As a business owner, you want to choose the right business structure that will protect your assets and save you money on taxes. One of the most popular options is a limited liability company (LLC) due to its many benefits, including personal liability protection and tax benefits.
We’ll cover the advantages, disadvantages, and details of an LLC so you can make an informed decision on how to structure your business.
What is an LLC?
An LLC is a business structure that merges the limited liability protection of a corporation with a partnership's tax efficiency and flexibility. The most compelling reason to form an LLC is personal liability and asset protection. If your LLC is sued or incurs debt, the court can only pursue the LLC's assets and not your own.
An LLC will be regulated differently depending on the state in which it was established. Additionally, LLCs as a business structure are less than 50 years old.
Although this relatively new option offers entrepreneurs more flexibility when structuring their businesses, there are still questions about how LLCs will be treated in court due to a shorter history of legal precedent.
Advantages of an LLC
Once you decide what business you should start and which legal structure to use, an LLC can give you the following advantages:
|Business type||Registration requirements||Liability||Taxation||Management|
|Sole proprietorship||None||Personal||Pass through to owner||Owner|
|LLC||Articles of organization||No personal liability||Pass through to members||One or multiple members|
|Corporation||Articles of incorporation||No personal liability||Corporation taxed on income||Board of directors|
Limited liability protection
An LLC offers its owners limited liability protection, which means it can protect your personal assets and help you avoid financial ruin resulting from a lawsuit. On the other hand, under a sole proprietorship, you would be personally liable for any debts or damages incurred by your business.
Although a corporation offers similar protection to that of an LLC, it can be more expensive and complex to set up and maintain.
LLCs also enable pass-through taxes, which means the LLC is not taxed on its profits. Instead, the money is "passed through" to the LLC's shareholders and taxed at their individual tax rates, similar to a sole proprietorship.
Flexible management structure
Another advantage to an LLC is the flexible management structure. Unlike a corporation, an LLC does not have to have a board of directors, and there are no required shareholder meetings or minutes. This can be an advantage for busy entrepreneurs who want to focus on how to make money instead of the hassle of maintaining a corporation.
No one likes paperwork. Luckily, creating an LLC doesn’t require much documentation beyond the initial setup, which is fairly simple. It’s also easier to set up and maintain an LLC than a corporation because annual reports for corporations require more information and can be more expensive to file.
No limits on members
An LLC does not have a limit in terms of members, whereas an S corporation is limited to 75 shareholders. This is advantageous if you want to raise money by selling equity in your business.
Moreover, you can create either a single-member LLC or a multi-member LLC with business entities as members. An S corporation can only have individuals as shareholders.
Disadvantages of an LLC
Potential for higher taxes
One of the disadvantages of an LLC is that it could be subject to higher taxes. As a pass-through entity, the income of an LLC is taxed at the individual tax rates of the LLC owners. If you're in a high tax bracket, you may end up paying more on your personal income tax returns than if your income was taxed as a corporation.
Ownership is harder to transfer
Another potential disadvantage of an LLC is that ownership is harder to transfer. This is because, unlike shares of stock in a corporation, interests in multi-member LLCs are not freely transferable. If you wish to sell your LLC, you are bound by the terms outlined in the operating agreement.
However, if the operating agreement doesn’t outline the process required to change ownership, your state’s laws may require you to dissolve your LLC if a member wishes to transfer ownership.
Formation and reporting costs
Another potential disadvantage of an LLC is formation costs. These can include the filing fees charged by your state and getting an employer identification number (EIN) from the IRS. Some business owners even consult a law firm for legal advice or hire a lawyer to help with the formation process.
This is unlike the setup process for a sole proprietorship, which is automatically created when you begin to perform business activities and does not require any filing or fees.
Potential limited Life
Another potential disadvantage of an LLC is that, in some cases, it has a limited life. This means that if one of the members dies, the LLC will dissolve. This can be a considerable disadvantage if you want your business to continue after your death.
In contrast, a corporation can exist in perpetuity. This means that if you want your business to continue after your death, you will need to have a plan to transfer the LLC ownership outlined in the operating agreement.
Because members of LLCs are considered self-employed, they must contribute self-employment taxes to Social Security and Medicare. For LLC members, this can mean paying twice as much in taxes as the typical employee because they are responsible for both the employee and employer’s share of the tax payments.
Not all LLC members are required to pay self-employment taxes on the profits they earn, however, particularly if they are just an invested member with no role in running the business.
Corporation structures limit the amount of self-employment taxes that must be paid. Depending on the structure, the corporation either pays part of the self-employment tax, or the member has more control over the taxable portion of earnings they receive.
