A frequent question when forming a business entity is whether to choose a corporation or a limited liability company (LLC). Both entities offer personal liability protection for the owners, but there are some differences. Knowing the origins of business entities can help in deciding which type to choose. Regardless of your entity choice, the biggest factor is creating a shield against personal liability.
Before business entities, a business operated as either a sole proprietor or a partnership, and in both cases business owners had no liability protection against creditors. Eventually, a separate legal entity called a corporation was created. Instead of owning the business assets directly, the business owners hold shares, and are not personally liable. However, as a separate legal entity, the federal government taxed the corporation separately, so both the corporation and the shareholders paid taxes on the business income.
The S-corporation is formed
The “S-corporation” (or small business corp.) was then created. It pays no income taxes and all income and loss pass through to the shareholders. To prevent huge corporations from using this tax benefit, the number of S-corporation shareholders is limited to 100 individuals, who may also have only a certain level of stock.
The LLC emerges
The LLC was created with the goal of achieving a blend between a partnership and an S-corporation. An LLC still had a liability shield and “pass through” taxation, but allowed multiple levels of ownership, allowed owners to allocate profit and loss differently from their ownership percentages, and owners were not required to be individuals and could be any type of entity.
The most common choice today
These days most new construction entities my law firm forms are LLCs because of the flexibility and also based on how taxes are paid. S-corporation shareholders are employees, with payroll taxes deducted from their checks and the corporation paying employer matching taxes. In contrast, LLC owners are not employees, and no taxes are withheld from their paychecks. Instead, LLC owners pay “self-employment” taxes and submit “estimated tax” payments to the government on a quarterly basis.