A limited liability company, or LLC, is a common business structure among startups and small businesses. In this case, the business is owned by its members. The business structure mainly affects legal liability and taxation, but in many ways, it can influence the very core of the business model and its daily operations. The main items influenced by a business’s formation and legal structure are:
- Initial paperwork obligation
- Formality of the business structure
- Membership structure of ownership
- Options for raising money
- Business taxation
- Degree of personal liability in the event of a business loss
The best first step to take is to explore formation structures on your Secretary of State website to better understand the options for formation and the implications on liability and tax burden. This is also the place to file that formation and to get legally set up with your state for varying state-specific filing fees.
Overview: Pros and Cons of an LLC
In this article, we’ll go over the highlights and negatives of going with an LLC for your business formation. Review the following table before digging into the Pros in the next section:
Pros of an LLC
An LLC is a reasonably low-risk, secure, and cost-effective formation for small businesses, especially for new business owners getting their bearings in self-employment. Here are the pros of filing as an LLC:
Ease of Filing
Paperwork-wise, filing an LLC is relatively low maintenance. Depending on how advanced your corresponding Secretary of State website is, this paperwork can be completed online in less than an hour. Filing fees vary widely by state—ranging from $40 in Kentucky to a staggering $500 in Massachusetts—but the process is similarly straightforward, and many state websites walk users through the process in an online portal.
The steps to setting up an LLC are as follows:
1. Determine your filing state
Your filing state is probably where you live and definitely where you intend to conduct business. Each state has varying filing processes and fees, so ground zero should be a visit to your Secretary of State website.
2. Name your LLC
Check out our name generator tool, and read about how to come up with a smart, sharp, and relevant business name if you don’t already have one.
3. Choose a Registered Agent
This is simply the process of assigning an individual to receive legal and regulatory documentation on behalf of the business. The registered agent is the formal and official contact for the business. Some business owners decide to perform this duty, but it’s worth looking into a fee-based registered agent service to add additional protection, formality, and compliance to the business model.
This is actually more affordable than it sounds, and the added risk-reduction may pay for itself over time (or at least for the first year). A few of the top Registered Agent service sites include:
4. Prepare your operating agreement
Just as a business plan is not always required but is strongly recommended, so it goes with an operating agreement. While some states require this, it’s wise to document member roles up front even if your state doesn’t. This is especially true if you are starting the LLC with multiple members/owners and defining roles becomes paramount.
5. File your LLC with your state
Filing your LLC with your state mainly includes completing the articles of organization, which outlines the basic business components, including the business name, location, and purpose, identification of the registered agent, and management structure.
6. File for an EIN
The business Employer Identification Number (EIN) or Tax Identification Number (TIN) is the business’s identification number for taxation. This is a mandatory filing if the business owners intend to hire employees or open a business bank account.
7. Open a business bank account
This is another should-do rather than a must-do and is especially relevant in the case of an LLC, in which keeping separate owner/business finances is exceedingly important.
Related: Best Small Business Checking Accounts
If you are especially partial to a guided, user-friendly process, forego the government portal and go straight to Incfile, an expedited site designed to get your LLC up and running quicker.
There is something to be said for that legal, state-issued stamp of approval on a business that states it is a formal entity. In addition to formalizing any business structure by way of state registration, an LLC is a more formalized structure than a partnership or sole proprietorship. This is because with the protections and credibility afforded by an LLC—particularly the limited liability—also come formalities, additional obligation, and slightly more paperwork. Because an LLC offers additional protections and tax benefits, some businesses transition from sole proprietorship to LLC over a period of growth.
Another hallmark of a formal vs informal formation is a separation of the owners from the business. In partnerships or sole proprietorships, the owners are not considered separate from the business and its liabilities and operations. Conversely, LLC and corporation owners and members are considered separate, which is partly why their personal assets are protected in the case of financial loss in the business. With that formality comes additional protection and limited personal liability.
Membership Flexibility, Ownership and Oversight
In a single- or multi-member LLC, more perks include unrestricted ownership and flexible management. “Members,” or Owners of an LLC, can include any number of individuals, partnerships, corporations, trusts, and even other LLCs. There are also many single-member LLCs, and these members can manage the business as they like—whether owners are hands-on or whether they elect to hire management for this purpose. These two options are known as Member-Managed and Manager-Managed, respectively. By contrast, for example, corporations are directed and overseen by a board or officers, not by ownership. The LLC, therefore, poses a more streamlined and simplified oversight structure.
In many states, if an LLC doesn’t specifically indicate whether it is Member-Managed or Manager-Managed, it will default to Member-Managed. This should be a conscious choice that is documented early on in the operating agreement.
Easy Cash Distribution
A major perk of an LLC is the ease of profit distribution to members. Not in the form of salaries, but rather in the form of “profit distributions” or a “draw of funds” from your share of the profit accounts. Another reason this is appealing is that draws are not taxed, and neither is the business (more on this in a moment); instead, you report your share of company profit on your personal tax returns at the end of the year.
