Operating a limited liability company (LLC) comes with the advantages of limited liability protection, ease of setup, flexibility in ownership type, and the ability to specially allocate distributions. Meanwhile, drawbacks include inconsistency in state law, finite entity life, and self-employment tax. While an LLC does have disadvantages, the benefits frequently outweigh the cons for small business owners, making it one of the most popular choices for entity type in the modern economy.
Pros of an LLC | Cons of an LLC | |
|---|---|---|
Legal Liability | Limited personal liability Owners/Members’ personal assets are protected in case of business loss | Inconsistency in state law Filing fees and registration requirements vary from state to state; legal protections for some kinds of LLCs have not been aggressively tested in court |
Formal Entity | Image credibility & ease of filing The formal structure of an LLC lends credibility to the business; most states have straightforward formation paperwork | Maintenance & annual fees As formal entities, states may require that LLCs file annual reports accompanied by fees that can reach several hundreds of dollars in some jurisdictions |
Membership & Management | Membership flexibility, ownership & oversight Unlimited number of members with minimal restriction on who can have ownership; flexible management options | Member turnover & entity termination Membership changes can result in burdensome paperwork; most states do not allow for perpetual LLCs, resulting in a finite lifespan for most limited liability companies |
Taxation | Income tax flexibility & pass-through taxation Members absorb all income on their personal tax returns instead of the LLC being taxed directly, thus avoiding corporate double taxation; however, the LLC can elect to be taxed as a C- or S-corp in accordance with the long-term business strategy | Self-employment tax/income tax without distributions Without electing to be treated as an S-corp, members are taxed on all income, irrespective of the amount of cash taken out during the year; members are also responsible for self-employment tax |
Access to Capital | Easy cash distribution Owners/Members can make “draws” on the company profit account rather than taking salaries | Limited investment options Outside investment may be difficult due to complex operating agreements and elaborate compensation provisions |
Which Business Structure Is Right for You?
Pros of an LLC
An LLC is a practical and low-risk entity type for small businesses. This selection is particularly beneficial for owners who are new to navigating formal business structures and need the flexibility to make modifications as the business grows. Here are the pros of forming an LLC:
Limited Personal Liability
In the case of an LLC business loss, personal assets—such as your house, vehicle, savings accounts, heirlooms, and investments—are protected from liability. This protection can mean the difference between losing your investment in the business and losing both business and personal assets.
Here are a few examples where an LLC would be useful in protecting members’ personal assets:
- Lawsuit
- Bankruptcy
- Business failure
- Unpaid debts
- Unmet obligations
Note that an LLC is not always an infallible form of protection. There are situations where owners and members are vulnerable to personal loss, such as in the following member-perpetrated circumstances:
- Member gives personal guaranty to for business loan or debt
- Member commits fraud
- Member personally and directly damages an individual
- Member intentionally commits a crime against the LLC or an individual
An LLC offers protection from wrongful acts committed by employees, colleagues, and other members, but members may still be personally liable for unlawful acts that they commit personally.
Image Credibility & Ease of Filing
The legal structure of the LLC offers more peace of mind to lenders and investors than a sole proprietorship or informal partnership. The separation of the LLC members from the business allows outside parties to analyze the entity on the basis of its own financial health. Sole proprietors may have trouble getting a loan since lenders only have personal creditworthiness to use in their risk analysis, so stricter qualifications and higher personal credit scores may be required.
With that said, personal creditworthiness may still be a factor for LLC business loans, particularly in the case of a single-member LLC. However, the credibility of the separate entity may reduce some of the rigidity of loan and investment requirements and may simplify administrative tasks such as opening a bank account.
From an administrative standpoint, forming an LLC is relatively simple. In many states, this paperwork can be quickly completed on the Secretary of State’s website for each state. Filing fees vary widely by state, ranging from $35 in Montana to a staggering $500 in Massachusetts. However, the process is similarly straightforward, and many state websites walk users through the process in an online portal.
Membership Flexibility, Ownership & Oversight
LLC owners can include any number of individuals, partnerships, corporations, trusts, and even other LLCs. Owners of single-member LLCs have complete autonomy in how the LLC is managed.
They also have the option to elect to hire management for this purpose. These two options are known as Member-Managed and Manager-Managed, respectively. By contrast, corporations are overseen by officers or a board of directors. While owner stockholders rely on the board to make appropriate strategic decisions, LLCs have a more streamlined and simplified oversight structure.
Income Tax Flexibility & Pass-through Taxation
Single-member LLCs are taxed as sole proprietors, while multi-member LLCs are taxed as partnerships. This is the tax treatment generally discussed in this article. However, LLCs can choose to be taxed as either a C-corp or an S-corp. This election can be made with initial formation or in later years.