Who should use an LLC?
Out of all of the types of businesses, an LLC may make sense for a business owner looking for the simplest and least expensive way to set up their business while covering their assets.
An LLC often makes sense for a small business owner looking for the personal liability protection that an LLC offers without the complication of setting up and running a corporation.
LLCs are also suitable for businesses engaged in high-risk activities, such as real estate investment or construction. Because these businesses can incur significant amounts of debt, it is common to establish a limited liability legal entity to protect the members’ assets if the business fails.
Any business that wants the personal asset protection of a corporation without the burden of a standard corporate structure may want to form an LLC.
For example, if your small business offers services that may result in a customer pursuing a lawsuit, it is a good idea to set up an LLC. Many coaches and advisors who provide health or financial advice opt to form LLCs in order to protect against personal legal and financial liability in the case of an unhappy customer who chooses to sue.
Alternatives to an LLC
There are a few alternatives to an LLC that you may want to consider, depending on your needs.
- Sole proprietorship: The simplest and least expensive way to set up a business operated by one person. In a sole proprietorship, a business does not have its own legal structure. The owner has complete control, and there are no formation costs involved. However, the sole proprietor is personally liable for all business debts and obligations.
- Partnership: A general partnership is similar to a sole proprietorship but involves two or more owners. An advantage of a partnership is that it can be less expensive and time-consuming to set up and maintain than a corporation. A disadvantage is that each partner is accountable for the partnership's debts and losses.
- C corporation: This is a traditional corporation, where a corporation becomes a legal entity that exists independently of its owners. Corporations can profit, pay taxes, and be held legally responsible. C-corps offer limited liability to the shareholders though they are subject to double taxation.
- S corporation: An S corporation is a unique kind of corporation created to avoid the double taxation problem that conventional C corporations face. S corporations offer limited liability to shareholders but are limited to only one category of stock and 100 domestic shareholders.
What are the tax advantages of an LLC?
One of the tax benefits of an LLC is that it allows pass-through taxation, which means that the business is not taxed. The taxes are passed on to the LLC's members, who only pay taxes on their part of the LLC's profits on their tax returns at their individual tax rate.
By contrast, C corporations face double taxation, which means that the corporation pays taxes on business income, and shareholders pay taxes on the distributions they receive from the corporation. This can result in significantly more money being paid in taxes under a C Corporation than an LLC.
What does it cost to create an LLC?
The cost to create an LLC varies from state to state but averages $40 to $500 to file for the Articles of Organization. Some states may have additional costs, such as a publication fee, annual report fee, registered agent fees, and business license fees. Check with your state's Secretary of State office to find out the specific fees associated with LLC formation.
How to form an LLC
Step 1: Choose a name for your LLC
Pick a name for your new business that is not already in use by another business and complies with your state's rules. Rules include indicating that the business is an LLC by using wording such as “Limited Company” or “LLC” and not including certain restricted words.
Step 2: File your LLC’s Articles of Organization
Next, file the Articles of Organization with your state's Secretary of State (or similar) office. This document must include the name, the address of the LLC, members' names, and the duration of the LLC.
You can visit your state’s website to get the form you need to file. Companies such as ZenBusiness and LegalZoom can also help you both prepare and file your Articles of Organization properly.
To learn more about these services, check out our ZenBusiness vs. LegalZoom comparison.
Step 3: Write an Operating Agreement
After filing the Articles of Organization, you can now create an LLC Operating Agreement. The Operating Agreement is a document that outlines the rules and regulations for the operation of the LLC.
Most states don’t require this, but it can still be a critical part of structuring your business because it includes important financial and organizational details.
Step 4: Get an EIN
The next step is to get an EIN from the IRS. The EIN is a nine-digit number used to identify your business for tax purposes. You can apply for an EIN on the IRS website.
Step 5: Comply with state and local requirements
After you have formed your LLC, you need to comply with state and local requirements. This includes getting any necessary licenses and permits and registering your LLC with the appropriate government agencies. In some states, you must publicly announce that you have formed an LLC.
Although every business type has its perks, the benefits of an LLC tend to stand out. Many small business owners, in particular, find that an LLCs’ legal structure and flexibility feel best for their companies.
True, there are costs associated with setting up and maintaining an LLC, but these could be outweighed by the protections and benefits it offers.
If you're considering forming an LLC, it's essential to do your research to make the most informed decision for you and your business.
Don’t forget to learn the other nuances of starting a business since choosing a legal entity is just one of many steps to launching a successful enterprise.
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