Limited liability companies are one of the most popular small business structures. Their popularity is largely in part down to their versatility – which includes them having the ability to become a corporation if the members of an LLC are in agreement to the transition. Here, we will look at the pros and cons of both LLCs and corporations and the steps needed to incorporate a limited liability company.
Advantages and Disadvantages of an LLC
Firstly, a limited liability company is a pass-through business entity. This means that an LLC is not required to pay business tax to the IRS. Instead, any profits generated by the enterprise are passed directly to its members (owners). That revenue will then be included with the member’s own personal tax return.
An LLC is owned by its members, These are individuals who all have a financial investment in the company. The level of investment can be equal or be varied, depending on the number of individuals involved. So for example, an LLC could be owned by two people, each of whom has a 50% stake in the business. Or, it could have three members: one with a 50% investment and the other two with a 25% stake in the business. Any profit generated by the company is then distributed accordingly to the percentage stake of each member.
Limited liability companies also offer a lot of flexibility when it comes to their management structure. They could be managed by all members, each with equal roles in the day-to-day overseeing of the business and its activities. Alternatively, if all members are in agreement with it, a vote can be held to elect one of the members as a sole manager. This laid-back approach can be appealing, especially to first-time business owners. It feels ‘friendlier’ and less formal and imposing. Another option is to hire a manager and put them on the payroll with a salary. This option may seem the best if the LLC members are not overly experienced with business dealings. It also means that with a third party payrolled to oversee operations, the owners themselves are then able to focus on other business elements.
With the assistance of LLC Business Formation Providers, LLCs can be relatively straightforward to establish. Enlisting professional help to create an LLC can also prove to be cheaper than doing it with the help of a business attorney – or alone. LLC formation services come with the additional benefit of peace of mind: they specialize in business creation and will ensure that your company is set up correctly every legal step of the way. The ease, with which an LLC can be established, has gone a long way to maintaining its popularity.
The founding principle of LLCs is that they keep the business separate from the personal. If the company has financial trouble, the members are protected. Debt collectors will only be able to seize business assets. The cars, houses, and any other personal assets of members are kept out of harm’s way.
LLCs are not free of disadvantages and can come with particular restrictions. One downside is that they are more expensive to start up than sole proprietorships and partnerships. Not only do states require an initial filing fee but LLCs also have ongoing compliances, which need to be met, and come with a price tag attached each time, such as annual reports and business-specific licenses.
Another drawback that may only appear further down the road is that the transferring of ownership of an LLC isn’t always easy. Corporations sell shares in their stock to increase ownership (unless an agreement prohibits it). With an LLC, all members must approve the addition of a new member – or members – and subsequently, the appropriate amendments to the re-distribution percentages of profits.
Advantages and Disadvantages of a Corporation
There are two types of corporations and both come with advantages to their structure. Firstly, an S Corporation is also a pass-through entity. So the owners themselves are taxed personally on both the profits and the losses of the corporation.
The other corporate structure is known as a C Corporation. C Corporations are subject to corporate income tax, meaning they are taxed as a separate entity to the owners.
Two of the chief advantages of a C Corporation are that profits can remain with the company and can then be paid out as dividends to its shareholders, and can also raise money by selling its shares.
The major disadvantage to a corporation is its legal complexity. Corporations are held to a lot of regulatory standards and involve substantially more paperwork than other entities. The record-keeping necessities for corporations are voluminous comparatively and can become quite a burden.
On top of this, corporations and their owners are not considered to be one and the same – which means double taxation by the IRS. The corporation is required to pay taxes on its income, and the shareholders pay taxes on any dividends they receive, so the same income is effectively taxed twice.
LLC vs. Corporation: Comparison
Let’s look at four major factors to both business structures and compare them:
- Liability: An LLC protects its members from personal liability, placing a barrier between personal assets and the assets of the company. Shareholders in a corporation have limited liability when it comes to any action against them due to financial issues such as debt the business may have;
- Tax: LLCs are a pass-through business entity that has the option with the IRS to file tax as a corporation. A corporation is a separate entity to its shareholders and will be subject to double taxation;
- Maintenance: Easy to start-up and relatively simple to maintain, LLCs have fewer formal annual requirements with the state. To retain its corporate business identity, a corporation has more stipulations relating to its maintenance, including mandatory meetings between its directors;
- Finances: An LLC may find that it struggles to bring in investment. Its founding members injected the money at the start and may struggle to gain future investments. A corporation can have an easier time raising more capital by selling shares in its stock.
How to Convert an LLC to a Corporation
When filing taxes for an LLC, the IRS provides an option for limited liability companies to be taxed as corporations instead. If opting in, it can negate the intricate steps required for conversion. The IRS supplies separate forms depending on corporation choice. This can be tempting but to yield the full scope of potential advantages, an LLC will need to incorporate – and to incorporate, there are two main methods of conversion.
The simplest route to transform an LLC into a corporation is via Statutory Conversion. The rules and regulations differ between states but generally speaking, the following steps are required.
An LLC is made up of members. Therefore, if the LLC Operating Agreement dictates it, consultation is needed between them with the agreement to convert being approved by all. The change must be approved by all those invested in the business. With all parties in agreement, a certificate for conversion must be filed with the Secretary of State. It’s common for the LLC’s original Articles of Organization to accompany this filing. On approval by the state, the members’ invested stakes in the LLC are then changed to stock, and the LLC will be dissolved – and the Corporation formed.
The alternative method is known as a Statutory Merger and is trickier but could be the only method available for conversion as the rules differ between states. A new corporation must be created, and then a Certificate of Incorporation with the Secretary of State needs to be filed. The newly created corporation is then merged with the existing LLC. and the member’s interests are converted to stock shares.
Now a corporation, the business structure is more complex. Stipulations for corporations include the need for a board of directors and an annual directors meeting.
As well as this, a corporation must adhere to relevant bylaws, issue stock certificates, and pay corporate taxes.