Corporation or LLC? Start with the Purpose

Should you form a corporation or an LLC? Find out how to make the choice-of-entity decision and the pros and cons of each option.

The decision to form a new business can be complex. It involves both state-law considerations (whether the business will be a corporation or LLC under state law, for example) and tax considerations (what tax classification is best for the business). These considerations determine both the type of entity to form and how it should be structured.

This guide cuts through the confusion. It provides practical, actionable guidance on choosing the right business structure to accomplish the owner’s business and legal goals at the lowest tax cost.

The Choice-of-Entity Decision

Should a new business organize as a corporation or an LLC? This decision—which attorneys call the choice-of-entity decision—depends on the business. Each business has characteristics that make it more suited to one business entity type and tax classification than another.

Attorney Practice Note: Although partnerships may be useful in very specialized circumstances, there is usually no reason to choose a partnership over an LLC. Partnerships have more legal risk than LLCs and provide no better benefits. Only 2 percent of new businesses are formed as partnerships. Because partnerships are seldom used, this guide does not discuss partnership formation.

The Four Business Profiles

To prevent missteps that need to be corrected later, it is important to select the business that accomplishes the owner’s legal and business goals at the lowest tax cost. Many new businesses fit into one of four business profiles, each of which has its own legal and tax needs:

  1. Real estate owners or investors. Real estate owners and investors often benefit from LLCs that are either disregarded for tax purposes or taxed as partnerships. This structure can provide charging order protection, avoid double taxation, and give the owners better opportunities to use entity-level debt to save taxes. Depending on the number of investments, a series LLC or holding company structure may provide added protection.
  2. Service businesses and other self-employed individuals. Service providers and self-employed individuals—including consultants, developers, designers, writers, instructors, or professionals in the fields of law, medicine, engineering, or accounting—can use LLCs taxed as S corporations to both avoid double taxation and save self-employment taxes.
  3. Bootstrappers. Bootstrappers sell physical or digital products and plan to use their own sales to propel future growth. Although they may want to keep the option open to attract investors, their business plan doesn’t depend on seeking outside funding. Bootstrappers can use a wait-and-see approach to entity formation, starting out as an LLC with the possibility of converting to a C corporation later (if needed to attract investors).
  4. High-growth technology startups. A high-growth startup with immediate plans to seek funds from venture capitalists or other institutional investors is often served best by a state-law corporation taxed as a C corporation. Although C corporations are taxed twice on their income, this may not be as much of a concern for founders that plan to reinvest profits and sell their stock as qualified small business stock in a tax-free sale.

These four profiles provide an analytical framework for evaluating the choice-of-entity decision. Although there are businesses that do not fit cleanly within any of these profiles, most businesses fit roughly into at least one category. Understanding which profile fits a specific business can help the owner’s choose the businesses entity and structure that is right for them.

Why Every Business Needs a Corporation or LLC

Although most business owners know that they need a corporation or LLC, not many understand why. The best way to understand why the need for an LLC or corporation is to understand what can happen if the owners don’t have one. If the owners conduct business without an LLC or a corporation:

  1. They can lose their personal assets over business obligations. Without a corporation or LLC, the owners are personally responsible for the debts and obligations of the company. If the owners are found to have breached a contract or end up in a lawsuit, the plaintiff’s attorney will file claims against the owners’ personal assets to satisfy the judgment. The owners’ personal real estate, bank account, and automobiles may all be at risk for debts and obligations of the business. LLCs and corporations limit personal liability for business obligations.
  2. The owners may miss out on tax savings. Strategic business planning can often reduce the owners’ overall income tax liability. The tax savings opportunities depend on the entity the owners choose, the income the business earns, the potential deductions available, and income from other sources. Without the right business structure, the owners may lose out on these opportunities.
  3. The owners have no framework for operating the business. When owners form a new business with the state, it becomes subject to a set of default rules that govern how the business is conducted. These default rules are further customized by the governing documents (like an LLC operating agreement or corporate bylaws). Taken together, state law and the governing documents provide a framework for organizing and operating the business. Without that framework, business operations are left to whim and can be easily challenged.
  4. The business dies with the owners. Unless they are formed for a specific term, corporations and LLCs never die. This perpetual existence allows owners to form a business that can continue to operate and be passed to others after the owners’ death. Depending on the owners’ personal tax liability, the business can use advanced tax planning to reduce estate and gift tax liability. Without an LLC or corporation, the business dies with the owners.
  5. The business loses professionalism and credibility. An LLC or corporation provides professionalism and credibility when dealing with third parties. Lenders, investors, contractors, and customers expect to deal with corporations or LLCs. They may question the professionalism if the owners conduct all business in their personal names.
  6. The owners will have trouble raising money or selling the business. Without a corporation or LLC, there is no way to convey a portion of the business to an investor or buyer. Any angel investor, venture capitalist, or other investor will expect a properly formed business entity as a condition of their investment. Similarly, any lender or prospective buyer of a business will expect the business to be legally formed and operated.
  7. The owners forfeit privacy. When owners conduct business in their personal name, that name is used on every single contract, advertisement, legal filing, or other matter involving the business. LLCs and corporations protect privacy by providing a professional business name through which to conduct the business.

Forming an LLC or corporation provides relatively low-cost risk protection and can avoid each of these problems.