You may have heard of a limited liability company or the term “LLC,” but what exactly does it mean? If you’re getting into entrepreneurship, chances are you’ve come across LLCs and may have even been encouraged by family and friends to start one.
It’s important to become intimately familiar with an LLC before choosing it as your company’s structure. As with any other business entity, LLCs have pros and cons, and weighing them is a critical decision for a new business owner. Fortunately, this guide contains valuable information to help you get started.
What is an LLC?
An LLC is one of the most common US business structures. Business owners often choose it over other business entities because it removes the owner’s responsibility for the company’s debts and liabilities.
An LLC is a popular business structure for startups because it provides liability protection, ensuring your assets are not at risk if your business is sued or cannot pay its debts.
Also, 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 on Schedule C.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
While there are several benefits to starting an LLC, here are three top advantages.
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. Instead, they fully 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.
Personal Liability Protection
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 common, they’re liable for that debt.
Compare this to a sole proprietorship, in which the business and the business owner are legally seen as the same, making the owner personally responsible for all obligations of the business.
LLCs and Taxes
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 in that 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 keep in mind 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 exceed those additional expenses.
As you can see, LLCs are a very advantageous choice when choosing a business entity. However, there are downsides to LLCs as well. Here are three important disadvantages to consider.
Attractiveness to Investors
The number one reason entrepreneurs choose a corporation over an LLC is that a corporation’s shares are easily transferable. This means that an investor can receive a certain number of shares in the corporation in exchange for their capital 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 difficult to transfer partial ownership to an investor.
While LLCs are less expensive to form and maintain but more expensive than a corporation. This is because sole proprietorships and partnerships don’t have to register with the state or file reports. On the other hand, LLCs have a cost associated with formation, ranging from $40 to $500.
LLCs also must, in most states, file an annual report, which also comes with a fee.
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 makes $100,000 in profit, the member must pay taxes on the entire $100,000, even if they only received $50,000.
Understanding an LLC’s ins and outs is essential before choosing it as your business entity. An LLC does bring many benefits, along with a few disadvantages.
If you’re unsure whether an LLC is right for you, consult an attorney and tax advisor. Take your time and make the choice that will give you the best chance of success.