Limited Liability Company (LLC): The Pros and Cons

Whether you’ve just started your business or your already operating a business for quite some time, choosing the form of business structure has probably crossed your mind especially if you are just operating as a sole proprietor.

One of the options for a business structure is a Limited Liability Company or simply called LLC.

Limited Liability Company(LLC) is a hybrid structure that provides the limited liability features of a corporation and the operational flexibility of a partnership. It is also chartered by the state and must be formed and operated in compliance with state law.

In an LLC, the owners are called members and not shareholders. There are no maximum number of members that can join the LLC but some states do not allow single member only.  In most states, there are no restrictions on who can be a member so individuals, corporations, other LLCs and foreign entities may qualify.

However, banks and insurance companies cannot be members of LLC. It is best to check your state’s requirements and the federal tax regulations for further information.

What are the Advantages?

  • Limited Liability – Just like with a corporation, LLC members are not personally liable for the debts of the entity. The risk of loss is limited to the amount of the investments unless of course the owners personally guarantee the debt obligation of the business.
  • Flexibility to Avoid Double taxation – LLC provides flexibility with regards to taxation. LLC with single members are automatically taxed as a sole proprietor while LLC that has two or more members are automatically taxed as a partnership unless the members elected to be taxed as a corporation. This allows the earnings to flow through the members and avoid the double taxation normally present with the regular corporations.
  • Much simpler and cheaper to formalize than Corporations – Unlike the corporations, there are no formal stockholder meetings, board of director meetings and you do not have to keep any corporate minutes required in order to operate as an LLC. Unlike the S Corporation, LLC have much less restrictions on who can be members of the business entity.
  • Less complex tax accounting than corporations – the tax accounting rules of an LLC are less complex than corporations.

What are the Disadvantages?

  • Double Taxation when corporation is elected – When LLC members elect to be classified as a corporation for federal tax purposes, double taxation occurs. Meaning that profits will be taxed at the business level and when dividends are distributed to the members, it will be taxed again on their personal tax returns.
  • May have to pay a minimum tax liability to the state – Some states requires LLC to pay a minimum tax liability and it does not matter if you are filing as a sole proprietor on federal tax returns. This is a big disadvantage especially if you have a net loss. As an example, the State of California requires a minimum tax payment of $800 per year and you have to pay this amount even if you reported a loss and did not pay any federal tax.
  • Must adhere to state regulations – It is regulated by the state and must be formed and operated in compliance with state law. Similar to a corporation, it requires more formal legal documents and cost additional money. This is not the case with a sole proprietorship and partnerships.
  • Inconsistent Regulations – State statutes are not uniform and businesses that operate in more than one state may not receive consistent treatment.
  • Payment of Self-Employment taxes – Dividends received from a regular corporations to the shareholders are not subject self-employment taxes. This may apply to S Corporation as well if the shareholders meet the income threshold. This is not the case with LLC. Since it has the same benefit of a sole proprietorship, LLC members has to pay self-employment taxes on all the earnings from the business.
  • Limitations on the Life of LLC – LLC may terminate within 30 years or less in some states. The duration of the LLC is usually determined when the organization papers are filed.
  • More complex tax accounting than a sole proprietorship – the tax accounting rules of an LLC are much more complex than a sole proprietorship.

Professional LLC

In some states, professionals cannot form an LLC in order conduct their business. They have to form and register as PLLC or Professional Limited Liability Companies. In this case, the PLLC can only protect the members from any debts from the creditors but not from the judgment caused by a malpractice from their profession. For example, a doctor,who is a single member of the LLC, will not be personally responsible for the debts of the business if the business defaults. However, patients who sued him and obtained judgment because he performed a bad surgery can go after the doctor’s personal assets if his malpractice insurance do not cover the judgment.

Examples of these professionals are physicians, accountants, tax practitioners, nurse practitioners, physical therapist, occupational therapist, recreational therapist, chiropractors, civil engineers, information technology analyst, etc.

Filing of Tax Return

For federal tax purposes, an LLC is not recognized by the IRS. So when filing the tax returns, the business entity must file as a sole proprietorship, partnership or corporation. Since members can either be corporations or individuals, the classification varies when filing tax returns.

  • Single Member  LLC – If the only member of the LLC is an individual, the LLC is classified as a sole proprietorship by default unless the business elected to be classified as a corporation by filing Form 8832 – Entity Classification Election. The LLC income and expenses are reported on Form 1040, Schedule C, E, or F. On the other hand, if the only member of the LLC is already a corporation, the LLC income and expenses are reported on the corporation’s return, usually Form 1120 or 1120S.
  • Two or More Members LLC – In general, LLCs with two or more members file a partnership return using Form 1065 – US Return of Partnership Income unless the election is made to file as a corporation. Each owner should show their pro-rata share of partnership income (reduced by any tax the partnership paid on the income), credits and deductions on Schedule K-1 (1065), Partner’s Share of Income, Deductions, Credits, etc

Source: sba.gov, irs.gov

Comments

  1. The LLC Company says:

    I think inconsistant treatment among states is the biggest disadvantage for LLCs. We’ve seen some greater uniformity in recent years, but it’s still difficult for people to understand that LLCs are newer and less defined. I suppose the lack of uniformity lets business owners have more flexibility in deciding where to register their business, but it still makes things overly complex for the average small business owner.

    Do you think the Uniform Limited Liability Company Act will gain any more traction in the coming years, or do you think states are going to stick with their own LLC rules?

  2. llc says:

    Great article, Limited Liability Company is the best type of business entity for start up business.