Managing a company without having to take responsibility for your assets? This is possible with a limited liability company (LLC) and this is the reason that many business owners in the US choose this legal structure. We explain what an LLC is, its hierarchy, as well as naming some of the advantages and disadvantages of this kind of business structure.Limited liability company: definition of the legal structure
As an entrepreneur, you have to decide which business structure your new company should have. Among the many different legal structures, you can choose to form a corporation. This can have many benefits for your future business, but also comes with unique disadvantages. To make the decision, you must understand exactly what a corporation is and the different types of corporations.
A popular alternative to this is a partnership. But what’s the difference between a corporation and a partnership?
- What is a corporation?
- What characterizes a corporation
- Advantages and disadvantages of corporations
- The difference between a partnership and a corporation
What is a corporation?
The term “corporation” includes a full catalog of legal structures. What they all have in common is that their existence is based on assets that are provided by their shareholders. Two key characteristics stand out for corporations: Firstly, they are recognized as a separate legal entity with detached accountability. Secondly: Shareholders in a corporation aren’t personally liable for any company debts or claims against the business: they are only liable for what they have personally invested.
A corporation is an institution that is founded by one or several people with legal personality and follows a specific (usually business-minded) goal. As a legal entity, a corporation is usually only liable for assets personally invested by its shareholders. In other words, liability is limited to contributions made towards the company. Shareholders are therefore only liable for the assets they’ve contributed (stocks and share capital).
Different types of corporations
These are the different kinds of corporations found in the United States:
- C corporation: The C corporation is the most common legal structure in the United States. It can have an unlimited number of shareholders who are protected from personal liability. The corporation is taxed on its profits, and a second time when dividends are paid to shareholders. One major disadvantage is that shareholders face the possibility of double taxation if corporate income is distributed to business owners as dividends.
- S corporation: The S corporation is designed to avoid the double taxation that comes with being a regular C corporation. This means that profits can be transferred to owners without being subject to corporate tax rates. To become an S corp, businesses must file with the IRS for S corp status. A drawback is that S corps cannot have more than 100 shareholders, and they all must be US citizens. Because not all states tax S corps in the same way, it’s best to know the profit margin in your state before committing to this legal structure.
- B corporation: The B corporation stands for “benefit” corporation. They differ from other corporations in mission and accountability. These corporations that meet the highest standards of social and environmental performance, public transparency, and legal accountability. Their goal is to be of public benefit, while achieving a profit. To prove this, some states require B corporations to file annual reports on how they have contributed to the public good.
- Closed corporation: This is a corporation with only a small number of shareholders and without a board of directors. These small companies have a less traditional business structure, because they are not publicly traded on any stock exchanges and are not open to public investment.
- Public corporation: A publicly held corporation is a publicly traded corporation. Almost all C corporations are publicly traded companies, where shares are traded on a public stock exchange.
- Professional corporation: Also known as professional service corporations, these corporations were created to allow professionals like doctors, lawyers, accountants, and the like to operate as a professional business. This means they can benefit from limited liability and centralized management. However, shares can only be transferred to those practicing the same profession.
- Nonprofit corporation: These corporations exist for charitable, religious, scientific, or educational purposes. Since their aim is to benefit the common good, they are exempt from paying taxes – but they must first file with the IRS to receive this status.
Other corporate business structures
When it comes to corporations, the first thing you probably think of are entrepreneurial business associations. But this kind of association can also be chartered without any financial goals.
In the United States, so called “public purpose corporations” are formed to help society, like the United States Postal Service, or the Corporation for Public Broadcasting. Governments can also form public purpose corporations, which are called “public authority public purpose corporations.” Although the governing body will have increased control, its purpose is to assist the public, for example to help build affordable housing or medical centers.
Lastly, a “quasi-public purpose corporation” isn’t incentivized to create profit. The main difference to public purpose corporations and public authority public purpose corporations is that this one is privately operated, and its goal is to carry out its underlying purpose.
What characterizes a corporation
Even though the various corporation types have different characteristics, there are some qualities that they all have in common.
A corporation is a “legal entity.” This means, it operates separately from its owners. As such, it can acquire assets, sue and be sued (although the same applies to partnerships). In addition, it’s possible that a corporation can be represented by a third party rather than by its owners. The identity of a corporation does not change if owners join or leave: Public corporations enjoy the same rights and responsibilities as individuals, and are therefore also referred to as “legal persons.”
Limitation of liability
A corporation has its own assets that are invested by its owners. Since the corporation is regarded as a legal person, all its business transactions only affect the corporation’s assets. While the founders did have to invest their own assets (to start it or at another time), corporations offer the strongest protection to its owners from personal liability. This means that the total assets of the owners are not at risk, should the business declare insolvency. Not least, this risk mitigation helps strengthen the willingness to invest.
There are also disadvantages to this low risk corporate model. Generally speaking, corporate owners get dividends, because they are regarded as shareholders. However, many growing companies don’t give dividends but inject profits back into the corporation to promote further growth.
In the US tax code, S corporations do not pay corporate income taxes on profits. Instead, the profits are allocated to shareholders according to their stake in the company, and the shareholders report those profits as taxable income on their personal returns.
