A Limited Liability Company, also known as LLC, is a much easier business structure to set up compared to corporations, such as an S and a C corporation. It provides flexibility and protection for the owners and shareholders. However, as with all business structures, you should consider all pros and cons of an LLC before deciding to form one.
Here are some advantages and disadvantages of a limited liabilities company to review before creating one.
Need to Know: Best Payroll Advice for small business owners.
What Business Types Should Choose to Become an LLC?
A limited liability company is a business structure in the United States, wherein the owners are not personally liable for the business's debts or other financial obligations. LLCs combine both pass-through taxation, such as in a sole proprietorship or partnership, and the protection and limited liability of its owners, such as in corporations.
To clarify, an LLC is not a corporation. It is a legal form of a company that creates the best of both worlds for business owners. LLCs provide protection and limited liability to their owners and have become one of the most popular business structures for new and small businesses. They have primarily considered more straightforward and more flexible than corporations are.
Forming an LLC makes your business become its own legal entity. Your company would have separate debts and legal matters but are still connected to your personal taxes. Additionally, regulations about LLCs vary from state to state.
Suppose you think you may need flexible business management and taxes, and asset protection, and have no plan of raising funds for your business, then a limited liability company is probably the best choice for your business.
An LLC is an excellent choice for small business owners, whether a partnership, a sole proprietorship, or a corporation with multiple members. It could operate without many of the formalities and complexities associated with a corporation, and at the same time, provide the same limited liability protection.
However, some business types are prevented from creating an LLC. Typically, the Internal Revenue Service prohibits financial companies, including insurance agencies, banks, and financial trust companies, from filing as an LLC. Additionally, LLCs are sometimes limited to certain industries in specific states. For example, if you are an accountant, a licensed healthcare provider, or an architect, you cannot form an LLC.
The requirements for forming an LLC may vary from state to state. However, there are still some common grounds across the board, which require you to provide the same information.
- Business Name
The very first thing business owners or company officials must perform is to choose the company's name. The name must be unique and not confusing. Additionally, the name must include the term "LLC" or "Limited Liability Company." Each state has its own unique set of name requirements that you need to know before finalizing the business name.
- Articles of Organization
Once you have selected the name of your business, the next item would be to document and file the articles of organization with the state the company is based. These articles establish the obligations of each member of the LLC, such as their rights, powers, and duties. Every state has a form that you must complete to create an LLC.
- Registered Agent
Some states require you to have a registered agent, who has residency generally in the state the business is forming, as a point of contact for all official paperwork. The agent does not need to have a position in the LLC.
- Business Licenses and Permits
Creating a company needs a variety of business licenses to operate in your state legally. Depending on the type of business you want to form, these licenses may differ from state to state. You may need to file tax registrations, zoning or land-use permits, health permits, general business licenses, and state-issued occupational licenses, among others. Be careful as filing all these forms in order could become overwhelming.
- Statement of Information Form
Along with your Articles of Organization, some states require you to file a Statement of Information as part of LLC formation documents. For example, California calls this form LLC-12r or form LLC-12. The form simply declares your company's name, the partners in the company, and the business address.
- Tax Forms
Filed along with other income tax documents, LLC tax form 1065 is the form you would need to use when filing a tax return on partnership income. LLCs and partnerships do not need to pay separate taxes, as they pass through all revenue and losses to the partners.
Form 7004 LLC tax extension form is used to file for more time to fill out your LLC taxes, giving you five months of extension to finish the tax documents. An LLC uses tax form 8832 if your partnership decides to elect a new tax standard. You could choose to be taxed as a partnership, corporation, or disregarded entity.
Good to Know: IRS Form 2553
- Operating Agreement
Although an Operating Agreement is not a part of the requirements when forming an LLC, it is very significant and highly recommended. This agreement helps create a group where you would not have an upset partner backing out at the last minute or unable to add a new member you want to consider.
The Operating Agreement states several crucial pieces of information, such as investment of additional capital, management structure, division of profits, and the process when a member of the LLC leaves or passes away.
- Limited liability
As the name suggests, limited liability is an LLC advantage that protects the owner as well as the shareholders from personal liability from debts and other financial obligations of the business.
- Pass-Through Taxation
While LLCs avoid dealing with "double taxation" experienced by corporations, they do encounter what is known as "pass-through" taxation. This type of taxation means that profits and losses are reported on every member or shareholder's individual tax return, whether or not they receive dividends. Pass-through means that an LLC typically does not pay taxes for itself. Instead, the burden falls on the owners.
