A limited liability company (LLC) is a unique business structure. It combines the elements of a sole proprietorship, corporation, and partnership into one company. If you are looking for a way to limit personal liabilities while performing commercial activities, this option is one of the best structures that you can use in the United States. Before organizing your business, you will want to consider the industry to which you belong, your overall personal assets, and what your liability risks are in this matter.
A limited liability company means that it’s members, which are the owners, are usually not responsible for litigation or debts that are business-related. If the company files for bankruptcy or faces a lawsuit, then personal money doesn’t get used to pay the debt.
The IRS still considers LLC taxes to be pass-through income in the same way that a partnership or sole proprietor earns. You don’t pay business taxes because the LLC isn’t a corporation by default, but the members can decide to get taxed as a corporation if they prefer. The government requires firms that choose this option to follow corporate tax law and filing requirements.
Several advantages and disadvantages of limited liability companies are essential to review before going through the incorporation process. Here’s what you need to know to get started.
List of the Advantages of a Limited Liability Company (LLC)
1. LLCs have management flexibility that other structures don’t provide.
A limited liability company can decide to be managed by its members. This advantage allows every owner to share in the daily decision-making of the agency. The business can also decide to hire managers that take care of this responsibility on behalf of the members. These individuals can be outside of the original ownership.
This benefit is useful for limited liability corporations where the members are not experienced in running a company or operating within a specific industry. Most states will default to the member-managed format when filing for the business, but the owners can explicitly state that they want to go in the other direction.
2. You can earn pass-through profits for federal taxation with an LLC.
A limited liability company receives classification by the IRS as a pass-through entity unless the agency explicitly states otherwise when filing to become a business. This advantage means that the profits go directly to the owners without being taxed by the government as a business income first. That means the income gets taxed on the federal income tax returns of each member instead.
That means it is easier to file taxes as a business owner when compared to the corporate responsibilities that exist. If your company loses money under the LLC structure, then every owner shares the hit on their returns. It is a benefit that can lower individual tax burdens.
3. LLCs offer limited liability as its name suggests.
The limited liability company structure makes it possible for the owners to not be held personally liable for the actions of the company. This benefit means that the personal assets of each member, such as a house, car, investment, or bank account, receive protection from creditors who tried to collect business debts. This protection remains in place as long as the business remains active, assuming that the personal financial records are kept separate from the business ones.
4. It is very easy to start an LLC in every state.
If you want to start a business that provides personal asset protection, then the LLC is the easiest structure to form in the United States. The initial paperwork and fees are usually easy to manage, with filing fees as low as $50 for the articles of organization in some states. Although Illinois and Nevada charge hundreds of dollars for the initial formation responsibilities, the process is still simple enough to navigate for the average person. That means members don’t need to pay for special expertise if they want to begin commercial activities.
5. LLCs have no restrictions on the number of partners or owners.
A limited liability company can begin with any number of owners. A single-member LLC is a fairly common structure in the United States. Some states allow for these companies to have multiple layers of ownership that include other businesses with the same structure. This advantage occurs most often with branded retail products, real estate entrepreneurs, and the pharmaceutical industry.
There no limitation on the number of partners or members that have affiliation with the limited liability company. This benefit is different than other structures, such as an S-corporation, that caps the number of stakeholders at 100.
6. LLCs allow for unrestricted pay to partners and owners.
A limited liability company isn’t restricted on how it decides to pay its partners or members. Each owner can receive more or less compensation than what their respective share of ownership happens to be. This advantage also applies to the tax write-offs that are available for expenses and reimbursements that get paid through personal guarantees.
The biggest difference between LLC owners compared to corporations is that the IRS doesn’t recognize the right of the limited liability company to pay salaries to its owners. LLC payments to members or partners get treated as draws. It doesn’t count against partnership income, leading to a potential misalignment of tax burdens in some situations.
