the amount of his investment in the corporation.
How will you know if this business structure is the right choice for your business?
Should You Form a C Corporation?
Considering a C-corporation involves several factors. You will know if this business type is right for you if you:
- Need venture capital for your financing
- Want the earnings of your business to stay in the business
- Seek flexibility in profit-sharing
- Seek flexibility in spreading the earnings of your business between the shareholders and the corporation
- Seek flexibility in providing health and medical benefits and other benefit programs
- Seek flexibility in setting salaries for employees to minimize taxes in Social Security and Medicare
- Want ease in selling your business, just in case
- Want to offer an accountable plan for both entertainment and travel
- Want to provide stock options to employees
- See your business owning a real estate in the future
Forming a C Corporation
The formation of a C corporation involves filing for application in your respective state, obtaining a federal tax ID, and choosing your management, which consists of a president, secretary, and treasurer at least. When you file your application in your state, you need to submit your articles of incorporation, corporate bylaws, written consent of incorporator and the resolutions that you came up with during the first official meeting of the board of directors. Remember to complete your filing because unless you do so, you cannot obtain your Certificate of Incorporation.
When it comes to C corporations, you will often hear what they call “piercing the corporate veil.” This legal term means that the court can put aside the limited liability of the corporation’s shareholders in a C corporation personally liable for the debts of the organization. You might ask, how does the court do that when this business structure is said to limit the personal liability of shareholders?
That is where the role of recordkeeping gets in. In a C corporation, you are required to keep certain documents and regularly file specific reports so you can maximize all the tax benefits the corporation is entitled to. However, since almost all your records are made public, meticulous recordkeeping in this type of business structure makes it a lot easier for courts to pierce the corporate veil.
Recordkeeping is one of the things that make a C corporation different from LLC. Unlike C corporation, an LLC is more difficult to pierce because it does not require such meticulous documentation and filing. Hence, most of the information is kept from the public eye. Here, chances of the limited liability of shareholders being removed from them are almost zero, unless they commingle their funds.
What is an LLC?
An LLC is more like an alternative to corporations and partnerships through offering a combination of the corporate advantage of limited liability protection and the partnership advantage of pass-through taxation. Given this tax arrangement, the income of an LLC is not taxed at the entity level. The downside of this structure is that it usually completes a partnership return if more than one individual owns it. Just like the C-corporation, the LLC is formed by filing incorporation documents in your chosen state and paying all the required fees.
Should You Consider an LLC?
If you happen to be any of these, then an LLC might just be the right business structure for you.
- Your business may own real estate.
- Since you have just started out, you anticipate losses for at least two years and want to pass these losses through yourself and the other shareholders.
- You seek flexibility in all accounting methods, primarily since LLC is not supposed to employ the accrual method of accounting.
- You seek flexibility in management, especially in terms of how the business is structured.
- You want fewer formalities compared with corporations.
- You seek flexibility in sharing profits among shareholders.
Forming an LLC
An LLC is much easier to form compared with a C corporation. Just like the C corporation, this business structure also requires state filing to the office of the secretary of state. However, this one can be completed online.
While forming an LLC is more straightforward than a C corporation, there are still certain things that you need to complete when you file. These include:
· Members of the LLC. Remember that an LLC should have at least one member, and each member is an owner of the LLC, just as how the shareholders in a C corporation are the owners of that corporation. Like a shareholder, the liability of an LLC member to repay the obligations of the organization is limited to the amount of his capital contribution in the LLC.
· Ownership Interest. The ownership interest of each LLC member is more commonly referred to as the membership interest. These interests are usually divided into units we call “shares.” The extent of an LLC member’s right to manage the LLC is dependent on his membership interest unless otherwise stated in the organization’s operating agreement.
· Manager. By default, an LLC is managed by its members. However, certain LLC agreements include a board of managers to control the daily operations of the organization. These managers are usually appointed or elected by the members/owners of the LLC and can be removed by the same people anytime. Take note though that just because you are a member, you cannot be the manager of the LLC. You can be. In that case, you are called the “managing member.”
