Fact checked for accuracy by Janet Berry-Johnson, CPA.
Choosing the business entity that works best for your situation is a big decision, and it might seem even more intimidating if you don’t know the details involved with creating an LLC.
Is a limited liability company structure the right selection? Or, would another type of business work better for you?
As with any decision, running your business through an LLC offers several advantages as well as disadvantages.
The key is gaining a complete understanding of the pros and cons, comparing them to the advantages and disadvantages of other business entities, and then making an educated decision.
In this article, you’ll learn the pros and cons of creating an LLC so you’re equipped to make the most intelligent business entity choice.
What Is an LLC?
LLC stands for limited liability company. It’s a business structure that you can use to combine the limited liability benefits of a corporation with pass-through taxation advantages offered via sole proprietorships or partnerships.
To be clear, a limited liability company is not a corporation. It’s also not a partnership or a sole proprietorship. Instead, it fits somewhere in the middle and acts as a legal form of a company that gives owners limited liability protection.
Advantages of Creating an LLC
Let’s look at the pros of setting up an LLC.
Ease of Filing
Compared to setting up a corporation, it’s relatively simple to set up and maintain ongoing filing requirements for an LLC. Each state has different requirements to file an LLC. Most Secretary of State websites do a good job of walking you through the process and there are also several LLC services that can help for a small fee.
Here are the steps you’ll typically follow:
- Visit the Secretary of State website for the state you want to file the LLC in (usually the state you live in or where you conduct the business). File the paperwork and pay the filing fees online.
- If you don’t already have a business name, you’ll need to define your LLC’s business name and identify it during the filing process.
- Select a registered agent. A registered agent can be you or any other entity with an address in the state where you form the LLC. It’s usually better to hire a third-party registered agent. This gives the state a physical address to send tax or lawsuit paperwork to.
- Not every state requires a formal operating agreement. It’s vital, however, to use one to list out member responsibilities if you’re filing a multi-member LLC.
- Contact the IRS to get a free EIN (Employer Identification Number).
- Open a business bank account for the LLC.
Asset protection is the major distinction that exists between a sole proprietorship or general partnership, where you don’t enjoy limited liability.
An LLC gives you the personal asset protection that keeps your home, cars, and other personal assets safe from lawsuits or creditor judgments against your LLC.
That’s why the name of this entity includes the term “limited liability.” This type of liability protection exists in part because owners of LLCs enjoy a separate status from the business itself and its operations. This isn’t true with a sole proprietorship, for instance.
An LLC’s limited liability feature does come with limitations. For example, your personal assets can get exposed to creditors if you committed fraud while operating your business. The IRS will easily attach liens to your personal assets if your LLC gets into major taxation issues with the agency.
Other entities, such as other businesses or taxation agencies, look at an LLC differently than someone conducting business as a sole proprietor. Formalizing your business structure with a state filing affords your company more credibility in the eyes of those you conduct business with.
You can form a single-member LLC or a multi-member LLC. A multi-member LLC, especially, provides flexible ways for managing your company. You can include an unlimited number of members in a multi-member LLC.
This means the LLC structure allows for a tremendous amount of business growth over time. If you want to add in a new investor who doesn’t wish to have anything to do with the daily business operations, you can simply add them in as a new member.
If you need to hire someone to come in and manage a new location your business added in another part of town, then you can bring them in as an LLC manager.
It’s more than likely that you’ll start a business with the member-managed LLC structure. It’s worthwhile to understand that you can change the LLC’s structure by adding outside managers whenever it fits your situation.
A “pass-through” taxation process dictates how an LLC’s business income and profit gets reported at tax time. Unlike a corporation, where the corporation itself files and pays its taxes at corporate tax rates, an LLC flows its profits down onto the personal tax returns of its owners.
This means you can potentially save on the amount of taxes paid by avoiding corporate income tax, along with what’s called double taxation. It also helps avoid complicated tax situations. Instead, everything gets consolidated onto one personal tax return for each member of the LLC. Read our column on LLC taxes for more information.
Simple and Flexible Cash Distributions
The way profits get distributed among members is a major advantage to using an LLC.
You can use “draw of funds” or “profit distributions” to share company profits with each member. The business itself and the draws don’t get taxed either because each member reports those profits on their personal tax returns at tax time (see the previous section about pass-through taxation).
