What are the advantages and disadvantages of LLCs? The key advantages of an LLC are limited liability protection, pass-through taxation, and simple operational and management structures.
And, the main disadvantages of an LLC are it can be difficult to transfer ownership, attract investment, and owners have to pay self-employment taxes.
WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF LLCS?
Are you a business owner and considering forming an LLC? LLCs are one of the most popular business entities in the US today.
What are the advantages and disadvantages of a LLC? And, why are they so popular? Below we run through everything you need to know about the pros and cons of an LLC.
LLC PROS & CONS OVERVIEW
ADVANTAGES OF LLC
LIMITED LIABILITY PROTECTION
One of the main advantages of an LLC is its limited liability protection. LLCs provide limited liability protection to their owners, also known as members. This means that owners can not be held personally responsible for legal actions or debts incurred by the company.
This level of protection is not available for sole proprietorships or traditional partnerships and is one of the key reasons many companies form as LLCs. Limited liability is not always guaranteed and can be waived in court in certain circumstances – such as fraudulent activity.
PASS THROUGH TAXATION
Another key advantage of LLCs is pass-through taxation. LLC companies do not pay any corporate tax. Instead, company earnings are distributed in full amongst the company members. Each individual then pays tax on these earnings in the form of a personal tax return.
In contrast, a corporation is subjected to double taxation. Company profits are first subject to corporate tax at a rate of 21%. And, once profits are distributed, each shareholder must pay income tax on these earnings. Check out our full guide on Tax Benefits of LLC.
EASY TO FORM
LLCs are relatively easy to form. Registration with your state authority involves the completion and submission of an Articles of Organization document. This document will be filed with your local state authority and involves the payment of a fee.
It is also highly recommended you create an Operating Agreement at this point. This document includes all the details on how the company is to be run and managed. It should be finalized and signed by all members at outset of forming the company.
While you can complete the formation process without any assistance if you are familiar with the process – must people hire an attorney or LLC filing service for assistance. For more see – LLC Formation.
EASY TO OPERATE
When discussing the advantages and disadvantages of LLCs, it’s important to consider operational flexibility and how it compares to other business entities. LLCs allow a great deal of flexibility when it comes to deciding how you want your company to be run.
Unlike corporations, there are no strict rules governing how the company is to be structured and managed. In fact, in most states, LLCs are free to create their own operational rules and document them in the Operating Agreement.
However, if you fail to create an Operating Agreement then your company will be run by the default rules that govern your state.
SIMPLE MANAGEMENT STRUCTURE
LLCs have a simple and flexible management structure. They can be either member-managed or manager-managed. In member-managed LLC the members take control of running the company on a daily basis. In a manager-managed company, the members hire managers to come in and run the company for them.
In contrast, a corporation has a much more rigid management structure. Here, the shareholders must elect a board of directors to run the company. The board must hold regular meetings and ensure all corporate regulations and paperwork are properly taken care of.
NO OWNERSHIP RESTRICTIONS
Most states impose no ownership restrictions on LLCs. Owners of an LLC are called members, and members can include individuals, corporations, other LLCs, and even foreign entities. And, there is no restriction on the number of members in an LLC – it can have unlimited members.
An LLC that has just one owner is known as a single-member LLC. And, an LLC with multiple owners is called a multi-member LLC. The absence of restrictions on ownership is a key advantage of an LLC.
TAX REGIME FLEXIBILITY
An LLC can choose how it wants to be taxed. By default, the IRS views an LLC as either a sole proprietorship or a traditional partnership for tax. This means the company benefits from pass-through taxation.
However, the LLC can elect to be taxed as an S Corp or a C Corp. When the company is first formed it is most likely in its interest to be treated as a sole proprietorship or a traditional partnership.
When the LLC begins to grow and becomes more profitable it may be in its interest to elect a new tax regime. For example, it may first switch to S Corp so that it can make savings on self-employment taxes.
