Comparing the Pros and Cons of a Limited Liability Company (LLC)Business Taxes
Over twenty million startups and small businesses in the US are registered as LLCs. Most owners cite the hybrid structure and flexibility as the main reason to choose an LLC over a partnership or sole proprietorship.
This is understandable since LLCs combine the best of two worlds by offering flow-through taxation typical of sole proprietorships and providing the same level of liability protection as corporations.
However, before you go ahead and start a business registered as this entity, you should take a moment to compare the pros and cons of a limited liability company.
Choosing the LLC structure also has its downsides, especially if you’re not planning to run your business alone. So let’s go through the nuts and bolts of LLCs and look at their benefits and drawbacks.
What is an LLC?
According to the IRS, a Limited Liability Company is a business structure owned by one or more members. The ownership of an LLC isn’t restricted to individuals. Hence corporations and other domestic or foreign entities can be members.
LLCs can have unlimited owners, but having too many owners can make a business ineligible for certain tax classifications.
Anyone from freelance photographers and writers to tech startups can register their businesses as LLCs. The United States doesn’t have a federal law regulating LLCs, so the rules and regulations you must follow will depend on your state.
The key trait of an LLC is that it safeguards the member’s assets from creditors. Hence, your personal property or funds in your private bank account cannot be used to settle LLC’s debts.
LLCs don’t pay taxes at the same level as other business entities because all income or loss is regarded as a member’s personal income.
Types of LLCs
Depending on the number of owners, LLCs can be single-member or multi-member businesses. It’s important to note that individuals can register their businesses as single-member LLCs in all states.
The owner or owners of an LLC can opt to manage the business independently or hire a manager. Member-managed and Manager-managed LLCs have different structures, so the paperwork you must submit during registration will depend on your chosen option.
If you’re planning on starting a family business, you should keep in mind that there are several differences between an LLC and a family limited partnership (FLP).
Regardless of your LLC type, your liability won’t be limitless because, under certain conditions, the court can rule to use your personal assets to cover the company’s debts.
S and C Corp Tax Classifications
LLC can use C or S Corp tax classifications when filing federal taxes.
The C Corp tax classification means a business will be taxed separately from its owners. In contrast, the S Corp tax classification allows all members to report the income they generate through an LLC on their individual tax returns.
Hence, if you want the IRS to recognize your LLC as a C Corp, you’ll have to file the Entity Classification Election Form 8832. Business owners who wish to register their LLCs under the S corp tax classifications must use Form 2553 Election by Small a Small Business Corporation.
However, you must first meet all the criteria for S Corporations laid out by the IRS before you can start reaping the benefits of this tax classification.
The Advantages of LLCs
Some of the main advantages of LLCs are:
1. Low Filing and Upkeep Costs
Registering a business as an LLC isn’t expensive, and in some states, you’ll have to spend less than $100 on the LLC filing fee. The annual and biannual fees depend on the state and range from $0 in Ohio, Texas, and South Carolina to $800 per year in California.
Also, filing the LLC paperwork is simple and usually takes less than an hour.
2. Pass-Through Taxation
The term simply means that all profits or losses an LLC generates are passed to the members. Consequently, owners of an LLC don’t have to pay corporate income tax; instead, they can report all profit and income on their individual tax returns.
Pass-through taxation isn’t the only tax advantage of using the LLC entity. For example, owners of LLCs that operate under the S Corp tax classification are eligible for a Qualified Business Income (QBI) deduction that enables them to claim 20% of the company’s net income.
3. Profit Allocation
Besides being exempt from corporate taxes, members of LLCs don’t have to pay taxes for the money they withdraw from their share of the profits. Hence, you’ll have easy access to cash if you file your business as an LLC.
4. Risks Associated with LLCs are Relatively Low
Limited liability means that members cannot lose their personal possessions in the event of a lawsuit or bankruptcy. Therefore, in most cases, your home, vehicle, or investments will be safe even if your business fails. The limited liability rule has exceptions.
5. LLC Status Brings More Authority to a Business
The structure of a Limited Liability Company is less informal than the structures of sole proprietorships and partnerships. Consequently, LLC members have more responsibilities and more paperwork than owners of businesses registered as partnerships or sole proprietorships.
Moreover, members of LLCs are considered separate from a business and its liabilities, which isn’t the case with owners of sole proprietorship or partnership businesses.
6. A Multitude of Ownership and Management Options
There are no restrictions regarding the number of members an LLC has, making them suitable for small businesses that are likely to grow.
On the other hand, single-member LLCs offer significant protection to self-employed individuals who want to offer services on their own or hire employees.
Members can choose if they want to manage an LLC or create a management team in charge of the business’s daily operations.
The Disadvantages of LLCs
Here are some of the disadvantages of LLCs you should be aware of.
1. Limited Liability isn’t Boundless
Even though LLCs protect members from losing their assets, members aren’t always exempt from liability.
Therefore, making a personal guaranty for a business loan or committing tax fraud can be why a court decides to ‘pierce the corporate veil’ and use a member’s personal assets to compensate for all LLC’s losses.
2. LLC Members Have Self-Employed Statuses
The IRS views all LLCs as partnerships unless members opt to file for S or C Corp tax classification. As a result, all members must cover social security and Medicare taxes on their own.
3. A Long List of Taxes
Aside from self-employment taxes, LLC members may also have to pay franchise, employment, excise, and personal taxes.
In addition, members must file the Schedule K-1 1065 Form to report their tax liability and their share in an LLC. Hence, the members may not share the tax burden evenly.
4. Transferring Ownership Can Be Difficult
Including new members in an LLC is a complex procedure that, in some states, can involve resolving an LLC and forming a new one. Moreover, in case one of the members dies or decides to leave a business, other owners must pay the remaining fees and terminate the business.
Any change of the LLC structure also implicates amending operating agreements and Articles of Organization.
5. Funding Opportunities
Finding investment opportunities for an LLC is difficult because offering shares to potential investors isn’t an option. In most cases, LLCs are funded by the capital secured by its members, loans, or crowdfunding campaigns.
Besides legal implications related to the ownership transfer, allowing new members to join an LLC can reduce the profit other members are making. As such, new owners can make an LLC less profitable despite bringing in fresh capital.
Frequently Asked Questions
There are no restrictions regarding the number of LLCs an individual can register. The only condition is that all businesses must be separate.
Individuals and corporations can register LLCs in different states. However, their businesses will be regarded as foreign LLCs, and they’ll have to obtain a certificate of authority before they can start working.
LLCs are no incorporated business entities. Instead, the term organized is used, which is why their founding documents are called the ‘articles of organization’ instead of ‘articles of incorporation’ used for incorporated companies.
Single-member and partnership LLCs will receive Form 1090-NEC if their annual spending for rent or purchase of goods and services exceeds the $600 mark. LLCs in the S corp tax classification aren’t issued this form.
Do the Pros of LLCs outweigh the Cons?
The short answer is that yes, the pros of LLCs outweigh the cons.
In most states, starting an LLC business costs less than $100. So if you live in Colorado or Michigan, you won’t have to spend much on filing fees.
Still, running an LLC comes with a certain amount of responsibility, and you must be prepared to submit reports on time and go through a relatively complex tax filing process every year.
Nonetheless, the number of businesses registered as LLCs has been increasing for over a decade, which shows how profitable this business structure can be.
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.