There are several business structures that can be operated today. One of the most common is called an LLC, or a limited liability corporation. This business structure offers owners the same chances to earn profits, but with better protections than a sole proprietorship and without the responsibilities of a corporation. Many people who form a new business will first look to an LLC to see if it will meet their needs.
If you’re thinking about starting a new business, then here are the advantages and disadvantages of beginning a limited liability corporation.
What Are the Pros of an LLC?
1. It offers income taxation on a pass-through basis.
For corporations, profits that are generated are generally taxed twice. Workers have their incomes taxed and the profits from the corporation are taxed as well. In an LLC structure, taxation happens on what is called a “pass-through” basis. This means members of the LLC can report profits on their personal taxes, eliminating the double taxes that have to be paid.
2. It limits personal asset liabilities.
Businesses that operate as a sole proprietor also file on a pass-through basis, but all of their personal assets are considered to be business assets. This means if something goes wrong and the business is held liable from a judgment, personal assets like homes or vehicles could be sold to clear the judgment. In an LLC, business assets are separate from personal assets, which means there is a higher level of protection.
3. Non-managing members of an LLC aren’t considered to be self-employed.
Anyone working for an LLC who isn’t a non-managing member won’t have to worry about being considered self-employed. That can make a big difference when it comes to paying taxes.
4. Share transfers are remarkably easy.
If LLC members want to change ownership stakes or exit the business altogether, the personal stakes that people have in the company can be easily transferred. This is especially beneficial for families that are managing a number of assets because it means the shares of one family member can be quickly transferred to another family member should the need arise. This eliminates inheritance difficulties.
5. Membership interests can be placed into living trusts.
Heirs can receive membership interests in an LLC that are passed directly to them when the time is right. With less legal red tape than other transfer methods, it is a lot easier to move on or take control when needed. Even corporations are allowed to be members of an LLC, which allows some business structures to introduce multiple structure layers that give them better overall protection.
6. Business expenses are completely deductible for managing members.
Because any monies received from profit distributions is considered self-employment, managing members are able to deduct their business expenses from their profit amounts to lower their overall tax liabilities. The biggest place for this is with health care insurance premiums. Because the payments are being made under the definition of self-employment, 100% of those premiums paid can become a deduction.
7. LLCs have their own credit profit.
Because it is a separate business entity, there is a separate credit profile in place for the limited liability corporation. This can make it a lot easier to borrow money for start-up capital if needed. For sole proprietors with low credit scores, it can be virtually impossible to find any funding options because the business credit is directly linked to their personal credit.
What Are the Cons of an LLC?
1. Income generated for an LLC member is subject to self-employment taxes.
People who are self-employed actually pay a higher tax rate out of their business income in the US. That’s because employers are responsible for matching the Social Security and Medicare taxes that employees are required to pay. This results in about a 7.5% additional tax every year because LLC members have to pay both sides of the tax instead of just half the tax.
2. LLC managing members can still be held personally responsible.
There’s a legal precedent which is known as “piercing the veil.” This means if a managing member of an LLC is believed to have committed an act of fraud or conducted illegal activities in some way, their personal assets can be used as compensation for any damages that have been caused. This area of law can be rather unpredictable and it is ever expanding and changing. Something as simple as jawalking is an illegal activity and could bring this issue into play. If you personally guarantee a loan or other forms of financing, then you can also be held personally responsible.
3. Member shares of profits are taxable, even if they don’t receive a disbursement from the LLC.
Whatever the pro-rata share of profits a managing member happens to have from their limited liability corporation, that share is considered taxable income. Those taxes must be paid even if that member does not actually receive any of the profits that the LLC lists. That can create a heavy tax burden some years as a large tax bill with very little salary could become due.
4. Managing members are not allowed to pay themselves wages.
Managing members of an LLC basically own shares that can have profit disbursements. They are not allowed to pay themselves a salary or any other form of wages. This means if the LLC has a difficult year and profits are low or non-existent, then their personal income is going to be low or non-existent as well. Add in the fact that fringe benefits don’t get counted as well and there can be some tough years when managing an LLC membership.
5. There is a cost to form the business.
Sole proprietors can form a business right now, at this very second, and be ready to do business. If they operate under their own name, then the only costs may be the need to have a business license or a sales tax authorization issued. LLCs have a formation cost that include the filing of articles of organization. Many states require member duties to be completely outlined before formation as well, which can mean a lot of extra start-up costs.
6. Multiple owners require multiple authorizations when decisions need to be made.
If there are multiple managing members in an LLC, then everyone must give their authorization to proceed when certain decisions must be made. This can limit response times and create management difficulties. Single member LLCs can be formed as well to help settle this issue, but because profits are distributed instead of paid as wages, there can still be a lot of hours off work for zero actual money.
The limited liability corporation pros and cons show that risks can be limited, but at a potential price. Weigh the pros and cons carefully and you’ll know if forming an LLC makes sense for you.