· Articles of Organization. The purpose of the Articles of Organization is basically to prove that your LLC exists. This serves as a piece of evidence of the existence of your LLC, which you should file with the Secretary of State of your chosen state of the business. The details that you need to disclose in the Articles of Organization vary from state to state, although these usually include the name of the LLC, its purpose and the name of the statutory agent.
· Operating Agreement. This agreement is what defines and determines the rights of each LLC member. Drafting this agreement is crucial in your business, especially since the LLC statutes offer too much flexibility and the default statutory rules are usually not suitable to most of the needs of the organization. You come up with this agreement through a thorough discussion with the members.
· Federal Tax ID. This one is optional and depends on the city where the LLC operates. Some states require LLCs to file this, while some do not. In some cases, you are even required to file with the city. Also known as the Employer Identification Number, the Federal Tax ID is only required if a certain LLC has employees.
Differences between C Corporation and LLC
Taxation. In both C corporations and LLC, the employees’ FICA and Medicare taxes and the state taxes are the same. However, they differ when it comes to federal tax income treatments.
Usually, the personal income tax rate is higher than the corporate tax rate. However, C corporations involve double taxation generally because the C corporation is treated as an entity that is separate from its shareholders. These reasons include:
· The C corporation is taxed based on its profits
· The profit is taxed again upon its distribution to the owners or shareholders of the corporation
In LLC, the organization may choose to be taxed either as a C corporation or an S corporation since it is not considered a corporation and is not treated as a separate entity from the ones who own it. Once an LLC decides to be taxed as an S corporation, it enjoys the privilege of bypassing the double taxation law by simply reporting the entirety of its income on the personal income tax returns of the LLC members. This way, the LLC does not simply bypass the double taxation but can also report the losses incurred by the LLC on the personal ITR of its members.
Now here’s the catch. Since the pass-through revenue of the LLC is treated as a personal income, its taxes are usually higher. In a legitimate S corporation, taxes are lower since the pass-through revenue is considered as dividends.
Although C corporations are subject to double taxation, they gain a favorable tax rate when profits are reinvested in the corporation. Since this business structure is allowed to use its profits as reinvestment credits against taxation, it can significantly reduce its tax burdens.
· Tax Reporting. The forms that C corporations and LLCs use in reporting their taxes also vary. C corporations use Form 1120 for income, Form W-2 for salary, and Form 1099-DIV for profit distribution. On the other hand, LLCs use Form 1040 Schedule C or Form 1065 for personal income tax, and Schedule K-1 for profit distributions.
As mentioned, an LLC can choose to be taxed as an S corporation. According to business analysts, an LLC that is taxed as such has the widest range of tax benefits if the LLC is single-owned or is just a small business. This is especially when the simplicity of the LLC’s creation, reporting, management, strong limited liability protection, and single taxation are all considered.
· Operation and Management. While both business structures are expected to file their annual reports with their respective states, they differ in terms of how they are operated and managed. Although C corporations are controlled by a board of directors who are elected by the owners of the corporation, its day-to-day operations are not directly controlled by these directors but by the officers appointed by them.
In LLCs, it is different. While an LLC can have a team of managers to manage its day-to-day operations, any of its members have the right to manage it directly. Also, its management is less formal in the sense that it does not call for regular formal shareholder and board meetings, where even the minutes of the meetings are supposed to be documented and filed, just like in a C corporation. That only goes to show how LLC offers more flexibility when it comes to its management and operations.
Perception-wise, a C corporation is usually the preferred business structure of large companies so investors understand C corporations well. On the other hand, investors often see LLCs confusing since the management and structure of this business structure are not as clear and as controlled as those of a C corporation.
If you are just starting a new company, deciding which form of organization or business structure is best for you may be demanding. But you see, each business structure has its own share of advantages and disadvantages. Understanding each of them, including the ins and outs of an LLC and a C corporation, will make it easier for you to make a choice.