Then, further down the road, it can choose to class itself as a C Corp if the potential savings made by splitting income outweigh the cost of paying corporate tax. The ability to elect tax treatment is a highly attractive feature of an LLC. For more see – How Is an LLC Taxed?
Credibility is a key issue when covering the advantages and disadvantages of a LLC. When you form an LLC you immediately generate greater credibility for your company. An LLC is seen as a more formal business structure than a sole proprietorship or traditional partnership.
And, this means it is better trusted by the general public. Just adding the letters LLC to the end of your business name will boost your company’s credibility.
PROTECT YOUR PRIVACY
Forming an LLC can help protect your privacy. When you form an LLC you can hire a Registered Agent Service and use their address as the official address of the company. This means you can avoid using your personal or even your work address.
Also, some states do not require the members’ details to be recorded on the Articles of Organization. If this is the case in your state, you can instead record the names of the company managers.
DEDUCT LOSSES AGAINST INCOME
LLC members can deduct company losses against their personal income – within the extent of the law. Deduction of losses is only available to members that play an active role in the running of the company.
An LLC is often regarded as the best company entity to serve as a holding company. A holding company is a parent company that holds the controlling stock or membership interests of other companies.
The holding company itself does not produce any goods and services as serves only as a vehicle of ownership of the subsidiary companies. LLC holding companies are used to provide liability protection to the subsidiary businesses it holds.
CASH METHOD OF ACCOUNTING
Another advantage of LLCs is they can choose to use the cash method of accounting. This means that cash is not entered onto the books until it is received.
In contrast, corporations must use accrual accounting methods. Accrual accounting dictates that income is earned when a transaction takes place and not when the payment is actually received. And, in many cases, there is a gap between the time payment is received and when the transaction was agreed.
USE OF LIVING TRUSTS
Members of an LLC can place their ownership interests in a living trust. It is more difficult for corporations to place shares in a living trust. A living trust is a legal document that allows you to distribute your assets to people and organizations after you pass away.
LLCs allow flexibility when it comes to the distribution of profits. In most cases, company profits are distributed amongst its members in line with each member’s ownership stake. But provisions can be made in the company’s Operating Agreement.
Members can choose to distribute earnings however they see fit. Corporations on the other hand must distribute profits in line with the proportion of shares held by each shareholder.
Liability protection is an attractive feature to any potential investor in your company. And, LLCs offer limited liability protection to investors. If you are looking to raise capital from outside sources for your company, an LLC may help by offering a layer of security and protection of personal assets.
A charging order is a court-authorized lien imposed against the distributions of a business entity. In the case of an LLC, if a member is taken to court and ordered to pay a creditor a charging order can be issued against that member’s earnings from the company.
The good news is that the order only affects that member’s earnings and all other members will continue to get paid as normal. Also, it does not affect the member’s role in the company and they do not lose any management rights as a result of the charging order.
DISADVANTAGES OF LLC
One of the key disadvantages for LLCs is that they do not appeal to potential investors in the same way as a corporation. If you plan to raise capital for your company by attracting outside investment, you may find that the LLC company structure limits your options.
Big investors prefer to invest in corporations. Corporations have been around longer and have many advantages including a clearly defined operating structure, easy transfer of assets, and well-established corporate law.
Additionally, LLCs cannot go public, while corporations can make an IPO (initial public offering). This happens when a privately owned company lists its shares on a stock exchange and makes them available for purchase to the general public.
TRANSFER OF OWNERSHIP
LLCs don’t have shares of stock and transferring ownership can be difficult, especially in multi-member LLCs. Many LLCs require agreement from all members before another member’s share can be sold to a new member.
And, it gets more complicated when it comes to management rights. If the share being sold belongs to a member that had a management role then questions have to be asked about the role the new member will play in the running of the company.
Adding provisions for transfer of ownership in the company’s Operating Agreement can streamline the process. However, corporations work best when it comes to transferring economic and management rights in a company.
