Advantages and Disadvantages of an LLC

If you’re planning on starting your new business as a limited liability company (LLC), it’s crucial to understand the advantages and disadvantages of an LLC before deciding if this entity structure is right for your needs.

In this article, we’ll explore the benefits, such as limited liability and tax flexibility, as well as the drawbacks of LLCs, like potential costs and administrative requirements, to help you make an informed choice for your business.

What is an LLC

An LLC is an extremely popular business entity type among new companies as it provides many of the same advantages as a corporation but with some added tax benefits.

While it first became available in Wyoming in 1977 it only started to be recognized by other states from the 1990s onwards. Despite this, LLCs are now the most common entity type in the US for small businesses due to their notable advantages and how easy they are to establish.

Advantages of an LLC

If you’re an up-and-coming small business owner, forming an LLC may be the best option for you as it offers a number of key advantages, which we’ve discussed in greater detail below.

Personal Liability Protection

Personal liability or personal asset protection means that, as an LLC owner, you won’t be held 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, including your car, house and any other belongings.

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.

Easy Formation

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

Unlike corporations, LLCs have few restrictions on the number of owners they can have as well as their management structure. By comparison, with an LLC you’re free to structure your business’s ownership almost however you like using an LLC operating agreement.

On top of this, LLCs are also free to choose between a member-managed and manager-managed entity structure depending on which better suits its needs:

• Member-managed: All members participate in the day-to-day operations and decision-making of the business
• Manager-managed: The members designate one or more managers to handle the daily operations and business decisions, allowing non-managing members to take a more passive role

This allows an LLC’s members to be as involved (or not) as they want in the daily running of their business.

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.

Trustworthy Image

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.

Disadvantages of 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 self employment tax (i.e., Social Security and Medicare taxes) than individuals classed as employees.

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 — which makes it less attractive for investors.

This is because pass-through taxation means the income of the LLC is reported on the personal tax returns of its owners, which includes the tax-exempt partners of the venture capital firm. Receiving active business income would compromise their 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.

Differences Between LLCs and Other Business Entity Types

In the sections below, we’ve provided a brief overview of how LLCs differ from the two most 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 aren’t considered a separate business entity for legal purposes.

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.