7. It doesn’t take much information to start an LLC.
Most states only require you to file the articles of organization with your local jurisdiction and pay the required fee to begin a limited liability company. This document requires only basic information about the company’s members. If you know the name of your business, it’s location, and the addresses of each owner or registered agent, then you can begin commercial activities. That means no legal representation is necessary to get started.
Most states allow you to file the articles of organization by mail or fill out the documentation online so that you can save a trip to the filing office.
8. You can convert an existing business to an LLC.
If you already have a partnership or work as a sole proprietor, then you have the option to convert your business to a limited liability company at any time. The tax structure does not change when you take this action. You just have more paperwork to manage over the course of the year. Some states only require you to fill out a certificate of conversion to take advantage of this benefit.
You may need to fill out articles of organization to start an LLC from scratch, and there might be a requirement to transfer your state and federal employer identification numbers. If you have a sales tax permit, business license, or professional certification, then these may have transfer fees associated with this process. Then you can receive the liability protections that this structure provides.
9. No residency requirements exist for an LLC.
If you want to start a business in the United States with someone who isn’t a permanent resident or US citizen, then a limited liability company is one of your best options. The only residency requirements that exist are on the state level. You might need to have a registered agent available for mailings and notifications if your headquarters are in a different jurisdiction. You can take care of that requirement while your partners or fellow owners enjoy living internationally.
List of the Disadvantages of a Limited Liability Company (LLC)
1. Owners face a self-employment tax under the LLC structure.
When you form a limited liability company, then the pass-through income benefits come with the same disadvantages that partnerships and sole proprietors face each year when filing taxes. The IRS considers an LLC as self-employment. That means each owner is personally responsible for paying the individual and business Social Security and Medicare taxes. This figure is based on the total net earnings of the company, and it is 15.3% for the 2019 filing year.
You do have the option as a limited liability company to be taxed as a corporation to avoid this issue. Then you and any other owners would pay the employee share of the Social Security and Medicare taxes only. The downside of this activity is that you then need to follow corporate tax law.
2. Member turnover can cause the LLC to dissolve immediately.
If an owner leaves the company for any reason, then most states require the LLC to dissolve immediately. The remaining members become responsible for whatever legal and financial obligations exist to terminate the business. It is still possible to form a new company with those who remain, but this disadvantage requires the new limited liability company to start from scratch. There isn’t an option to buy, sell, or transfer shares because the corporate structure doesn’t exist.
This disadvantage can make it difficult for an agency to exist indefinitely. If you have concerns in this area, then the formation of a corporation is the only way to avoid this issue.
3. There are limits to the liability restrictions that LLCs offer.
A judge can rule that the structure of your limited liability company doesn’t protect your personal assets in a court proceeding. This action, when it occurs, is referred to as “piercing the corporate veil.” Any company runs the risk of experiencing this disadvantage if they don’t keep their business transactions separate from their personal accounts. It is also possible to receive this ruling if the owners are shown to have operated the agency fraudulently in ways that resulted in losses for other people.
4. Some LLCs must pay additional taxes because of their structure.
Several states have started taxing limited liability companies because of the advantages that the structure provides to its members. Texas, New York, and California are three examples of many that require agencies to pay franchise or capital values taxes based on their commercial activities. This disadvantage applies to even one-person LLCs.
5. Investors are hesitant to put money into LLCs.
Because of the pass-through taxation benefits and the lack of a corporate structure, venture capitalists and angel investors are less likely to put money into these businesses. It is the same disadvantage that partnerships and sole proprietors face when pursuing an idea. Some owners can avoid this disadvantage by choosing to get taxed as a corporation because that requires them to follow the existing corporate law, but the lack of equity in a company can make it difficult to receive a legitimate investment offer.
6. Limited liability companies don’t issue shares.
Although a limited liability company can legally have any number of owners, the administration of the business becomes more of a challenge as the number of partners rises. This disadvantage is due to the fact that the LLC structure does not permit the issuance of shares that can be bought, sold, or redeemed. That’s why it is sometimes beneficial to pursue a C-corporation status if there are numerous stakeholders involved in the pursuit of an idea.