In a corporation, it’s necessary that the owners can manage the business. As mentioned above, it’s also possible for a corporation to be represented by a third party. Beyond this, it’s also possible for the owners to elect a CEO from their ranks like those on the board of directors or those on the supervisory board. It can also make sense to separate investors from management. That’s because an investor isn’t by nature capable of or interested in running a business.
Establishing a corporation
The independent legal status and the liability clause that is limited to personal assets poses strict requirements when it comes to establishing a corporation. Some states require owners to hold a business license, which needs to be in place before the corporation can be formed. You also might have to choose an entity name that meets state requirements, common corporate suffixes include “corporation” or “incorporated” for a business corporation, or “PC” for a professional corporation. Next, you should draft your corporate by-laws, where you define the rights and rules of shareholders, directors, and officers. Lastly, you need to register your corporation in your state. This will include a filing fee and a registration form.
Profit distribution and decision making
Generally speaking, the owners add different amounts of financial value to the business. Depending on the amount that you contribute towards a business, shareholders are entitled to the amounts that are proportionate to their percentage shareholding.
For example, if a shareholder has contributed 20% of the assets, then they are possibly also entitled to 20% of the earnings. In other words, shareholders are entitled to the amounts that are proportionate to their percentage shareholding. The same goes in the case of liquidation: a liquidation distribution is considered to be full payment in exchange for the shareholder’s stock, rather than a dividend distribution, to the extent of the corporation’s earnings and profits.
Bookkeeping and taxation
Each type of corporation has its own unique set of bookkeeping and tax requirements. While smaller corporations (S corporations) pass their earnings on to shareholders and reported on each owner’s tax returns, C corporations are a little more complex. The biggest disadvantage of C corporations is that they are taxed twice: first as a corporate entity and then on dividends paid to shareholders. A C corporation must file a Form 1120S each year to report its income and to claim its deductions and credits.
Income earned by a corporation is normally taxed at the corporate level using the corporate income tax rates shown in the table below:
|Taxable income over||But not over||Tax due|
|$0||$50,000||$0 plus 15% on amount over $0|
|$50,000||$75,000||$7,500 plus 25% on amount over $50,000|
|$75,000||$100,000||$13,750 plus 34% on amount over $75,000|
|$100,000||$335,000||$22,250 plus 39% on amount over $100,000|
|$335,000||$10,000,000||$113,900 plus 34% of amount over $335,000|
|$10,000,000||$15,000,000||$3,400,000 plus 35% of amount over $10,000,000|
|$15,000,000||$18,333,333||$5,150,000 plus 38% of amount over $15,000,000|
|$18,333,333||---||35% of amount over $18,333,333|
Although requirements vary across jurisdictions, C corporations are required to submit state, income, payroll, unemployment, and disability taxes. In addition to registration and tax requirements, corporations must establish a board of directors to oversee management and the operation of the entire corporation.
Advantages and disadvantages of corporations
The choice of which business structure to choose for your business is not an easy one. After all, your choice will have significant consequences on the nature and the success of the business, and once you’ve made your decision, it’s not so easy to change it. That’s why it makes sense to be informed about the advantages and disadvantages of the various legal structures, before you make your choice.
The fact that corporations offer the strongest protection to their owners from personal liability is probably the biggest advantage of choosing the C corp as your legal entity of choice. Your entrepreneurial risk is clearly laid out and straightforward. In addition, there’s the fact that C corps act as a legal entity that’s separate from its owners: Assets can be easily moved around and transferred – including buying and selling shares. When it comes to running a C corp, an optional division between shareholders and directors is a further advantage. An investor might want to invest in a company, but doesn’t have the skills or the desire to run it. For this, a corporation is the perfect solution.
A benefit of forming a corporation is certainly also the reputation that you gain in business life and in public life. Especially a C corporation is considered a solid option, since it operates separately from its shareholders.
But forming a corporation can also cause problems for new entrepreneurs. The complex process that involves registering your business with your state, getting a tax ID number, and filing appropriate licenses and permits can be daunting. In addition, corporations also require a higher start-up cost compared to other structures.
A further disadvantage of corporations is the taxation. Unlike sole proprietors, partnerships, and LLCs, corporations pay income tax on their profits. In some cases, they’re taxed twice: first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns.
|Limited liability||Start-up costs|
|Transferability of shares||Lengthy start-up process|
|External representation||Strict accounting guidelines|
|Public image||Profit taxation|
The difference between a partnership and a corporation
Many small business owners find themselves having to choose between forming a partnership and a corporation. The biggest difference between the two is that a partnership is not a separate legal entity and not a legal person, it is a “pass through entity.” This has several consequences: While a partnership does come with rights and responsibilities, the general partners owning the business are held liable for all company debts and legal responsibilities. In other words, the assets of the general partners will be taken to pay company debts in the case of an insolvency.
Taxation differs too: Since any profit or loss passes through to the general partners in a partnership, partnerships do not have to pay business taxes. Partnerships have to file a tax return with the IRS to report a profit or loss, which is also where the general partners must include their results. Further advantages compared to corporations are that partnerships are cheaper and simpler to form.
Partnerships are also often accompanied by partnership agreements which clearly state the percentage that each general partner has contributed and is responsible for.
|Legal person||Not a legal person|
|No individual liability||Full liability for debts|
|State and national tax, plus shareholders are taxed on their salaries||No business tax, but a tax return with profits and losses must be filed to the IRS|
|A lot of administrative fees||Less costly to form|