What is the definition of a Limited Liability Company (LLC)?
Limited Liability Company (LLC) - A form of business organization with the liability-shield advantages of a corporation and the flexibility and tax pass-through advantages of a partnership.
The LLC is somewhat of a hybrid between a corporation and partnership, it’s the middle ground. Starting an LLC allows business owners to take advantage of the benefits of a sole proprietorship/partnership and a corporation, meaning they can limit personal liability, while getting tax and operational flexibility. All 50 states recognize LLC’s as a valid business structure. Business owners use LLC’s as a way to reduce personal financial risk while maintaining tax simplicity.
LLC’s are becoming more and more popular among small and mid sized business owners. They are easier to start and manage than a corporation, have less formalities, and offer flexibility on the number of owners and management. There are several considerations that come into play with LLC’s - should you form one, the costs, the filing requirements, etc.
LLC owners are called members and there can be as few as one member (a single member LLC) or multiple members. Members can be other companies as well, so there are plenty of options and lots of room to maneuver when thinking about setting up an LLC.
Any type of business can be an LLC, and it’s a popular form of business entity so it comes up with all types of business and industries, such as:
- Consulting firms
- Marketing and advertising agencies
- IT firms
- Contractors and Builders
- Fitness studios
Advantages of Forming an LLC
LLC’s create separation between the owners and the business. If you own a partnership or a sole proprietorship, from a legal standpoint you and your business are the same person - which is dangerous because you are going to be liable for any obligations and debts of the business. An LLC limits this personal liability and puts legal separation between owners and the business. The LLC is responsible for its own debts and obligations, if the company is sued, the owners aren’t personally sued. There are some situations that would lead to owners being personally liable, so be sure to carefully manage your company set up as your business changes and grows in order to keep taking advantage of the limited personal liability.
Reduced Corporate Formalities
A major reason for forming a formal business entity such as a corporation or LLC as opposed to being a sole proprietor or partnership is the limited liability discussed above. However, forming a formal business entity comes with some additional corporate formalities and paperwork. An LLC has reduced formalities (record keeping, minutes, meetings, filings, etc.) compared to a corporation and requires less paperwork to get established and started. You typically aren’t required to hold annual meetings or keep extensive records (although they may be beneficial in terms of limiting personal liability) and usually aren’t required to file annual reports, making it easier to start up and manage from an administrative standpoint.
Corporations have a fixed management structure that involves shareholders, a board of directors and officers all who play a different part in management and maintaining the day to day operations of a corporation. The shareholders must meet every year, elect directors and have a say in various other company decisions that will need to be made. LLC’s however don’t have that formal structure and can set up a management process in the way that makes most sense for the business and the way it operates, including putting all the decision making in the hands of a single individual. The allows for flexibility and speed when LLC’s need to make decisions about operations, future plans, hiring or any number of other decisions that come up in the course of operating a business.
LLC’s get the best of all worlds when it comes to taxation, they can have their pick of how to be taxed, opting to be taxed as a sole proprietor, partnership, S corporation or C corporation - whatever works best. The IRS, as a default, will tax LLC’s either partnerships or sole proprietorships, depending on whether they have one owner or more than one owner. It’s as easy as filing paperwork to change this classification to whatever best suits the needs of the owners. This also gives LLC’s the option of avoiding the double taxation that C-corporations face, where they first pay taxes on company profits and then the owners pay taxes on any dividends that are paid out.
Forming an LLC makes your business more official, and while that’s not necessarily a reason on its own to form one, it is an added benefit. You’ll use LLC after your business name on official documents and other formal agreements and it will lend some level of professionalism to clients and vendors. It will also help avoid situations that some sole proprietors run into - clients, customers and vendors not taking them seriously because they haven’t taken the steps to form a formal business entity, which has been known to cost them clients, miss out on opportunities and make it harder to acquire the resources needed to operate the business.
Disadvantages of Forming an LLC
Additional Administrative Requirements
There are some administrative requirements that come with an LLC that don’t apply to sole proprietorships or partnerships. You’re going to have to file some paperwork with the state to get it started and pay a registration fee (and most likely an annual registration fee after that); however, compared to forming a corporation, the filing is pretty minimal.
One major concern for LLC owners is keeping personal business separate from the LLC’s operations. This means the LLC needs it’s own records, bank account and should at a minimum make a record of any meeting held by the owners where major company decisions are made or approved. They have to keep their personal business separate from the LLC's operations. In addition to the separate bank account, the LLC will also need to keep separate financial records.
Taxes can be both an advantage, as discussed above, and a disadvantage for LLC’s. Unless you choose to be taxed like a corporation, you’re probably going to be subject to self-employment taxes, which means that all profit will be passed through to the owners, who will pay taxes on the profits on their personal tax returns. The issue that comes up is these taxes are many times higher than they would be if the company profits were taxed at the corporate level instead of passed through to the owners. It’s important to consider your specific situation when determining how your LLC will be taxed (and a good idea to get your accountant's advice) so you can avoid paying higher taxes that you may be able to otherwise avoid.
Depending on what type of business you’re starting and the amount of capital you might need to get it off the ground, an LLC could present some problems in terms of raising capital from outside investors. C-Corporations are more attractive investment opportunities because they can offer stocks that do not require the holder to pay taxes until the asset is sold. An LLC typically requires more complicated agreements to raise capital from investors and many investors simply don’t invest in companies that are set up as LLC’s. However, don’t let this discourage you, if an LLC is the right entity for you as you get started, you can always change to a C-corporation down the road if you need to raise significant outside capital and investors are leery of putting money into an LLC.
Similar to taxes, the management set up of an LLC can be both an advantage and a disadvantage. LLC’s aren't required to have formal positions, unlike a corporation which usually has directors, officers and managers. While this is beneficial in the sense that it allows flexibility in how the company will be run, it can cause problems and confusion about who’s responsible for what in the business operations. It’s important to clearly define roles and obligations in a company operating agreement so there are no hiccups in the operation of the business and no questions about who has the authority to make certain decisions that will bind the company.
Let's Sum It Up
LLC’s have many advantages and are appealing to many entrepreneurs across numerous industries. It’s important to consider what type of business entity when starting out, you can always change as you go, but it helps to get off to a solid start. Weigh the pros and cons with your particular situation and decide what’s best for you, and take into consideration the other business entities that are available to you.
Ultimately, an LLC offers some real advantage, especially over a sole proprietorship or partnership and is the perfect entity for many small businesses.
Have questions about LLC’s or legal strategy in general? Contact us for a free consultation and risk management analysis.