Further flexibility on cash distributions exists because you can choose to split profit equally or unequally, based on each member’s specific stake in the business. For more, read our guide on how to pay yourself from an LLC.
Disadvantages of Creating an LLC
As with most things in life, using an LLC as your business structure also includes disadvantages to consider.
Maintenance and Paperwork
LLCs don’t require as much paperwork as corporations do, but there’s still considerably more work involved in this area when compared to general partnerships or sole proprietorships.
Some states require LLCs to file annual reports to remain active and in good standing. These reports typically include a detailed filing process and paperwork to fill out. You’ll also need to pay filing fees during the annual renewal process. This might only come to $25 or $50 in some states. Other states, however, charge a few hundred dollars to remain compliant each year.
Due to the pass-through taxation rules, all LLC members must also stay meticulous with their personal tax return filings. The same goes for your financial records. To maintain limited liability, you need to keep separate financial records to maintain legal separation between the company and its members.
Even with the benefits of pass-through taxation, you still must remain aware of other taxation issues when operating your business inside an LLC.
The IRS considers LLC members as self-employed individuals, not employees. Each member must pay self-employment taxes on the amount of company profit that flows from the LLC down onto the personal return. This means you’ll pay regular income taxes on top of paying social security and Medicare taxes on your personal tax return.
You do have several financing options with an LLC:
- Debt financing: You can use government grants and loans, bank loans, or personal funds to initially or continually fund the company.
- Equity financing: LLCs typically get their startup capital from members injecting capital into the company.
- Crowdfunding and fundraising: You can also take advantage of crowdfunding websites, peer-to-peer fundraising, or private fundraising sources.
Limitations exist when looking for outside investors, however. Corporations issue shares. LLCs don’t issue shares. This makes an LLC less attractive to investors when compared to corporations because investors must become co-owner or contributing members in the LLC.
Member Turnover Inflexibilities
While it’s true that you can add as many members and managers to your LLC, it’s also true that some states make it more difficult than others to remove members and managers.
Your state may require you to complete a full refiling when changing the LLC’s structure. This could include dissolving the current membership and then reforming with the newly-structured membership.
At the very least, these types of turnover situations will include articles of organization and operating agreement amendments. From there, you’ll need to file amended IRS paperwork and Articles of Amendment with the Secretary of State.
Other Types of Businesses to Consider
Let’s help you compare the pros and cons of an LLC to the pros and cons of a sole proprietorship, partnership, and corporation.
You run an unincorporated business when operating as a sole proprietor. Operating your business in this manner doesn’t require any formal paperwork or action. As long as you operate alone, then you’re a sole proprietor. An example of this might be a freelance designer.
The IRS taxes you on your personal 1040 form using a Schedule C attached to it.
- 100% control over your business operations
- You receive all profits
- In most states, you don’t have to file an annual report or pay a fee. However, you may need a business license.
- You’re 100% personally liable for business debts
- Some banks may not lend easily because the business has little collateral
- You’re fully exposed in the event of lawsuits
A partnership doesn’t require incorporation paperwork either. All three partnership types are informal structures when compared to a corporation or LLC. The three kinds of partnerships include general, limited, and limited liability.
- Less paperwork or expenses when compared to filing a corporation or LLC
- Flow-through taxation rules for partners
- No structured corporate requirements exist
- Personal property isn’t protected
- Each partner is liable for the actions (and debts) of the other
- Difficult to attract investors
A corporation represents the most structured form of business entity. You can use either an S corporation or a C corporation. These two options include various differences when it comes to structure and taxation. However, here are the main pros and cons of corporations from a global perspective.
- Limited liability protection
- Easier to attract investors and raise capital when needed
- Stock options (C corporations)
- Easier to transfer ownership to others (S corporations)
- Formation requires the most paperwork and expertise
- Tax mistakes can cause the loss of S corporation status
- Far more ongoing regulation
- The possibility of double taxation exists
The Last Word
Many reasons exist to use an LLC as your business structure. You also need to stay aware of the disadvantages when using this type of entity. However, when you compare the pros and cons of an LLC against the pros and cons of other business structures, an LLC makes for a nice mixture of all types.
If you see that an LLC works best for your situation, then take your next step by getting the paperwork together, filing with your state, and enjoying the benefits of using the LLC for your business. After you’ve done all that, read our guide on what to do after you’ve formed your LLC.
Filed under: Advice Columns