When starting a business, choosing a business entity type is one of the most critical decisions. Many entrepreneurs choose a limited liability company (LLC) because it offers many benefits.
Read on to explore all the benefits and disadvantages of choosing LLC over the other legal forms.
What Is an LLC?
An LLC is a popular business structure for startups because it offers personal liability protection so that your assets are not at risk if your business is sued or cannot pay its debts.
In addition, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
Benefits of Starting an LLC
Let’s discuss the specific benefits of an LLC.
1. Simplicity of Administration
LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complicated.
In an LLC, the members do not have to answer to anyone. They ultimately control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power.
3. Limited Personal Liability
In LLCs and corporations, owners are considered separate entities from the business, so both structures offer personal liability protection. However, in a few instances, owners do have personal liability. For example, if an owner personally guarantees a bank loan, which is expected, they’re liable for that debt.
In a sole proprietorship, on the other hand, the business owner and the business are considered the same, so the owner is personally responsible for all obligations of the business.
As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
For corporations, the business income is taxed at the current rate for corporations (21% as of late 2022,) which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions.
However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings are more significant than those additional expenses.
5. Profit Sharing Flexibility
Most businesses, no matter the entity type, split profits based on owners’ capital contributions. Corporations pay dividends based on the ownership percentage of the shareholders.
With an LLC, on the other hand, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.
If you have a sole proprietorship, your name is the legal business name legally. However, an LLC allows you to choose your business name, lending greater legitimacy.
Disadvantages of Starting an LLC
1. Attractiveness to Investors
The main reason entrepreneurs choose a corporation over an LLC is because a corporation’s shares are easily transferred, making a corporation more desirable to investors, who can take partial ownership in the form of shares in exchange for their investment.
This is not the case with LLCs. LLC ownership is expressed in percentages rather than shares in the operating agreement. This makes it much more challenging to transfer partial ownership to an investor.
2. Profit Distribution
With an LLC, members must pay taxes on their share of the business’s profits, even if they are not distributed to members. So, if the LLC has one member and the LLC makes $100,000 in profit, the member must pay taxes on the entire $100,000, even if only $50,000 was distributed to them.
While LLCs are less expensive to form and maintain, they are more expensive than sole proprietorships or partnerships. This is because sole proprietorships and partnerships do not have to register with the state or file reports. On the other hand, LLCs have a cost associated with their formation with the state.
LLCs also must, in most states, file an annual report, which also comes with a fee.
As you can see, many reasons entrepreneurs choose to form an LLC exist. It’s much simpler to form and manage than a corporation, you have liability protection, and there are few rules about management and profit sharing. You also have flexibility in terms of taxes.
Consult an attorney and tax advisor if you’re unsure if an LLC suits you. It’s best to take your time and choose the option that will give you the best chance of success.