The Pros and Cons of an LLC: Decide on Your Business Structure
Company structure is the first thing to think about when starting a business: The way you form your enterprise will impact everything from your money-raising options to the tax rate you’ll pay.
The limited liability company, or simply the LLC, has mushroomed in popularity over the last two decades, especially among small-business and startup owners. Although opting for this business structure seems like a no-brainer for many entrepreneurs, it’s essential to keep in mind that limited liability companies carry several disadvantages for their owners, too. To learn more about the pros and cons of an LLC, keep reading this article.
What Is an LLC?
Before we dive into all the blessings and hurdles you may face as an LLC owner, let’s start by defining this type of business structure.
A limited liability company is a hybrid concept that marries the liability protection of a corporation with the flexibility, simplicity, and tax advantages of a partnership. An LLC can have one or many owners, officially called “members.” Individuals, other LLCs, corporations, or foreign entities can all be LLC members, and there are no limits to how many members a limited liability company can have.
Certain business types, such as insurance companies and banks, generally cannot be formed as LLCs. Despite these restrictions, more than 2.4 million US businesses identify as limited liability companies today. According to the IRS, this is the country’s fastest-growing business variant.
To help you decide whether structuring your new business as a limited liability company is a wise choice, we’ve compiled a comprehensive list of LLC advantages and disadvantages. Let’s get started.
The Advantages of an LLC
An LLC is a cost-effective and low-risk option for small businesses, especially entrepreneurs just getting their self-employment bearings. Here are the good sides of filing as a limited liability company:
Limited Personal Liability
As the name suggests, your liability as an owner is limited, which means that the members’ personal assets - bank accounts, investments, inheritance, homes, and vehicles - are protected from people and organizations looking to collect from the business. That protection is one of the most apparent benefits of an LLC and remains in place as long as you keep your personal and business finances separate.
Liability protection can be the difference between losing your business and crossing the poverty line, so this feature alone is appealing enough to entrepreneurs trying to take the edge off personal risks and protect their valuable assets.
Business liabilities and financial loss can mean many different things, but here is what running your company as an LLC shields your personal assets from:
- Business failure
- Unpaid debts
- Unmet obligations
Easy Cash Distribution
The LLC advantages are not just legal - they’re also monetary. For one thing, an LLC eases the profit distribution to company members - although not in the form of salaries but as profit distributions or members’ draws from the company’s profit accounts. So, why is this appealing? Well, neither the draws nor the money your business receives is taxed: All you have to do as an LLC member is report your share of the company’s profits when filing your personal tax returns.
So how does an LLC work when it comes to taxation? Unless its owners choose otherwise, a limited liability company is a pass-through or a flow-through entity, which means that the company revenue goes directly to its members, bypassing corporate income tax. Instead, as we have already mentioned, the profits of an LLC are taxed on its members’ federal income tax returns. Not only does this simplify the tax filing procedure, but it also helps LLC owners save substantially on taxes by avoiding double taxation.
The tax benefits of an LLC also include potential tax deductions. For example, the Qualified Business Income (QBI) deduction offers LLC owners a 20% deduction from the business’s net income. What’s more, this perk comes on top of the standard business expense deductions.
An LLC can either be managed by its members (member-managed LLC), which allows all owners to share in the company’s day-to-day decision-making, or by a manager or managers (manager-managed LLC). The managers can be company members, or they can be outsiders. The option of setting up an LLC as a manager-managed entity and hiring a professional for this role comes in handy when members lack the experience for running a business. Note that many states consider all LLCs member-managed by default unless explicitly stated otherwise in your filings with the Secretary of State.
Ease of Filing
Paperwork-wise, forming an LLC is a relatively simple task. However, be sure to look into the policies of your business-formation office beforehand, as you might be eligible for a wide variety of state-specific fees and LLC taxes. For example, Kentucky’s filing fee for the articles of organization is $40, while the same service in Illinois will set you back either $150 or $400. Cost variations aside, the process is straightforward enough for aspiring business owners to handle on their own - most state websites offer to walk users through the paperwork in less than an hour. However, reaching out to an LLC service company, a legal services firm, or an accountant for help is always a good idea.
As far as LLC upkeep goes, ongoing requirements usually come on an annual basis.
When weighing the pros and cons of an LLC, it’s important to remember that establishing your company as an LLC lends you credibility for all future endeavors. It means that you’ll have to deal with more formalities, paperwork, and additional obligations; however, you’ll get a more formalized structure than a sole proprietorship or a partnership in return. Given that an LLC offers all the aforementioned types of protection and tax benefits, this is the type of business many entrepreneurs decide to transition to once their company has grown enough.
The Disadvantages of an LLC
From management flexibility to tax benefits and limited personal liability, opting to structure your business as an LLC seems like an easy choice. However, before you make your final decision, remember that there are two sides to every coin. The concept of a limited liability company also has drawbacks we suggest you consider before sealing the deal.
