What is an LLC? Advantages & disadvantages

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An LLC (limited liability company) is a business structure that shields its owners from personal responsibility for its debts or liabilities. LLCs are considered hybrid entities that incorporate the features of corporations, partnerships, and sole proprietorships.

While the limited liability aspect of an LLC is comparable to that of a corporation, flow-through taxation is a characteristic of partnerships rather than LLCs. This means an LLC’s profits and losses are not taxed directly but passed through to its members, who report them on their tax returns.

It’s essential to note that regulations surrounding LLCs can differ from state to state. Anyone, be it an individual or an entity, can become a member of an LLC, except banks and insurance companies.

In summary, an LLC is a corporate structure that shields its owners from personal liability for the company’s debts or liabilities. LLCs are not taxed directly on their profits; instead, their profits and losses are passed through to members, who report them on their tax returns.

What should I know about a Limited Liability Company (LLC)?

A Limited Liability Company (LLC) is a business entity permitted under state regulations, which vary from state to state. The owners of an LLC are typically called members.

In most states, ownership is not limited to specific entities, meaning anyone can become a member, including individuals, corporations, foreign individuals, foreign entities, and even other LLCs. However, some exclusions, such as banks and insurance companies, cannot form LLCs.

The business must file an Articles of Organization with the state to establish an LLC. Compared to a corporation, LLCs are more straightforward to set up and provide greater flexibility and protection to investors.

LLCs have the option of not paying federal taxes directly. Instead, the owners report their profits and losses on their personal tax returns. Additionally, LLCs can select a different classification, such as a corporation.

In the event of fraud detection or failure to comply with legal and reporting requirements, creditors may pursue the members for damages.

Understanding Wages in a Limited Liability Company (LLC)

The wages paid to limited liability company (LLC) members are considered operating expenses, which you can subtract from the company’s profits. This deduction can be made for tax purposes, as the LLC members are also considered company employees.

In simpler terms, LLC members who also work for the company can receive compensation for their services, which is considered an expense that the company incurs. This expense is then deducted from the company’s profits when calculating taxes, which can help lower the company’s overall tax liability.

It’s important to note that this deduction only applies to LLCs taxed as partnerships or sole proprietorships. If an LLC chooses to be taxed as a corporation, the rules for wages and deductions can become more complex.

LLC Taxation: How Does It Work?

If you’re considering forming an LLC, one of the most important factors is how it will be taxed. The federal government considers LLCs to be a “disregarded entity.” This means that the IRS taxes LLCs differently than other types of businesses.

If you’re a single-member LLC, the IRS will tax you as a sole proprietorship. The IRS will tax you as a partnership if you have multiple members. Alternatively, you can elect to be taxed as an S corporation or a C corporation.

Once you’ve decided, you’ll need to calculate your taxes based on the tax rules for that entity and prepare an LLC return for the state where you do business. One benefit of this taxation structure is that LLCs are not subject to separate federal taxes unless the LLC is a C-corp.

Limited Liability Companies (LLCs) have a unique structure known as “flow-through”. This means the company’s profits and losses are passed down to each owner. As a result, each owner reports this information on their individual income tax return. This structure helps avoid the double taxation problem, which corporations often face.

Although this structure has its advantages, there are also some downsides. Business owners may find themselves in a higher tax bracket and need to pay self-employment taxes. In such situations, it may be more beneficial for them to be taxed as an S-corp to save money.

Are LLCs Taxed Differently Than Corporations?

Absolutely. When it comes to corporations, profits undergo taxation twice. First, at the corporate level and again when those profits are distributed to individual shareholders. Businesses and investors heavily criticize the process known as “double taxation.”

However, limited liability companies provide a more favorable alternative by permitting profits to be directly passed on to investors. This means that taxation occurs only once, as part of the personal income of the investors, rather than the double taxation faced by corporations.

Setting up an LLC

While the criteria for LLCs may differ from state to state, certain similarities exist. The first step for the proprietors or members is to decide on a name.

Subsequently, articles of organization can be compiled and submitted to the state. These articles detail the privileges, powers, duties, liabilities, and other responsibilities of each member of the LLC. The documents also contain the names and addresses of the LLC’s members, the name of the LLC’s registered agent, and the company’s statement of purpose.

The state registers the articles of organization and collects a fee for it. Additionally, the business must submit further documents and pay fees to the federal government to obtain an employer identification number (EIN).

Check our article on forming an LLC for a more comprehensive guide. However, here’s a simple step-by-step guide on how to create an LLC.

