Updated: Sep 20, 2019
Start-up business owners often have a lot of questions when it comes to selecting the types of business entities. The most common ones are Limited Liability Company (LLC) and Corporation (Inc). This article is for educational and advertisement purposes. Should you have questions regarding your business, you should consult with a lawyer. You can contact Li Law Group at 402-391-2486, or fill out this intake to schedule an appointment.
1. Owner's Personal Liability
Personal liability protection is the primary reason to form a legal business entity. Both LLCs and corporations provide some degree of separation of owner liability and the business’s liabilities, shielding the owners/investors from the creditors of the business. This means only the money actually invested into the business stands to be lost, personal money and assets of the owners or investors are protected. Be aware: there are ways around this shield—notably, personal guarantees on debts, sometimes taxes, piercing of the corporate veil, personal negligence and fraud. Obtaining business insurance is another important method of liability protection.
Both LLCs and corporations also have formalities which need to be respected in order to maintain the liability protection desired. Not maintaining these formalities can allow courts to disregard the legal identity of the entity and pursue the owner(s) personally to satisfy debts, this is known as “piercing the veil.” LLCs generally have fewer formalities than corporations. As an owner, you should not use the business funds or assets as your own, i.e. ensure you are writing checks from the business account only for business purposes. Also, make sure the business is properly capitalized, as court may question a business that does not have enough funds to pay foreseeable expenses. Corporations have additional formalities to maintain such as naming directors and officers, holding meetings, giving notices to shareholders, and keeping certain records (although both entities have biennial reporting requirements).
These entities receive different tax treatment: C-corporations have “double taxation” while LLCs can elect one of several treatments but generally have “pass-through” taxation. A single owner LLC is by default taxed as a sole proprietorship, meaning the IRS disregards the business entity entirely and all the income and losses are denoted on the owner’s taxes. When an LLC has multiple equity owners, a form, K-1 schedule, must be filed describing the equity division, but income and losses are still “passed-through” or attributed to the owners who then must pay tax on their proportional share. C-corporations are treated the same regardless of number of owners: income is taxed independently within the business and then any distributions to owners are taxable to the owners, thus a “double tax.”
Economically, the corporate double tax is not always more burdensome than the LLC pass-through taxation. Self-employment tax and taxes on “phantom” income (being taxed on income that remains in the business) are characteristics unique to pass-through treatment. Also, accounting costs can vary between LLCs and corporations. Note that, in an LLC, losses are divvied up and passed-through to the owners along with income. Whereas in a corporation, losses may be carried forward until they can be offset by income, potentially valuable “assets.” Pass-through treatment, generally, results in a greater tax burden for the individual owners.
Based on your accountant’s recommendation, an LLC may be preferable in your tax situation. If your business, in its infancy stage, may not develop income for a significant amount of time, the added tax burden to you might not be so disadvantageous. The business’s taxes will remain fairly simple as long as you remain the sole owner. If, however, you foresee potential business losses as being a valuable asset, you should consider forming a corporation instead of an LLC.