Limited Liability Has Limits
Contrary to popular belief, limited liability is not foolproof - in a legal proceeding, a judge can rule that limited liability doesn’t protect your personal assets. This disadvantage of an LLC is sometimes referred to as “piercing the corporate veil.” LLC owners can be at risk of vulnerability to business losses in the following circumstances:
- If a member commits any type of fraud, including tax fraud
- If a member gives their personal guarantee for a business loan or debt
- If a member personally and directly damages a fellow LLC member or another individual
- If a member intentionally commits a crime against the company or an individual
You might think running an LLC comes with tax benefits only, as pass-through taxation is one of the most important reasons entrepreneurs choose to form their businesses as limited liability companies. However, running a business means reporting to the IRS, and with this business structure, you may have to deal with a long list of miscellaneous taxes, such as:
- Employment taxes
- Self-employment taxes
- Personal or corporate taxes
- Franchise taxes
- Excise Taxes
- K1 forms for individual members used to report tax liability and share of ownership
Limited Investment Opportunities
When looking at the pros and cons of forming an LLC, it’s important to take potential financing avenues into account. While limited liability companies have quite a few investment options such as equity financing, debt financing, fundraising, and crowdfunding, they can’t count on outside investors. Considering that an LLC can’t issue shares as a corporation can, the only way for a private or an angel investor to make a financial contribution is to become a member and thus a co-owner of the LLC. You might think this isn’t too different from selling shares, but it might completely disrupt the way your company works and its decision-making process.
Maintenance and Paperwork
Starting an LLC may be uncomplicated paperwork-wise, however, maintenance is often a completely different story. Depending on the state, LLC owners may be required to submit annual reports to keep their company in good standing. Moreover, these reports often come with fees and meticulous paperwork.
Additionally, because of the flow-through taxation to the owner’s personal income tax return, running an LLC means that you have to be careful with keeping separate financial records (and separate bank accounts) for your company and yourself to avoid any personal liability.
Member Turnover Has Consequences
While creating an LLC is a relatively simple and low-risk business formation avenue, things can turn quite ugly in the long run. Even though its ownership/membership structure is highly flexible and doesn’t impose limits on the number or type of owners, any change to the original infrastructure may lead to an LLC refiling. In other words, in many states, if an LLC member goes bankrupt, leaves the company, or dies, the other members may be obligated to dissolve the business and go through a reformation with the current membership.
Starting an LLC
Should you decide to proceed with LLC formation, here are the steps you’ll need to take:
1. Choose Your Filing State
Your filing state will probably be the state you live in. However, make sure that it’s also the state where you plan to conduct business. Keep in mind that no two states have exactly the same filing procedures and fees, so start the process by paying a visit to your Secretary of State’s website.
2. Pick a Name for Your LLC
You must file your LLC under a unique name in the state (or states) where you intend to do business. To ensure that your preferred moniker is not already in use, conduct a thorough search of County Clerk offices, online directories, and the Secretary of State’s website in your states of choice. Fortunately, many states let you reserve a name until you’re ready to file your articles of organization.
3. Appoint a Registered Agent
Choosing a registered agent means assigning an individual or company to receive all regulatory and legal documentation on behalf of your business. Put simply, a registered agent is an LLC’s official contact.
4. File Your LLC With Your State
While discussing the advantages and disadvantages of an LLC, we mentioned that ease of formation is one of its strongest points. Creating one mainly consists of filing the articles of organization - a document outlining the company’s basic features such as its name, location, business purpose, management structure, and the registered agent’s identification.
5. Create Your Operating Agreement
An operating agreement isn’t a requirement. It is extremely handy, however, especially if you run an LLC with multiple members. Depending on the state, the agreement can either be oral or written. Either way, this document should contain information about your membership structure, the duties and powers of members and managers, voting rights, and how profits and losses should be distributed.
6. File for an EIN
While talking about the pros and cons of a limited liability company, we stressed that this type of business entity comes with several tax benefits and a few tax-related disadvantages. However, no profits or taxes can be made or paid without filing for a business Employer Identification Number (EIN). This step is mandatory if the owners intend to hire employees or open a business bank account.
7. Open a Business Bank Account
Establishing a business checking account helps draw a clear line between your company and personal affairs. It also minimizes the risk to your personal assets if your LLC’s practices are called into question by a lawsuit.
When looking at the lists of pros and cons of an LLC, you’ll find the limited liability feature among both the advantages and the disadvantages. Why is that? The answer is relatively simple. While the LLC does offer limited liability - its members’ personal assets such as bank account, investments, heirlooms, homes, and vehicles are protected from creditors seeking to collect from the business - that liability has its limits, and you won’t be protected if you run the business fraudulently.
Yes, you can. You will remain personally liable for any lawbreaking you perform while running an LLC business, no matter if the wrongdoing is related to the company’s operations or not.
An LLC can still be sued after termination. Nevertheless, if the company’s members manage to dissolve the company properly, the chances of a successful lawsuit will be slim.
Given that LLCs are legally considered separate from their owners/members, creditors can only pursue assets that belong to the limited liability company. The members’ personal belongings remain protected unless they face the action of “piercing the corporate veil.”
While speaking of the pros and cons of an LLC, we’ve mentioned easy cash distribution as one of the benefits of this business model. The members are not paid salaries, but they get profit distributions or members’ draws from their share of profit accounts.
Albert Einstein is said to have identified compound interest as mankind’s greatest invention. That story’s probably apocryphal, but it conveys a deep truth about the power of fiscal policy to change the world along with our daily lives. Civilization became possible only when Sumerians of the Bronze Age invented money. Today, economic issues influence every aspect of daily life. My job at Fortunly is an opportunity to analyze government policies and banking practices, sharing the results of my research in articles that can help you make better, smarter decisions for yourself and your family.
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