If you plan to start a new business, choosing a limited liability company (LLC) business structure comes with both benefits and disadvantages. For many business owners, setting up an LLC offers the best of both worlds. The most common benefits of LLCs include providing business owners with personal liability protection like a corporation while also giving them the tax flexibility of a partnership or sole proprietorship.
Read on to learn how an LLC can take on any type of management approach while still providing specific protections and tax options for its business owner(s).
What is an LLC?
An LLC is a business structure that allows you to easily organize a new business. Yet, many states only started to recognize this type of business formation in the past 20 years. (It became available in Wyoming in 1977, but most other states didn’t follow suit until the 1990s).
Forming an LLC — often viewed as one of the best ways to establish a small company — gives business owners many of the same benefits and protections as forming a corporation, but with some added tax benefits. In addition, an LLC’s owners are called members instead of partners or shareholders.
For a more detailed overview of the LLC business structure, check out our What is an LLC article.
What are the Advantages of an LLC?
If you’re an up-and-coming small business owner, choosing to form an LLC may be the best option for you. Why? This business structure offers several notable advantages.
Personal Liability Protection
Personal liability or personal asset protection means that, as an LLC owner, you’re not personally liable for any business debts or damages stemming from lawsuits brought against the company. Without limited liability protection, you place everything you own at risk.
If your LLC faces a lawsuit, goes through bankruptcy, or encounters other types of loss, creditors can’t seize your personal assets to cover any related debts.
Pass – Through Taxation
Another great advantage of forming an LLC is that it qualifies for a single layer of taxation without having to meet any complex tax requirements. This “pass-through” tax structure comes in handy if you’re a new business owner because it means you only pay taxes once on your company revenue — unlike the double taxation corporations face.
Under a corporate tax structure, the company itself pays taxes on its revenue and you, as a shareholder, also must pay taxes on your earnings. In contrast, your LLC can claim its losses on your personal income tax returns each year. An LLC also can decide to be taxed as an S corporation (S corp) or a C corporation (C corp) in order to gain greater tax flexibility for its members.
When it comes to taxation, all business owners should keep detailed records and follow the proper tax and accounting procedures to avoid tax audits.
Forming an LLC also offers simplicity and operational flexibility because state laws allow LLC members to determine the best set of operational and governance rules applicable to their business.
This can prove extremely beneficial because it means you can customize the rules to support the most effective operation of your LLC. While some states don’t require LLCs to have an Operating Agreement, it’s necessary to avoid future business disputes among LLC members.
Flexible Ownership and Management Structure
LLCs have few restrictions on the number of owners they can have as well as their management structure. For example, an LLC doesn’t have a board of directors or annual shareholder meetings and its owners have more choice in the management structure of their business.
With an LLC, you can issue as many shares as you want to any other entity or individual of any nationality. In contrast, corporations face certain requirements on the type of shares they can issue and to whom.
You also can structure your LLC’s ownership however you like. LLCs have a lot of leeway in terms of how they can handle individual ownership — and those rules can vary from member to member if desired.
When establishing your LLC, you must state in your Articles of Organization if your company will use a member-managed or manager-managed management structure. In a member-managed LLC, all of the business’s members have an equal say in its daily operations. Unless stated otherwise in the LLC’s Operating Agreement, all members also will have an equal right to sign contracts and enter into transactions on behalf of the business.
In a manager-managed LLC with separate managers, those designated managers may or may not hold a stake in the company. Most LLCs with more than two or three operating members choose a manager-managed structure. When you choose manager management, your LLC can have as many of its members serve as managers as desired. But, not all members must be managers.
Flexible Profit Allocation
LLCs also have more flexibility than other business structures in how they allocate profits to their owners. Specifically, LLCs aren’t required to distribute profits equally or according to ownership percentages.
Two people may have equal interests in an LLC, for example, but they may agree that one of them will receive a greater share of the profits because that individual contributed more money or labor in the business’s startup phase.
Another benefit of forming an LLC is that doing so positions the company as a more trustworthy business. Simply by choosing the LLC business structure, a company’s owners demonstrate thoughtful and serious planning.
Anyone can come up with a name and call themselves a business. By forming an LLC, you’ll present a more credible image to potential customers and partners. That goes a long way for a new business working to establish its brand.
