THE ADVANTAGES AND DISADVANTAGES OF FORMING AN LLC
Limited Liability Companies (LLCs) are the easiest and most inexpensive business structures that provide owners with protections against personal liability. The members of an LLC are not personally liable for the actions of the company and their personal assets are protected from the business’s creditors. They are the also simplest and most inexpensive business structure in the United States.
Limited LiabilityThe biggest advantage of an LLC is that the members are not personally liable for the actions of company. Therefore, the members personal assets (homes, cars, bank accounts, investments, etc.) are protected from creditors seeking to collect from the LLC. These protections remain in place so long as the LLC is not run for fraudulent purposes and business and personal financials are kept separate. Other potential liabilities that LLC owners can be shielded against include unpaid business debts (unless you personally guarantee them), vendor disputes, and damages (for example someone is hurt by your business or on property owned by the LLC).
This is in stark contrast to a sole proprietorship where owners have unlimited personal liability for the debts and the actions of the business. Additionally, with a sole proprietorship if your business borrows or loses money, you are personally liable for those debts. Conversely, with an LLC, you are only liable if you provide additional personal guarantees.
Pass-Through Federal Taxation on ProfitsUnless an LLC opts otherwise, it is a pass-through entity, which means its profits go directly to its members without being taxed by the government on the company level. Instead, members are taxed on their federal income tax returns. As a result, filing taxes is easier than if your business were taxed on the corporate level. Moreover, if the LLC loses money, you and other members can shoulder the hit on your returns and lower your tax burdens.
Easy to Create and Administer1. Choose and Register a Name
After choosing a name for you LLC, you will need to register is with the Secretary of State in the state where you plan to conduct business. Your name must be unique and to ensure someone else is not already using your name, you can do an online search at the Secretary of State’s website. For a small fee, most states will allow you to reserve a name of an LLC prior to filing articles of origination.
2. Choose a Registered Agent
You must choose a registered agent who will be the person you designate to receive all official correspondence and legal service for the LLC. The registered agent must be chosen prior to filing articles of organization because most state require the registered agent’s name and address to be listed on the form.
3. File Articles of Organization
States require basic information about your LLC in the articles of organization such as the name, principal place of business, management type and registered agent. Filing articles of organization is essentially brings you LLC into existence.
4. Obtain an Employer Identification Number
Any business that has employees or operates as a corporation or partnership is required by the IRS to have an EIN, a nine-digit number assigned to businesses for tax purposes. This rule is applicable because since LLCs are creatures of state law, they are classified for federal tax purposes as either a corporation or partnership.
5. Draft an Operating Agreement
A LLC’s operating agreement should include detailed information about its management structure, including an ownership breakdown, by percentage member voting rights, powers and duties of members and managers, and how profits and losses are to be distributed. Some states require the operating agreement to be in writing while others allow an oral agreement. Many states do not even require an operating agreement. Nevertheless, it is a good idea and useful document to have.
6. Set up a business checking account
One of the most important things you can do to ensure that limited liability remains in place is to ensure you keep your business and personal finances separate. One of the most critical things you can do is t set up a small business checking account in the name of the LLC. Having a separate checking account for your LLC draws a bright line between business and personal affairs.
To administer you LLC each year you must file a annual report and pay a fee and file excise and franchise taxes where applicable. You should also check with the appropriate clerk’s office or other to make sure your business license continues to meet all applicable requirements.
Management FlexibilityAn LLC can opt to be managed by its members or by managers. Management by members allows all owners to share in the business’s day-to-day decision-making, Management by managers, who can be either members or outsiders, may be beneficial if members have no experience in running a business and want to hire others who are. n many states, an LLC is member-managed by default unless explicitly stated otherwise in filings with the secretary of state
No Annual Meeting and Minutes RequirementAnother major advantage of owning an LLC is that there is no requirement to hold an annual meeting and keep minutes. In a corporation, the shareholders and board members usually must meet at least once a year to vote on corporate matters and elect officers. This requirement is not a statutory requirement of an LLC.
Ability to Change Tax StructureUnique to LLCs, owners can choose how they want to be taxed. The vast majority chooses the pass-through method as discussed. In addition, LLCs can also make a C-Corp election to file their own tax returns. Under this tax structure, LLCs are still typically less expensive than corporations and most other alternatives. In fact, taxes on LLCs are much than C-Corps, which are taxed twice on corporate profits. LLCs are only required to pay self-employment tax. Finally, LLCs can use an S-Corp election to take advantage of certain tax benefits, including the ability of members to pay themselves a salary without self-employment tax. S-Corps are also exempt from the second layer of taxes on corporate profits, which is unlike C-Corps.
Self-Employment and Franchise and Excise TaxesThe IRS, by default, considers LLCs the same as partnerships for tax purposes, unless the members opt to be taxed as a corporation. If taxed as a partnership, the government considers members who work for the LLC to be self-employed. As a result, those members are personally responsible for paying Social Security and Medicare taxes, collectively known as self-employment tax and based on the business’s total net earnings.
Conversely, if an LLC elects to be taxed as an S corporation, owners who work for the company pay Social Security and Medicare taxes only on actual compensation, not the whole of the company’s pretax profits.
Additionally, many states impose franchise and excise taxes for the privilege of doing business within its boundaries. For example, in Tennessee the franchise tax is based on the greater of net worth or the book value of real or tangible personal property owned or used in Tennessee. The excise tax is based on net earnings or income for the tax year.
Member TurnoverSeveral states provide that if a member leaves the company, goes bankrupt or dies, the LLC must be dissolved and the remaining members are responsible for all remaining legal and financial obligations necessary to terminate the business. While the remaining members may continue to do business, they must start an entirely new LLC.
Limitations to Limited LiabilityThere are a few exceptions in which a court may hold that a member of an LLC has lost their limited liability. This is referred to as “piercing the corporate veil” and includes certain circumstances which, among others, may include:
Fraud: If you defraud customers or investors, acting through your business, then you can be subject to unlimited personal liability.
Commingling personal and business funds: If you fail to segregate business and personal money then you can subject yourself to liability incurred through your business.
Failure to meet LLC requirements: LLCs have certain requirements like holding annual meetings and keeping minutes. Failure to meet these requirements can result in unlimited liability.
Use of personal money to meet business obligations: Paying business bills with personal money may subject you to additional liability.
Initially failing to sufficiently capitalize LLC: If you fail to sufficiently capitalize your LLC with enough funds to satisfy its obligations, you may potentially be held personally liable for its debts.
Difficulty Raising MoneyIf you are starting a new business and will need to raise money from outside investors, this can be made more difficult by using an LLC. Because of the pass-through nature of LLCs and their flexibility for managing members, they are a greater risk for outside investors, who are more likely to invest in C-Corps and other types of entities. LLCs cannot issue shares, and therefor the only way for an outside investor to invest in an LLC is to buy-in as a member. As a result this makes it nearly impossible to raise equity capital.