So, you’ve identified a good business idea and you’re passionate about bringing it to life. You’ve also done your research and concluded that forming a legal entity is the best way to protect yourself and your business interests.
Therefore, you decide to form a limited liability company (LLC) – but how do you go about it and what are the factors you should consider? This article discusses the key advantages and disadvantages of starting an LLC in the US and how you can prepare yourself for smooth formation.
What are LLCs advantages?
Choosing a business structure as an LLC offers a number of advantages as follows:
Flexible tax treatments
LLCs enjoy better flexibility in terms of taxation. Besides 2 default tax statuses given by the IRS, LLCs can also elect to be taxed as S-Corporations or C-Corporations, depending on the business needs.
Each tax status has its own pros and cons, so it’s important to consult with a tax advisor to see which one makes the most sense for your business.
- Taxed as a sole proprietorship
A single-member LLC is treated as a sole proprietorship for tax purposes, which means the business income is included on the member’s personal tax return. This way, the member doesn’t need to file a separate business tax return and reduce paperwork.
- Taxed as Partnership
The IRS treats a multi-member LLC as a partnership for tax purposes unless it files to be treated as a corporation, meaning it does not pay taxes on business income. Instead, the profits and losses are ‘passed through’ to the members and included on their personal tax returns, also known as pass-through taxation.
Being taxed as a partnership helps LLCs avoid double taxation, as the profits flow directly to the owner and are paid at the personal income tax rate.
Double taxation occurs when company profits are taxed twice, once at the corporate level and once at the individual level.
For example, a corporation’s profit is taxed to the corporation when it is earned and then taxed to the shareholders when it is distributed as dividends, resulting in a double tax.
When a corporation distributes dividends to its shareholders, it does not receive a tax deduction. Shareholders cannot deduct the corporation’s losses.
- Taxed as a C corporation
The members of your LLC can elect to have the company classified as a C-corporation. In this case, the LLC would file a corporate tax return and pay taxes on corporate income, but it can avoid self-employment tax.
However, this structure is subject to double taxation because corporate profits are taxed at the corporate level when earned, and then again when distributed to the members as dividends.
- Taxed as an S corporation
An LLC can elect to be taxed as an S corporation by submitting IRS Form 2553. This would exempt the LLC from corporate income tax and provide a tax deduction for social security and medicare tax.
Instead, the company will be subject to pass-through taxation similar to a partnership.
How an LLC Being Taxed as an S Corp Works?
Beth sets up an LLC for her cryptocurrency venture and elects to have it taxed as an S corporation.
The company earns $200,000 per year. Beth is paid $100,000 as an employee, and the remaining profits of $100,000 are passed through and reported as an S corporation distribution on Beth’s individual income tax return, not as employee salary.
Because it is not viewed as employee wages, neither Bath nor her company needs to pay Social Security or Medicare tax on this amount. The only payment is $15,300 in self-employment taxes (15.3% x $100,000 = $15,300).
Beth would have had to pay self-employment tax on her entire $200,000 profit if she had not chosen S corporation status for her LLC. This entails paying $2,900 more in Medicare taxes and $1,252 more in Social Security taxes (total sum for both employer and employee).
An LLC protects members’ personal liability by limiting their exposure to financial risk and preventing assets from being used to pay off business debts. In general, if the LLC is sued or owes money, the members’ assets, such as their homes, cars, properties, or investments, are usually shielded from seizure.
An LLC’s members must draft an Operating Agreement that specifies the level of liability protection that each member desires. Some members may prefer complete liability protection, whereas others may be willing to accept some personal risk in exchange for a larger share of profits.
The Limited Liability Company Agreement may require all members to sign a personal guarantee, outlining the circumstances under which they will be held liable for the LLC’s debts.
If your LLC commits fraud or engages in illegal activities, you could lose this valuable safeguard and be held liable. For example, if you are the owner of an LLC and sign a contract out of your authority, you may be held liable if the LLC fails to fulfill its contractual obligations.
So while an LLC offers some personal liability protection, it’s important to understand the limits of this protection and take measures to reduce your risk.