LIMITED LIABILITY IS NOT GUARANTEED
One of the biggest disadvantages of LLCs is that the limited liability protection of the company is not always upheld by the courts. In certain circumstances, a judge may waive your limited liability protection if a case is taken against your LLC.
In the industry this is referred to as “piercing the corporate veil” and it places your personal assets in jeopardy for any claims or debts against the company. Two common scenarios that lead to loss of limited liability are – lack of separation between business and personal finances and fraudulent activity.
To protect the corporate veil of an LLC you must separate your business and personal finances. Do not use the business accounts to cover personal bills – there must be a clear separation between the two. And, avoid fraudulent activity.
SELF EMPLOYMENT TAXES
Another disadvantage of LLCs are self-employment taxes. Profits and salaries received from an LLC are subject to self-employment tax unless you choose to have your company taxed as a corporation.
The government considers the members of an LLC to be self-employed and therefore must pay self-employment taxes. These taxes are substantial and include Social Security and Medicare charges. Currently, they are being charged at a combined rate of 15.3%.
RESTRICTIONS ON CERTAIN GROUPS
Restrictions are in place to prevent certain groups from forming LLCs. For example, banks and insurance companies cannot form an LLC. Additionally, some professionals are restricted from forming LLCs but the rules vary from state to state.
While some states do not allow professionals such as doctors, accountants, and attorneys to form LLCs they may be able to form a PLLC – Professional Limited Liability Company. The rules vary from state to state and other types of professionals can form PLLCs in some jurisdictions.
When you form an LLC you will encounter formation costs. The costs vary depending on the state you choose to register your company but every state charges a fee.
You will have to pay a State Filing Fee when you file your Articles of Organisation with the state authority. This fee ranges from $40 to $500 depending on the state.
In addition to the filing fee, other charges may apply, including permit fees, publication fees, fictitious name fees, and name reservation fees. For more information see – How Much Does an LLC Cost?
In addition to formation fees, you will have to pay maintenance fees to ensure the continued registration of your LLC. Maintenance fees also vary from state to state but in general, an LLC must pay Annual Report Fees and Franchise Tax.
Annual reports capture an updated snapshot of all the pertinent details the state authorities need about your LLC. And, when you file a report you will be charged a fee.
A franchise tax is an annual tax that many states apply to LLC companies. It is usually charged at a flat rate but can vary depending on the company’s earnings.
CASE LAW NOT WELL ESTABLISHED
An LLC is a relatively new form of business entity. The first LLC was formed in Wyoming in 1977 and it wasn’t until the 1990s that the business structure became widely popular. This means it has been in common use for just 30 years.
The history of case law surrounding LLC companies is not as well established as it is for corporations – which have been around for much longer.
This means there is a degree of legal uncertainty surrounding certain areas of LLC operation. US courts are still defining their rulings on cases concerning LLCs.
INTERNATIONAL CORPORATE TAX
LLCs are often recognized as corporations in other countries. Many countries do not recognize the LLC business entity and therefore treat it as a corporation.
If you plan to do business in one of these foreign jurisdictions, your LLC will be charged corporation tax just like a C Corp. It will not benefit from pass-through taxation.
PROFITS IMMEDIATELY RECOGNIZED
Another disadvantage of LLCs is that profits are immediately recognized. The profits generated by an LLC automatically flow through to the LLC members in line with their pass-through tax structure. In contrast, a C corporation does not have to immediately distribute profits to its shareholders.
This has the benefit of meaning that shareholders are not always taxed on the corporation’s earnings. Corporations can choose to hold back profits for reinvestment or distribution as dividends at a later date.
FRINGE BENEFITS ARE TAXED
Fringe benefits are a topic that often crops up when discussing the advantages and disadvantages of LLCs. Fringe benefits are treated as taxable income in an LLC.
