When you’re setting up a new business, one of the first things you need to establish is its structure. For instance, you may choose to form a sole proprietorship, a partnership, an S-Corporation, or a regular corporation (also known as a C-Corporation).
However, one of the most popular business structures is the limited liability company (LLC).
So, what does LLC mean? An LLC is classified as a separate business entity owned by investors (members), who either manage it themselves (member-managed LLC) or appoint managers to do so (manager-managed LLC). Before you complete your LLC operating agreement or single-member LLC operating agreement, read about the advantages and disadvantages of forming an LLC.
It’s vital you learn how to form an LLC the correct way to prevent headaches and lost profits as you start up your business.
LLC Advantages and Disadvantages
The simple, flexible structure of an LLC is ideal for small businesses. But what are the benefits of an LLC exactly?
- Limited Personal Liability – This is the key advantage for LLC owners (also known as members). An LLC is legally separate from its owners, so it’s responsible for its own debts and obligations. This means that, although you can lose any investment you’ve made in your company, your personal assets are protected if the business gets into legal trouble.
- Reduced Bureaucracy – You might be thinking that corporations also offer limited personal liability. They do, but they’re also bound by specific requirements that may not be appropriate for a small business. One of the advantages of an LLC is that you’re not obliged to hold annual shareholder meetings. Furthermore, you’re not required to keep extensive records like a corporation. In fact, many states don’t even require LLCs to file annual reports.
- Tax Advantages of an LLC – The biggest benefit of an LLC is arguably its tax structure. There’s no specific federal tax classification attached to an LLC, but it can use the tax status of a sole proprietorship, a partnership, an S-corporation, or a C-corporation. This flexibility allows you to mitigate the amount of taxes you need to pay annually.
- Ownership Flexibility – Another advantage of an LLC is the flexibility it offers. With an LLC, taxes can pass through the business and be paid on the owner’s personal tax return instead. An LLC is not obliged to have any specific number or type of shareholders either.
- Management Freedom – With an LLC, you’re not required to have a board of directors or annual shareholder meetings. No formal structure is needed, and owners have more flexibility in the way they run their business and make decisions.
- Profit Distribution Options – LLCs have great freedom in how they distribute profit to their owners. You don’t have to distribute profit equally, nor do you have to distribute it according to the ownership share of each member. For example, if three members own an LLC equally, they can still agree that one party should receive a higher percentage of the profit, since that person invested more during the initial formation of the business.
Disadvantages of an LLC
There are also drawbacks to setting up an LLC. Disadvantages of an LLC include the following:
- Cost – Certain states, such as California, charge additional fees for operating an LLC — like an annual franchise tax.
- Self-Employment Tax – Unlike an S-Corp, if income is split between LLC members and the business, all income may be liable for payroll or self-employment taxes. LLC taxes may be higher than corporation taxes if individual members are paying out-of-pocket for federal items such as Medicare and Social Security.
- State Restrictions – Some states may not allow certain professions, such as doctors or dentists, to operate using an LLC.
- Membership Limitations – If you’re making an amendment to the LLC operating agreement, each member must give permission before membership interests are transferred. However, this could also be an advantage in some circumstances.
- Asset Protection – Many states will not support asset protection for single-member LLCs (an LLC with one owner).
LLC Tax Rates and Exemptions
A key advantage of an LLC is the way it’s taxed. Let’s find out more about LLC taxes and exemptions.
Understanding how LLCs are taxed depends on the number of members it has. A single-member LLC is taxed as a sole proprietorship, whereas a multi-member LLC usually pays income tax as a partnership.
Neither single-member nor multi-member LLCs pay taxes on business income; instead, the tax “passes through“ to each member’s personal tax returns. The separate partners pay tax according to the size of their share of the business. As the business grows, LLCs may be able to save money by choosing a new tax treatment with the IRS.
An LLC may enjoy federal income tax exemptions in the following cases:
- By filing Form 1023 under section 501(c)(3) of Title 26 of the U.S. Internal Revenue Code
- It’s a single-member LLC, and that single member is exempt from tax under section 501(c)(3)
- If the IRS treats your LLC as a pass-through entity for federal income tax purposes, and all of its members are 501(c)(3) organizations
- Most domestic LLCs exempt under Section 501(c)(3) may receive deductible, charitable contributions, as well as private foundation grants, without expenditure responsibility
Note: Tax exemption for federal income tax purposes doesn’t always translate to exemption from state income taxes or state property taxes, so check your specific state’s LLC tax exemptions.