- More Flexibility
While a limited liability company needs to file articles of organization with the state it is forming, it has a more flexible management structure compared to a corporation. This LLC advantage evolves from the phrase "unless otherwise provided for in the operating agreement." The flexibility allows business owners to create a structure customized to the company's requirements.
- Combination of Corporation and Partnership
One of the significant LLC advantages is that this type of business entity has characteristics of both a corporation and a partnership. Like a corporation, where the company acts as a stand-alone entity, an LLC separates the business and the owners. This divides the financial obligations of the company and the actions of the owners.
For example, if one member carries out an illegal act or puts himself in a lawsuit with a client, it would not affect any other members of the company and the business itself. A company with limited liability is operated much like a partnership, whereby managing the company allows for more flexibility compared to corporations with stricter guidelines.
- Perpetual Existence
Much like a corporation, a limited liability company has perpetual existence, meaning it has a life of its own. It could continue to operate and exist even after the members sell or transfer their shares or die.
- Multiple Tax Options
One of the LLC tax benefits you could take advantage of is choosing whether you want to be taxed as a corporation, partnership, sole proprietorship, or even as an S corporation. However, the owners of an LLC, called members, are responsible for paying self-employment tax that covers Medicare and Social Security payments.
- Fewer Compliance Issues
In some states, the benefits of an LLC also enjoy fewer compliance issues. This means that the business entity does not need to conduct an annual meeting and less paperwork and recordkeeping compared to a corporation. Additionally, an LLC does not need to have a board of directors.
- Unlimited Number of Owners
When forming a limited liability company can essentially have as many owners as it wants. While the IRS limits some business entities to 75 owners or less, LLCs could have more than 75 owners.
The owners of an LLC only act as investors like in a limited partnership. They have little or no say in the daily operations of the business. However, this should be clearly stated in the operating agreement of the company.
- Ability to deduct losses
To an extent permitted by law, active members of an LLC can deduct the business's operating losses against the member's regular income. However, this could be seen as a disadvantage to some members who do not want deductions in their income. Owners and shareholders of an S corporation could also deduct operating losses, as opposed to shareholders of a C corporation who cannot.
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Although there are many benefits of an LLC, there are also disadvantages of a limited liability company that you need to consider when forming a business. Here are some of the downsides of opting for an LLC status.
- Raising Capital and Funding
Some investors and venture capitalists may hesitate to put their money in an LLC due to the pass-through taxation and lack of a strict corporate structure.
- Additional taxes
Many states, including Texas, California, and New York, require LLCs to pay a "capital values tax" or a franchise tax to operate.
- Pass-Through Taxes
For some owners, pass-through taxation could become one of the disadvantages of a limited liability company. Due to pass-through taxes, some LLCs prefer a one-person owner situation. This allows shareholders to avoid pass-through taxation, as they may not appreciate being subjected to one.
- Less Structure
Unless the business creates a detailed operating agreement and puts it in place, the lack of strict requirements for governing and managing the business could mean problems along the way. Although, making an operating agreement would require the company to pay additional costs for attorney fees.
- Medicare and Social Security Taxes
In some cases, the owners of an LLC could pay more in taxes compared to owners of a corporation. Unlike corporations, which the IRS taxes only the salaries, an LLC pays taxes on both profits and salaries, making it larger in comparison. Social Security and Medicare taxes equal 15.3% and, as such, are a more significant disadvantage to LLC owners.
- Owners Should Recognize Profits Immediately
Shareholders in a C Corporation are not always subjected to tax based on the corporation's profits. This is because a C corporation does not need to immediately hand out its earnings to its shareholders in the form of a dividend. As such, as an LLC avoids double taxation, the company's profits are automatically included in an owner's income.
- Fewer fringe benefits
Fringe benefits refer to benefits that business owners give to their employees that go above and beyond regular financial compensation. They could include group insurance, medical insurance, medical reimbursement plans, and parking.
Unlike employees of a C corporation who do not have to report fringe benefits as taxable income, LLC employees must treat these fringe benefits as taxable income. This is also the case for employees who own more than two percent of an S corporation.
- LLC Termination
Regardless of when shareholders come and go, a corporation would still exist and operate unimpeded. This is the opposite for a limited liability company because the LLC will cease to exist when a member departs.
When deciding to form a limited liability company, make sure to consider all pros and cons of an LLC. If you want the business entity owners to have protection against business liabilities, an LLC could be the best choice for you. As easy as it may seem to create an LLC, it could also get complicated without proper guidance and knowledge.
Several websites could help you complete all LLC requirements needed to file. Before making the decision to create an LLC, consider talking with an accountant or tax attorney. They could guide you, help you, or even accomplish all paperwork for you.
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