7. The fees to start an LLC could be a disadvantage for some people.
If you are the only person who will be an owner of the limited liability corporation, then the fees to start this business are going to be higher than what they would be if you were a sole proprietor. Although the licensing and permit costs are typically the same with either structure, you must go through the application processes that are not necessary with the more informal company option.
The investment into forming a limited liability company gives you more asset protection without changing your overall tax structure, but there are more reporting responsibilities to follow. These administrative tasks come with time and monetary investments that you must consider when evaluating the advantages and disadvantages of an LLC.
You will need to choose a DBA name when you become an LLC. It can still be your name if you wish or that of your partners, but the filing requirements and costs are still part of the additional fees you must expect.
8. There are additional tax forms that you must file as an LLC.
The process of preparing your taxes becomes more complex when you decide to become a limited liability company. Even if you decide to be a pass-through entity, you must still prepare K-1s to file for each member of the firm. These documents must get filed with every member’s personal tax return as part of their Schedule C. This disadvantage applies even if there is no money coming in or out of the business.
An LLC must prepare its own tax filing each year, so most members choose to get taxed as a partnership. Franchise and excise taxes may require additional filings.
9. Owners get taxed on their respective share of the profits.
One exception to the IRS rule of taking draws from the company as income involves guaranteed LLC payments. The organization can choose to pay members as a way to reimburse them for the use of capital by the limited liability company. This option also applies if a member provides a service or another benefit to the agency. If you have partners in the company and each takes a draw that is not directly proportional to our respective ownership share, then it is possible to get taxed on more than what you actually earned from the LLC.
10. Some firms do not receive the right to form a limited liability company.
If you are a solo entrepreneur, then most states allow you to form a limited liability company without an issue. It typically only requires one member to form an LLC. This benefit does not apply to companies that operate in specific industries. If you are trying to start an insurance company, banking business, or a trust, then a different business structure is necessary to begin commercial activities.
Some states do not allow doctors, accountants, licensed healthcare workers, or architects to form a limited liability company. If you have any questions regarding this matter for your jurisdiction, then you must direct your questions to the appropriate agency that issues licenses and permits.
11. You might need to publish your intent in the local newspaper.
Although you don’t need much documentation beyond the articles of organization to start an LLC, some states do require you to publish an intention to form. This information gets put into the local newspaper so that any objections to your activities can become known before you begin commercialized work. You might need to have an LLC operating agreement to meet this stipulation, which is an optional document in other states.
If you do put together an operating agreement, then the documentation should spell out how each owner divides profits. It should also dictate how business decisions get handled, and there should be coverage about how new partners can come into the agency. This process ensures that the company operates by its own rules instead of the default ones mandated by the state.
12. There could be tax recognition of your existing assets with an LLC.
If you decide to convert an existing business to a limited liability company, then there could be tax recognition on your appreciated assets. This is another way that extra taxation can occur when you want to gain the benefit of this business structure. These concerns are unique to each situation, so it is best to consult a tax advisor if you plan to convert a sole proprietorship or partnership to an LLC.
A limited liability company is an ideal option for entrepreneurs who want to establish a business as a stand-alone entity. It is also suitable for anyone who wants to limit their liability by segregating the company’s financial records from the owner’s personal assets. These benefits apply even though the LLC is usually the easiest and cheapest kind of company to create outside of a sole proprietorship.
An LLC isn’t always the best choice in every scenario. If a business is not to the point where an owner requires liability protection, then the expense of forming a limited liability company doesn’t make sense. A large company that requires robust structures or engages in the practice of licensed professions might require incorporation instead.
These limited liability company advantages and disadvantages are just the beginning of the process of forming an agency. Every business has unique needs that its owners must meet to create a successful foundation. The key points in this guide are intended for reference only, and it should not serve as a substitute for localized professional advice.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.