When launching a startup, every entrepreneur must decide on the optimal legal form for operating their business.
Though many small businesses owners start as sole proprietors, forming an LLC is a sound decision in many cases. This post explains the pros and cons of operating as an LLC.
Here’s a short video explaining the advantages and disadvantages of an LLC:
LLC pros and cons: comparison table
Easy and low-cost company incorporation process.
Ongoing maintenance costs, including annual reports, minimum annual taxes, designated representative annual fees, and tax compliance costs.
|Liability||Personal liability protection from liabilities of LLC.|
“Corporate veil” may be pierced if members commingle personal and business funds.
Members may be liable for personal acts of fraud or deception.
|Management decisions may be decentralized or centralized depending on the operating agreement.||LLC assets may be exposed to the decisions of multiple members.|
|Taxation||Flexible tax classification: C corporation, S corporation, partnership, sole proprietorship.|
Opportunity for a lower income tax burden.
Different tax treatment at the federal and state levels.
Minimum franchise tax due in some states.
|More opportunities than a sole proprietorship.|
LLC interests may be used as secured collateral under the UCC.
Not as many opportunities as a corporation has.
Advantages of an LLC
Flexibility, ease of formation, perpetual existence, limited liability for all members, tax benefits, and low cost of maintenance make LLCs an attractive choice of entity for small business owners.
Liability protections for owners
A limited liability company can protect the members’ personal assets from the entity’s debts. However, the LLC protection is not absolute. An LLC member can be personally liable for illegal acts, personal guarantees, and where the member commingles personal assets with LLC assets.
Flexible management structure
A limited liability company offers the ability to have centralized or decentralized management of LLC operations. Generally, there are two types of LLC management structures. The first is a member-managed LLC. The second is a manager-managed LLC.
In a member-managed LLC, management responsibility is shared by the members. In a manager-managed LLC, one, or a few people, are chosen by the members to manage the LLC.
The flexibility to decide whether and to what extent to centralize business management separates LLCs from corporations or partnerships.
A limited liability company offers several options to members of an LLC concerning its tax treatment for federal and state purposes.
For tax purposes, an LLC may be treated as a disregarded entity — i.e., as a sole proprietorship if there is only one member or a partnership if there are multiple members. LLCs can also elect an alternative tax classification such as a C-corporation, an S-corporation.
If the LLC has one member, the LLC is treated as a disregarded entity (i.e., a sole proprietorship). As a sole proprietorship, the owner reports LLC income on Schedule C of their Federal 1040 and pays personal income tax. The owner also pays self-employment taxes on LLC business income.
If the LLC has multiple members, the LLC is treated as a partnership. The LLC reports income from operations on Federal Form 1065. LLC members also receive a Federal Form K-1 showing the members’ share of LLC profit or loss. The member then reports this information on their personal tax return.
Either a single-member LLC or a multi-member LLC may elect to be treated as a C-corporation for tax purposes. C-Corps are subject to double taxation.
First, corporate income is taxed at 21%. Second, dividends received by shareholders of corporations are taxed to the shareholder on their personal tax returns. Progressive tax rates apply.
An LLC that elects to be treated as a corporation may also elect “S” status to avoid corporate tax. As an S-corporation, LLC income is reported on the members’ tax returns similar to a partnership.
However, unlike a partnership, LLC members may be employees of an S corporation. It can offer tax benefits, including lower self-employment taxes, as you won’t be covering such social security payments as Medicare.
More investment opportunities
Because of the ease of formation, limited liability, pass-through taxation, low maintenance costs, and flexible management, a limited liability company is an excellent vehicle many savvy entrepreneurs use to pool money for various investments such as stocks, commodities, and real estate.
Easy ownership transfer
Like a corporation, an LLC is a legal entity separate from its owners and may be bought and sold. While a corporation sells its stock certificates, an LLC sells membership interests.
The ability to sell LLC member interests differentiates an LLC from a sole proprietorship. To sell a sole proprietorship, the business owner must sell all the separate assets of the business.
Access to business capital
For the same reason, it is easier to add new members or transfer an interest in an LLC. It’s also easier for an LLC to raise capital. An LLC can raise capital by issuing member interests to new members in exchange for capital.
Also, an LLC can raise capital by borrowing from banks using the LLC member interests as security.
Further, the formality of being a separate legal entity lends credibility to the business.
For this reason, lenders and investors are more receptive to investing in the business, and it is easier to seek financing through crowdfunding, government grants, etc.
Cons of an LLC
While an LLC is a terrific type of business entity. It’s not perfect.
Here are the disadvantages of incorporating as an LLC.
Extra LLC maintenance costs
A limited liability company does have additional maintenance costs not associated with a sole proprietorship.
During the company formation state, these include fees to the Secretary of State for issuing Articles of Organization. There are annual report fees, state business license fees, registered agent fees, state minimum taxes, and tax compliance costs.
A limited liability company has certain annual compliance costs not associated with a sole proprietorship.
For example, LLCs are subject to extra state requirements such as:
These add up both as costs and extra time for admin work.
Inability to issue stocks
A limited liability company issues membership interests while a corporation issues stock. These two instruments may function alike, they are very different.
Historically, corporate stock is easier to transfer than LLC membership interests. Also, it has traditionally been easier to raise capital by issuing stock than issuing LLC member interests.
If you are in the enviable position of “going public” with your business, it is easy to convert your LLC to a corporation.
Limits on liability
While an LLC offers protection from LLC business debts, there can be instances where LLC owners become liable.
For example, where a creditor “pierces the corporate veil” because a member commingles personal assets with LLC assets across bank accounts.
Also, an LLC member may lose their limited liability protection and be personally liable for his actions in certain circumstances. It would be the case if the member represented that he was not acting on behalf of the LLC or if the member’s actions were illegal.
Here’s a quick summary of LLC pros and cons you should know.
- Asset protection through limited personal liability
- Ease of formation
- Low filing fees
- Low cost to maintain
- Flexible management structure and sharing of company’s profits
- Flexible tax treatment
- Transferability of interest easier than a sole proprietorship
- Credibility with investors and lenders
- Ongoing maintenance
- State minimum taxes
- Registered agent fees
- Tax compliance
- Different tax treatment at the federal and state level
- Member interests are not as freely transferable as corporations
This material is provided for informational purposes only. The provision of this material does not create an attorney-client relationship between Paul Donovan and/or Donovan Legal PLLC and the reader and does not constitute legal advice. Legal advice must be tailored to the specific circumstances of each case, and the contents of this article are not a substitute for legal counsel. Do not take action in reliance on the contents of this material without seeking the advice of counsel.