LLC employees that receive benefits such as medical insurance, parking reimbursement, and group insurance will have to include them in their tax returns and pay tax on them.
In many states, if an LLC member leaves the company – then the company ceases to exist. If an LLC member chooses to leave the company, goes bankrupt, or dies then the company will have to be wound down.
The best way around this is to include provisions for members leaving and joining the company in the Operating Agreement. Otherwise, if the remaining members wish to continue doing business they will need to create a new LLC from scratch.
CAN LACK CLARITY OF ROLES
A common disadvantage of LLCs is that they can lack clarity of roles. Unlike a corporation, that has a board of directors and formal positions that are well understood, the roles within an LLC are often not well defined.
This raises difficulties when conducting business with investors and suppliers. It can create confusion around who is in charge and who is in a position to speak and agree to deals on behalf of the company.
CHOICE OF COURT
Another concern when covering the advantages and disadvantages of LLCs is limitated options available in choosing a court. LLCs face restrictions when it comes to the choice of court that will settle a company dispute.
While LLCs are regulated by the state law in which they were registered – complications arise when they face a dispute that crosses state boundaries.
When it comes to a federal legal dispute, LLCs are often treated as partnerships and not corporations. This restricts your options when it comes to the choice of court to settle the dispute.
If you plan on forming an LLC, you have three options. You can form the LLC yourself by working through the process, you can hire an attorney, or you can hire an LLC formation service.
Nothing is stopping you from forming an LLC by yourself. There are several steps involved and you will have to complete some paperwork and forms, most notably, the Articles of Organisation and an Operating Agreement.
Forming an LLC can be a complicated and time-consuming process so most people choose to enlist some help. You can hire a business attorney to guide you through the process or engage a professional LLC formation service.
Hiring a business attorney is an expensive course of action and can easily cost in excess of $1,000. A much more cost-effective method is to hire an LLC formation service to process the application on your behalf. If you need some help choosing an LLC formation company, check out – The Best LLC Formation Company Reviews.
FAQ – ADVANTAGES AND DISADVANTAGES OF LLCs
WHAT IS AN LLC?
An LLC is a business structure that combines the advantages of pass-through taxation of a partnership or sole proprietorship with the limited liability protection of a corporation. An LLC is recognized as a legal entity separate from its owners. For more information see – What Is a LLC?
HOW DO YOU FORM AN LLC?
The steps involved in forming an LLC vary from state to state. However, the most critical stage is the completion and filing of your company’s Articles of Organization with your local state authority – usually the secretary of state. For more information see – How To Start An LLC Business.
WHAT IS THE BIGGEST ADVANTAGE OF FORMING AN LLC?
The biggest advantage of forming an LLC is limited liability protection. This means that an owner’s personal assets are protected from the debts run up by the company. In most cases, an owner’s personal assets such as their house and bank accounts can not be used to pay off company debts or to cover legal actions against the LLC.
WHAT IS THE BIGGEST DISADVANTAGE OF FORMING AN LLC?
The biggest disadvantage of an LLC is that they are not as attractive to investors as corporations. If you are forming a company and want to raise capital by attracting an outside investor then you may want to consider forming a corporation instead. Investors prefer to invest in corporations.
AT WHAT POINT SHOULD I FORM AN LLC?
If you are a sole proprietor or a partner in a traditional partnership you should form an LLC if you want to protect your personal assets. An LLC offers protection to its owners by ensuring their assets cannot be used to cover company debts.
About the Author
Jason Roth: Editor in Chief
Jason is editor in chief at My LLC Guide. He holds a wealth of business management experience and has been advising companies on business formation issues for many years. Jason specializes in resource planning management, staff utilization, and productivity consulting.
He has worked predominantly in the west coast area where he graduated from the Marshall Business School at the University of South California. When he’s not working in his business advisory role, Jason likes to climb on his Indian Scout motorbike and enjoy the open road.