What are the Disadvantages of Forming an LLC?
While small business owners enjoy the personal liability protection and flexible tax options an LLC can provide, this type of business structure also has a few drawbacks.
Personal Income Reporting Requirements
Each LLC owner/member must report any personal income they receive as profits from the business. As long as the LLC earns a profit, each member must pay taxes on their share of that profit.
LLC owners may choose to reduce their individual tax burden by electing to form the LLC as an S corp or C corp for tax purposes. Individuals classed as self-employed by the Internal Revenue Service (IRS), such as LLC owners, must pay higher Social Security and Medicare taxes than individuals classed as employees.
For more information, see the Social Security and Medicare Tax Requirements section below.
Less Investor Funding
The tax implications of the LLC business structure can sometimes prevent investors from funding the business. If you plan to seek outside investors for your new business, you may face some challenges. For example, venture capital firms are less likely to fund LLCs because they can’t invest in pass-through taxation business entities if their firm has tax-exempt partners. If such a firm did so and received active business income, it’d breach that tax-exempt status.
Social Security and Medicare Tax Requirements
The IRS views LLC members involved in running the business as self-employed. That means those members must pay self-employment taxes for Social Security and Medicare — taxes typically deducted from the paychecks of wage earners.
Self-employed individuals also must file annual tax returns and pay their quarterly estimated taxes.
What are the Differences Between LLCs and Other Types of Businesses?
Here’s a brief overview of how LLCs differ from two other common business structures.
LLCs vs. Corporations
While LLCs pair limited liability protection with pass-through taxation, corporation owners or shareholders also benefit from limited personal liability for business-related debts.
But, unlike LLCs, corporations must pay taxes as separate, taxable entities in addition to their owners paying taxes on their share of the corporation’s profits. Corporations also must hold annual meetings to maintain their corporate status as well as sell stock to raise capital.
Fortunately, forming an LLC provides entrepreneurs with greater flexibility. For example, an LLC may elect to be taxed as an S corp or a C corp. Forming an LLC with a C corp tax designation can prove advantageous for some businesses because it allows for more tax deductions.
LLCs vs. Sole Proprietorships
Like an LLC, a sole proprietorship is easy to form and provides its owner with complete control of the business. In fact, you’re automatically considered a sole proprietorship if you conduct business activities and don’t register as any other kind of business structure.
Sole proprietorships can make a good choice for low-risk businesses and owners who want to test their business idea before adopting a more formal business structure. But, unlike LLCs, sole proprietorships don’t produce a separate business entity. This means you can be held personally liable for the debts and obligations of your business because your business assets and liabilities aren’t separate from your personal assets and liabilities.
While sole proprietors can obtain a trade or “doing business as” (DBA) name like other business structures, they may find it difficult to raise money because they can’t sell stock and banks don’t often lend to sole proprietorships.
Advantages and Disadvantages of an LLC FAQ
What are the advantages and disadvantages of forming an LLC?
The LLC business structure protects owners/members from personal liability in case of judgments or debts against the business. But, one of the drawbacks of using this business structure is that LLC members still have to report their personal income for tax purposes. See above for more information about the key advantages and disadvantages of forming an LLC.
What does an LLC do?
An LLC provides a formal structure for operating your business as well as flexible taxation options. While most LLCs pay taxes as a sole proprietorship or partnership, LLCs also can choose to be taxed as an S corp or a C corp.
What are the LLC benefits by state?
LLCs enjoy similar benefits in most states. While some states offer more flexible reporting requirements, forming an LLC in many states means you’ll have access to flexible taxation and management options.
What are the tax benefits of an LLC?
LLCs enjoy pass-through taxation. This means an LLC’s earnings pass straight through to its owner(s) without the company having to pay separate, corporate taxes.
What are the benefits of forming an LLC vs. a sole proprietorship?
One key benefit of forming an LLC is that its members aren’t personally liable for the debts of the business. In contrast, a sole proprietor can be held liable for the debts incurred by their business. For more details, see the LLCs vs. Sole Proprietorships section above.
What are the benefits of forming an LLC vs. a corporation?
It’s easier to form and manage an LLC than a corporation. LLCs also enjoy pass-through taxation benefits while corporations face double taxation. For more details, see the LLCs vs. Corporations section above.