Hand-in-hand with the previous bullet point is the benefit of something called “Pass-Through Taxation.” All this means is that business income or profit “passes through” to the business owner’s personal tax return, bypassing corporate income tax and the potential of double taxation. In the long run, this can save members of an LLC substantially on taxes. Not to mention that being taxed only once, on a personal tax return one would file anyway, simplifies the process of taxation altogether.
Another tax-related benefit of LLCs are potential tax deductions. An example of one of these deductions is a newer benefit called the Qualified Business Income (QBI) deduction, which permits LLC owners a 20% deduction from the business’s net income, in addition to standard business expense deductions.
Limited Personal Liability
The very name of this formation explains how ownership is held liable. The liability is limited, meaning that in the case of a business loss, your personal assets—such as your house, vehicle, savings accounts, heirlooms, and investments—are protected from liability. This protection can mean the difference between losing the business and completely losing your shirt. This component alone is often enough to appeal to small business owners who are trying to mitigate personal risks and protect precious assets.
Financial loss and business liabilities can mean lots of different things. Here are a few examples in which an LLC’s would be an indispensable asset in protecting members’ personal assets:
- Business failure
- Unpaid debts
- Unmet obligations
Limited liability is not fail-safe though; there are exceptions that do make owners and members vulnerable to the business’s losses, such as in the following member-perpetrated circumstances:
- Member gives personal guaranty to for business loan or debt
- Member commits fraud and/or tax fraud
- Member personally and directly damages an individual
- Member intentionally commits a crime against the LLC or an individual
Cons of an LLC
Easy paperwork, flexibility, and limited liability: It all sounds pretty appealing, right? However, for several of the pros of starting an LLC, there is another side of the coin—the cons of that very aspect of filing as an LLC. Consider the following cons before pursuing your LLC:
Maintenance and Paperwork
Some states require annual reports in order to keep an LLC in good standing. These sometimes correspond with fees (again, depending on the state), reports, and meticulous paperwork and filing processes. Additionally, because of pass-through taxation to the owner’s personal tax return, owners/members must keep separate financial records in order to avoid any personal liability, which also necessitates separate bank accounts.
Inflexibility of Member Turnover
While an LLC is a sturdy and low-risk option for business formation, it can sometimes represent a delicate balance. That is, even though membership/ownership structure is very flexible and permits any number or type of owners, a change to this infrastructure may require a refiling of the LLC. In some states, when a member joins or leaves an existing LLC, that LLC may be obligated to dissolve and reform with new membership.
In most cases, this change will also require amendments to existing operating agreements and articles of organization, filing Articles of Amendment with your state registration agency, and amended paperwork submissions to the IRS. Were a change in members to affect your LLC, it may be wise to first consult an attorney to understand the ramifications in your jurisdiction and your unique circumstance.
Limited Investment Options
LLCs actually have quite a few avenues for financing, starting with general equity and debt capital.
✔ Equity Financing – Most equity financing for LLCs comes from injection capital contributed by starting members. LLCs can raise equity capital from new members as a price of admission or as intermittent contributions in exchange for a share in the company.
✔ Debt Financing – Many LLCs are initially or continually funded by loans, a type of debt financing. These loans may come in the form of personal or informal loans, bank loans, lines of credit, or government loans and grants.
✔ Fundraising and Crowdfunding – An LLC can also take advantage of private fundraising activities, peer-to-peer fundraising, and online crowdfunding sites to fund the start or scaling up of the business.
✖ Outside Investors (Angel and Private) – Because LLCs can’t issue shares like corporations can, the only way to invest in an LLC is by becoming a contributing member and co-owner of the LLC. Outside investors see LLCs as riskier investments with much more red tape than a high-return investment in a corporation. And while more members in an LLC may mean more capital injection on their behalf, it may also mean the dilution of the profit pool.
Miscellaneous Taxes and Misaligned Tax Burden
Even with the favor of pass-through taxation, there are other extraneous taxes to consider when choosing an LLC formation. These can include the following:
- Self-Employment Taxes
- Franchise Taxes (where applicable)
- K1 forms for individual members to report share of ownership and tax liability
- Employment Taxes
- Personal or Corporate Taxes
- Excise Taxes
As explained under easy cash distribution, owners and members do not take salaries but rather draw on profit as a type of profit-sharing. Members are then taxed on their respective share of profits, regardless of payments made to members.
The exception to this are guaranteed payments, which are paid to LLC members for services rendered or use of capital. This ensures that members of the LLC are fairly compensated and financially stable regardless of or before the profitability of the LLC. But because these payments may not be directly proportionate to the ownership share of the corresponding member(s), it skews their income according to the IRS and may result in disproportionate (too high or too low) taxation on that member.
If the cons truly outweighed the pros of forming an LLC, it wouldn’t be the most common business filing in the country. In recent years, LLC business filings reached nearly 2.7 million in the US, surpassing all other entity types for the 16th consecutive year. As with any business decision, consider your circumstance in order to evaluate different business structures. Examine your business risks, paperwork, liability, member structure, and taxation implications in order to evaluate different business structures that are suitable for your business. Other common business formations include Sole Proprietorship, Partnership, Corporation, and Cooperative, which you can also explore as options for your business.
Recommended Related Articles