A limited liability company, or an LLC for short, is a hybrid business structure. It combines the flexibility and simplicity of a partnership with the liability protections that are found within a corporation structure. You also gain the tax advantages that are part of the partnership structure within an LLC.
The official term for an owner in an LLC is a “member.” Members may be individuals or businesses, with no limit to the number that are permitted. The personal or business assets of each member are protected from the creditors of the LLC should debts be incurred.
Wyoming was the first state in the U.S. to offer a limited liability company structure. More than 2.5 million companies across the United States are now taking advantage of the LLC structure to create jobs and market opportunities.
These limited liability company advantages and disadvantages may help you be able to determine if an LLC structure is the right one for your business.
List of the Advantages of Limited Liability Companies
1. LLCs are currently classified as a pass-through entity.
When a business is structured as an LLC, the profits it creates are able to go directly to its members without being taxed by the government from a corporate standpoint. These profits are taxed on the income tax returns of each member instead. For businesses who are members of an LLC, the process is similar, where the profits would pass-through to the primary profits of the home business. That means if the LLC loses money, you lower your overall tax burden.
2. There is management flexibility offered with an LLC.
A limited liability company can decide to be managed by its members. Under that structure, all members would share in the daily decision-making required to operate the business. An agreement governing rights and responsibilities is usually necessary for this. The LLC can also be managed by internal or external managers who are hired to oversee the business. In the U.S., most LLCs are defaulted to member management unless the filing for the company states otherwise.
3. It offers limited liability for members.
The members of an LLC are not held personally liable for the actions of their company. That means the personal assets of each member are protected from creditors who are trying to collect on debts created by the business. This structure does not protect members from criminal conduct that law enforcement may deem to have occurred by the business. The personal financial protections stay in place as long as the members are involved in the business and their personal and business financials are kept separately from each other.
4. LLCs are very cheap to get started.
The startup administrative requirements for an LLC are very minimal compared to the requirements needed to start a corporation. In a state like Arizona, the initial filing fee for the LLC articles of organization are just $50. In some states, the fee can be $500 or more, which is still cheaper than the corporate filing. The administrative upkeep for an LLC is also easier than what corporations are required to file each year. Licensing and certification costs are still required and vary based on the industry of the business.
5. An LLC can be structured as a corporation for tax purposes.
If the members of an LLC don’t want to be classified as being self-employed, then it can be structured as an S corporation for taxation purposes. That would allow the members to own Social Security and Medicare taxes on their actual compensation instead of on the pretax profits earned by the company. There are additional reporting regulations required under this alternative structure, making it a useful option for those who wish to avoid self-employment taxes.
6. There is no limit to the number of members allowed.
An LLC can be started with any number of members. It is even possible to start an LLC with only one member. In Delaware, an LLC can even be part of a conglomerate group as part of a multi-layer company. That is a definitive advantage over the S Corporation structure, which limits you to 100 owners in total. In a sole proprietorship, you’re allowed one owner. In a C Corporation, you are taking the company public, which creates even more issues.
7. LLCs do not restrict pay to its members.
Under the structure of a limited liability corporation, there are no restrictions in how the company pays its members. Each member can be paid more or less than what their overall share of ownership may be. Members can receive fewer tax write-offs for expenses and reimbursements they pay personally, or they can receive more of them. Although this doesn’t apply to single-member LLCs, it can be structured with multiple members.
8. Members are able to deduct health insurance premiums.
If you are a managing member of an LLC, then you’re permitted to deduct 100% of any health insurance that you pay. This is allowed up to the extent of your pro-rate share of the net profit of the limited liability company, as the profits count as earned income. If members have earned income, they will also qualify for this benefit.
9. LLCs can have members contribute assets to the business.
When you are a member of an LLC, you’re allow to contribute assets to the company. That includes the contribution of capital. You are also permitted to loan money to the LLC or put value into the business in other ways. You’re permitted to take money out of the LLC to repay a loan given to the business which includes interest.
10. In most cases, there is not a citizenship requirement for member status.
When creating an LLC, it is possible to include members which are not citizens of the United States. Although this is not always possible, foreign investors find that the structure of an LLC is one of the easiest ways to enter the U.S. market with a new product or idea. They just need to partner up with other members who feel the same way they do about what is being offered, then become active members of the business.
11. The paperwork requirements for an LLC are minimized.
When you’re running an LLC, you don’t have the same requirements to document your meetings with shareholders or the Board of Directors. There are generally fewer record-keeping requirements as part of the limited liability company experience compared to the corporation structure requirements. The members are even permitted to determine which ones among themselves are permitted to have voting rights.
