An LLC is a popular business type for small and large businesses alike. Like all formal business entities, there are pros and cons to consider, and the limited liability company might not be the right choice for your company. In this guide, we’ll cover the five primary advantages and four disadvantages of an LLC.
Advantages of an LLC
1) Easy to form and maintain
LLCs are the easiest formal business type to create in America today, especially in comparison to a corporation. With an LLC, the basic formation requirement is simply to prepare and file your articles of organization with your state government, whereas other entity types have more legal hoops to go through.
Similarly, LLCs do not have as many maintenance requirements. In general, an LLC needs to file an annual report and any fees required by the state, and in some states there’s also a franchise tax payment as part of the maintenance process. In terms of ongoing compliance issues, these are fairly simple requirements.
2) Fewer formalities and paperwork
Corporations are legally required to maintain a heap of paperwork, including bylaws, minutes from shareholder meetings, minutes from director meetings, business ledgers, and much more. The formalities required are often considered to be a hassle, and that’s without even mentioning the incorporation process itself, which requires far more time and effort than forming an LLC.
Luckily, LLCs do not have to worry about these requirements. An LLC does need to maintain some business records, but not to the same extent. Any meetings are held at the discretion of the members, whereas corporations must have meetings for both shareholders and the board of directors.
3) Personal asset protection
As a formal business entity, an LLC has what’s commonly referred to as a “corporate veil.” The veil establishes a line between your business finances and your personal finances.
This division is extremely important. Here’s why: if the LLC runs into debt or legal trouble, someone has to pay up, but thanks to the corporate veil, the LLC itself will pay these costs. If your company’s finances are insufficient, your personal funds and assets cannot be taken to make up the difference.
For example, let’s say that you run a bicycle repair shop. You complete a standard tune-up for a client, but the cyclist wrecks because a part you replaced came loose. The client, who broke several bones in the fall, sues for damages. Your small repair shop lacks sufficient funds to pay for the settlement.
In this situation, if you are a sole proprietorship, you would be ordered to pay these expenses from your personal assets ― your car, house, and more would be at risk. As an LLC, you would not encounter this problem. Hopefully, debts and lawsuits will be a rare occurrence in your business ventures, but when something does happen, the corporate veil will help protect you.
4) Flexible membership structures
Corporations operate under rigid structural formalities that can be a hassle to comply with. While the LLC has the freedom to choose managerial structures, corporations must comply with strict requirements, with a board of directors, appointed officers, and shareholders all filling distinct roles.
There are further restrictions on S corporations as well. Unlike an S corporation, an LLC or C corporation can have a single member, a dozen members, a hundred members — there is no restriction on the number of members an LLC or C corporation can have. Similarly, your members can be foreign investors, not just U.S. citizens. With an S corporation, you cannot have any non-resident alien owners, and you can’t have more than 100 members either.
5) Tax flexibility
LLCs may choose to be taxed as a corporation or a pass-through entity. This flexibility is uncommon for businesses, and it allows the LLC’s members to pick the tax approach that most benefits them.
LLCs usually elect the default option, which is to be taxed as a pass-through entity. With this tax approach, the LLC itself does not pay taxes. Instead, the business income is passed through to the members of the LLC, who then report that income on their personal tax returns.
LLCs taxed as corporations work in the opposite way ― the LLC pays taxes itself. This approach requires the entity to pay the corporate income tax, and is typically only preferable if the LLC’s owners are high-income individuals for whom the corporate tax rate would be lower than their individual tax brackets.
Disadvantages of an LLC
1) Trickier to raise funds through investments
LLCs are allowed to raise capital through outside investments, but corporations are far more appealing to most investors. First off, LLCs cannot issue stock, and shares of stock from a corporation are a preferred form of investment for nearly all private investors. Furthermore, venture capitalists almost never invest in LLCs, because the pass-through entity type is highly disadvantageous for VC investors.
2) Self-employment taxes
While taxation is typically an advantage for LLCs, it’s a disadvantage in the realm of self-employment taxes. This is because all LLC owners are considered to be self-employed individuals, which means they’re subject to the 15.3% self-employment tax rate, a rate that includes both the employer and employee portions of Medicare and Social Security. By contrast, corporation owners are not legally viewed as self-employed people, and are therefore exempt from paying this tax.
3) Legalities vary from state to state
One downside of the LLC is the way each state is allowed to create its own guidelines for how they should be formed and maintained. Therefore, it can be difficult to figure out exactly what’s expected from your LLC, especially if your business operates in multiple states.
In addition, the LLC was introduced to the American business landscape fairly recently, so there can also be some inconsistency and confusion regarding how courts in different states handle lawsuits involving LLCs, because there’s a lack of precedent in some states.
4) More hassle than operating an informal business
While the LLC has an advantage over corporations in this area, it still requires more time, effort, and money to form and maintain than a general partnership or sole proprietorship. With these informal business structures, there’s no formation process, no maintenance requirements, and no fees to pay. Of course, sole proprietorships and general partnerships have some significant disadvantages (like no personal asset protection), but the LLC is certainly more of a hassle to form and operate.
The limited liability company (LLC) is such a popular business entity type for a reason, as it combines some of the corporation’s advantages with those of informal businesses like general partnerships. The result is a fluid and flexible business structure that still maintains its professionalism and legitimacy.
Still, the point we would like to drive home is that the LLC is not for everyone. While it does have several significant advantages over the corporation (as well as over informal entities), there are also some disadvantages that could apply depending on your exact situation. With that in mind, we hope you will weigh these pros and cons to make sure the LLC is the right structure for your business.