If the election is made in later years, it will be treated as though the partnership transferred all of its assets to the newly elected corporation. So, the tax treatment is the same as if they actually formed a new corporation, but the process is much easier as there is no paperwork to file at the state level. Simply file a form 8832 with the IRS to be treated as a corporation.
LLCs are considered pass-through entities. That means that the income, expenses, and tax attributes of the annual business activity is passed through to the members using K-1 schedules issued from the business tax return. Since this taxation is passed through the LLC, federal income tax is not assessed with the filing of the LLC tax return.
Single-member LLCs don’t even have the additional step of a separate LLC tax return. Income and expenses are reported directly on the owner’s personal tax return. In the long run, the LLC structure can save members from a second layer of entity-level tax and simplifies the process of taxation altogether.
Easy Cash Distribution
Another LLC benefit is the ease of profit distribution to members. With other entity types, owners must be compensated through salary or dividends, LLC members can have their share of profits transferred directly to their personal accounts. These profit distributions are frequently referred to as owners’ draws. Since LLC members are personally taxed on their share of profits in the year the profit occurs, the cash withdrawal of profit is not taxed.
Cons of an LLC
Easy paperwork, flexibility, and limited liability are all appealing aspects of an LLC. However, there are contrasting factors to keep in mind when establishing and operating a business using this structure.
Inconsistency in State Law
Filing fees and registration requirements vary from state to state. For example, a few states—such as New York, Arizona, and Nebraska—have a requirement that a detailed notice of the LLC’s formation be published in a newspaper or similar outlet for a designated amount of time.
In addition to state-specific formation requirements, the legal protections for certain kinds of LLCs have not been aggressively tested in each tax jurisdiction. As such, there is little precedent for how local courts will treat challenges to LLC structure and protection.
Maintenance & Annual Fees
Some states require annual reports in order to keep an LLC in good standing. While setting up the entity might be fairly simple, keeping up with the annual maintenance paperwork and filing fees can be a financially exhausting and time-consuming exercise. Additionally, because of pass-through taxation, owners/members must keep separate financial records. This record separation necessitates separate bank accounts and individual tracking of increases and decreases in each member’s investment in the LLC.
Member Turnover & Entity Termination
Even though the membership/ownership structure is extremely flexible, a change to this infrastructure may require a refiling of the LLC. In most cases, this change will also require amendments to existing operating agreements and articles of organization. You may also need to file amended paperwork with the IRS. If a change in membership is being considered, it may be wise to first consult an attorney to understand the ramifications of your proposed changes.
Self-employment Tax or Income Tax Without Distributions
While LLCs have flow-through taxation, which is great for income taxes, they’re not a great choice when you consider self-employment taxes. All of the income flowing through to active members is subject to self-employment taxes of 16.3%—in addition to any income tax.
Self-employment tax is the equivalent of the FICA tax that employees pay of 7.65%, except that self-employed taxpayers—including LLC members—must pay both the employee and employer share of FICA, which totals 16.3% (7.65% × 2). In contrast, shareholders of S-corps only pay FICA tax on their W-2 wages and not on the S-corp income flowing through after the wages. LLCs with net income higher than a fair wage to the LLC members should consider filing form 8832 to be treated as an S-corp.
Additionally, as explained in our section on easy cash distribution, owners and members do not take salaries but rather take cash withdrawals from their share of profit. Members are taxed on their respective share of profits, regardless of whether it was withdrawn as a cash distribution. These taxable profits that remain in the LLC can cause cash flow problems for the members because they may not have the cash to pay the tax. One solution is for the LLC to make additional cash distributions to the members to help pay taxes.
Limited Investor Options
Outside investors may prefer to invest in a C-corp over an LLC. When an investor eventually wishes to dispose of their ownership interest, a corporate entity can more easily liquidate an investor’s interest than an LLC. In addition, members of LLCs cannot take advantage of the section 1202 gain exclusion upon disposition of their interests. Using the IRS section 1202 exclusion, investors can exclude up to $10 million in gain of qualified small business stock.
Because LLCs don’t have the corporate advantage of issuing shares, 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.
Frequently Asked Questions (FAQs)
No, members are not taxed on withdrawals from the LLC since each member is already taxed on their share of the company’s annual profits, irrespective of cash taken out.
Four benefits of owning an LLC include limited liability, administrative ease, flexibility in ownership, and the ability to specially allocate income, deductions, and credits among members.
An LLC is a preferred choice for small businesses because of the ease of setup and flexibility of operation.
Bottom Line
An LLC continues to be one of the most popular forms of business structures, but it may not be ideal for your needs. As with any business decision, examine the business risks, paperwork, liability, member structure, and tax implications to identify the business structures most 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.