List of the Disadvantages of Limited Liability Companies
1. Limited liability doesn’t mean zero liability.
It is possible for a judge to rule that the LLC structure does not protect your corporate assets. If you do not keep your personal finances separate from your business finances, then it opens the door for the courts to pierce the corporate veil of the LLC. Other areas where you combine personal and business assets may increase your personal liability to business creditors as well. If you run the business in a criminal way that results in losses for others, the courts may also find you personally responsible.
2. It requires the self-employment tax to be paid under some structures.
In the United States, the default classification for an LLC is the same as a partnership or sole proprietorship for tax purposes. That means the members who work for the LLC are considered to be self-employed. That means they must pay Medicare and Social Security taxes from the employer’s standpoint, which is what is referred to as the “self-employment tax.”
3. Member turnover has high consequences.
Throughout most of the United States, the membership of the LLC must remain intact for the business to continue operations. Even if one member leaves the company, the LLC must be dissolved. The definition of “leaving” the company includes going bankrupt and death. All remaining members are responsible for the financial and legal obligations necessary to bring the business to a close. The remaining members can continue working together, though it would need to be under a brand-new LLC.
Note: In some states, a unanimous positive vote by all remaining members of an LLC to remain in business together, filed with the Secretary of State, may allow the business to continue operating without needing to dissolve and restart.
4. LLCs are not permitted to issue shares.
What makes an LLC difficult from an exit strategy standpoint is that this structure is not permitted to issue shares which hold value like a corporation is permitted to do. Members are not allowed to issue shares that can be redeemed, purchased, or sold. Once you become a member, you’re locked into the company. If you decide to leave, then the company is forced to dissolve. That means you must be committed to the endeavor before filing the articles of organization.
5. There is no recognized right to pay a salary in an LLC.
In the United States, the LLC does not have a recognized right to pay its members a salary. Under the corporation structure, both S and C, the company can pay a salary to its owners, which are then deductible against the profits earned by the company. Under LLC structures, any payments sent to the members of the company are treated as a draw. They do not count against the income of the company.
6. You must pay annual filing fees to maintain your LLC.
Starting an LLC is not a one-and-done expense. You must continue to pay an annual maintenance fee to maintain your filing to do business in the state where the business is recognized. Although some states do not charge this fee, it is close to $1,000 per year in other states. Each filing is handled by the Secretary of State, and some can be filed online for convenience, but the fee will still apply. If you’re struggling for profits, this can make things more difficult to stay in business.
7. An LLC can do business in multiple states only with multiple filings.
It makes sense to file your LLC paperwork in your home state. That will allow you to conduct business throughout the state, though some cities may require you to purchase a business license to operate within their boundaries. If you wish to do business in other states, you must also file your LLC paperwork there as well. You must then pay the annual maintenance fees to maintain your business in each state. That’s why single-member companies, if they are small and run on a tight budget, might use a sole proprietorship instead to avoid these fees.
8. You’ll have more tax forms to file as an LLC.
Compared to a sole proprietorship or general partnership, an LLC is going to have more tax paperwork at the end of each financial year. The business must prepare its own tax filing. Form 1065 is used by most LLCs when they wished to be taxed like a partnership. Once the returns for the business are complete, then the LLC must distribute K1 forms to every moment to show their individual tax liability for the year. Individual excise or franchise taxes may also apply, depending upon the state where the LLC is registered.
9. It is difficult to raise capital under an LLC structure.
Because an LLC benefits from a pass-through structure, there is a greater risk to investors when putting money into this type of company. That’s why a limited liability company can often find it difficult to raise outside capital. If fundraising is a top priority for your company, then an S Corporation structure is probably a better structure to consider. If you reach more than 100 owners, then you’ll need to go to a C Corporation structure.
10. LLCs require the ownership to be spread across its members.
Unless you are operating a single-member LLC, then the ownership of the business is spread across all members. The percentage of equity in the business does not need to be equal. It does require that equity be distributed where one person cannot have 100% control of the business unless they are the only member. Although this spreads out risks across all members, it also means the profits are spread across all members as well. In a bad year for profits, you may find that the income generated may not be enough to meet your needs.
11. Single-member LLCs are taxes like a sole proprietorship.
If you are operating a single-member LLC, then you lose the taxation option benefit that multiple member LLCs receive. Under the current tax structures, a single-member LLC is treated like a sole proprietorship for tax purposes. That means the income generated by the company is reported on your personal tax return. You’ll still receive the limited liability benefit here, however, so your personal assets will not be placed at risk in most normal circumstances.
If your business involves a lot of potential liability and you’re looking for potential tax treatment benefits, then the pros and cons of an LLC indicate this structure could be right for you. If you have a lot of stakeholders already in place, then a corporation structure may be a better option. When there isn’t much liability, work their business as a side hustle, or are just starting up something to try an idea, then maintaining a sole proprietorship or partnership could be a better option to consider.