An LLC allows business owners to keep their personal and business affairs separate, which can be extremely beneficial if you value your privacy.
Because some states do not require LLCs to list members on formation documents, you can form an LLC without disclosing your identity. However, from a business standpoint, this isn’t always the best approach, as it can make opening a bank account and establishing business credit more difficult.
It’s also important to note that each state has different laws governing LLCs, so check with your state’s Secretary of State office to see what level of disclosure is required.
If identity protection is your top priority, consider Wyoming or Delaware, which have excellent business privacy laws.
Other advantages of LLCs
LLCs have fewer formalities and paperwork to file than corporations, and members are specifically exempt from the following obligations:
- strict record-keeping procedure
- conduct annual general meetings
- maintain details of shareholders, directors, officers, and employees
Furthermore, in an Operating Agreement, you can change the rules that govern your LLC formalities as needed.
You have two management approaches to choose from:
- Member-managed approach: all members can participate in the company’s management and decision-making.
- Manager-managed approach: members appoint one or more managers to handle day-to-day operations and make business decisions on their behalf.
This allows you to choose the best way to manage your company based on the members’ skills, interests, and time commitments.
Ease of startup and maintain
The LLC is simple to set up, with little initial paperwork and low fees. The incorporation process is straightforward, simply file the Articles of Organization with your state’s Secretary of State office and pay the required filing fee.
After forming your LLC, you must file an annual report and pay an annual fee to keep your business entity status. These requirements differ by state, but they are generally far less onerous than those of a corporation.
What are LLCs disadvantages?
Before registering your business as an LLC, consider the possible disadvantages that are listed below:
Limited investment option
An LLC cannot issue shares to outside investors; therefore, your ability to raise capital may be limited. If you want to attract outside investors, you’ll need to convert your LLC into a corporation, which can be a time-consuming and expensive process.
Furthermore, LLC ownership is difficult to transfer because investors cannot become members unless all other members consent.
In some states, even if all members agree to the transfer, the state may still refuse unless there are exceptional circumstances such as a member’s death, divorce, retirement, or other such events.
Additional tax burden
Depending on your chosen state, the LLC may be subject to additional costs, such as:
This is levied by some states on LLCs for the privilege of doing business there (e.g., California, New York, Delaware, etc.).
Based on the state’s rule, franchise tax can be a flat fee or a percentage of the LLC’s income.
In some states, LLCs with employees must pay federal employment taxes, mainly including:
- Social Security (6.2% for the employer and 6.2% for the employee, or 12.4% total);
- Medicare (1.45% for the employer and 1.45% for the employee, or 2.9% total); and
- Unemployment tax at the rate of 6%.
An LLC is required to pay an annual fee to keep good legal status. The LLC renewal fee differs by state but is generally higher compared to other business types.
If you choose to structure as a series LLC, your maintenance cost can be even higher due to the need to file additional paperwork for each series. Moreover, you may need to pay foreign qualification fees to do business in other states.
The lack of strict governing requirements means that LLC members have more freedom when it comes to running the business, but it also means that there is less structure and more risk within the company. For instance, members may not be required to hold regular meetings or keep minutes, making it difficult to hold members accountable for their actions.
There is also a risk that members may not be able to agree on key business decisions, which could lead to the company being paralyzed or even dissolved.
A well-drafted operating agreement can help to mitigate risk. Although hiring an attorney to draft it for you will incur additional costs, it will protect your LLC from potential member disputes and ensure everyone is on the same page regarding the company’s operations.
It’s easy to see the benefits and drawbacks of an LLC, but how do you know it’s the best structure for you?
We’ve created a US Business Entity Selection Tool to help you find the right business type by answering a few simple questions.
As you are now aware, there are advantages and disadvantages to forming an LLC. Considering both sides of the coin will boost your confidence in making the best decision for your company.
If you’re still unsure whether an LLC is the right business structure for you, chat with our friendly consultant for practical support. Feel free to drop a message via firstname.lastname@example.org and we’ll get in touch the soonest.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
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