  1. Choose a Unique Name: The first step in forming an LLC is choosing a unique name representing your business. Make sure to research the availability of the name online and with the county clerk’s office and the secretary of state’s website in the state where you plan to operate. Many states allow you to reserve a name for a specific period by paying a fee.
  2. Choose a Registered Agent: A registered agent is someone you designate to receive official correspondence for your LLC, someone within your company, or a third-party company that provides registered agent services. Make sure to choose a registered agent before filing your articles of organization, as most states require you to list a registered agent’s name and address on the form.
  3. File Articles of Organization: Filing articles of organization is the step that officially brings your LLC into existence. Most states require you to provide basic information about your business, such as the name, address, and management type.
  4. Get an Employer Identification Number: If your LLC has employees or operates as a corporation or partnership, the IRS requires you to obtain an employer identification number (EIN). This nine-digit number is used for tax purposes and is assigned to businesses.
  5. Create an Operating Agreement: To ensure efficient business management, drafting an operating agreement is essential. This agreement should outline all the critical details, such as the percentage of ownership of each member, voting rights, powers, duties of both members and managers and the method of distributing profits and losses. Depending on the state where your business is located, you can either have an oral or written agreement. Although optional in many states, having one can be very useful.
  6. Open a Business Checking Account: Keeping your business and personal finances separate is always wise. Opening a separate business checking account is an excellent first step to achieve this. It will create a clear line between your personal and business finances. This separation is essential if you want to reduce any potential risks to your assets, especially if a legal action arises that questions your business practices.

Advantages of LLCs

When deciding on a business structure, creating a Limited Liability Company (LLC) can provide several benefits over operating as a sole proprietorship, general partnership, or corporation.

Limited liability

Limited liability protection is one of the most significant advantages of forming an LLC. The members of an LLC, which are the owners, are protected from personal liability for any actions taken by the LLC or its other members. This means that if the business incurs debt or faces legal action, creditors cannot go after the personal assets of the owners, such as their house or savings accounts. In contrast, Creditors can seize the personal assets of sole proprietors and general partners to pay off business debts.

It’s important to understand that just like a corporation, an LLC can lose limited liability protection if the company’s veil is pierced. To prevent this, LLC owners should ensure they adhere to legal formalities and maintain a clear separation between their personal and business finances.

Membership Flexibility

LLCs offer flexibility in terms of membership, as members can be individuals, partnerships, trusts, or corporations. Additionally, there is no limit to the number of members an LLC can have. In contrast, S Corporations have strict limitations on the types of shareholders they can have, and there is a cap on the number of shareholders allowed.

Management Structure

Another advantage of an LLC is its management structure. Members can choose to manage the LLC themselves or elect a management group to handle the day-to-day operations.

The board of directors manages corporations instead of shareholders. In a member-managed LLC structure, the owners oversee the daily business operations, while in a manager-managed structure, the LLC operates similarly to a corporation, where directors and officers are responsible for business management.

Pass-through Taxation

LLCs also provide pass-through taxation, meaning the business does not pay taxes. Instead, any business income or loss is passed to the owners and reported on their personal income tax returns. Any taxes due are paid at the individual level. In contrast, C Corporations are taxed at the business entity level, and shareholders are taxed on the income they receive from the corporation.

Business Credibility

Starting an LLC can also help establish credibility for a new business, as it provides a more professional and established image than a sole proprietorship or partnership.

Limited compliance

Finally, LLCs face fewer compliance requirements and ongoing formalities than other business structures. This makes it easier for LLCs to operate and maintain their status in good standing.

Disadvantages of LLCs

Although an LLC (limited liability company) has several advantages, it also has some disadvantages you should consider before creating one.

Cost

One disadvantage of an LLC is its cost. Typically, an LLC costs more to establish and maintain than a sole proprietorship or a general partnership. In addition to an initial formation fee that most states charge, many states also require ongoing fees, such as annual reports and franchise taxes. You may want to check with your Secretary of State’s office to determine the total cost of forming and running an LLC.

Ownership Transfer

Another disadvantage of an LLC is its transferable ownership. Unlike a corporation, ownership in an LLC is often more complex to transfer. In a corporation, shares of stock can be sold by the corporation to increase ownership, and shareholders can sell their shares to others unless there is a shareholder agreement that prevents it.

However, in an LLC, unless the members agree otherwise, all members must approve adding new members or changing the ownership percentages of existing members. This can make it more difficult for an LLC to raise capital or for members to sell their ownership interests.

LLC vs. Partnership: Understanding the Differences

When choosing the right business structure, deciding between a partnership and a limited liability company (LLC) can be challenging. However, understanding the fundamental differences between these two entities can help you make an informed decision.

The primary distinction between a partnership and an LLC is that it offers personal liability protection for the owners by separating their assets from the company’s business assets. If the LLC incurs debts or legal liabilities, the owner’s assets will not be at risk.

LLCs and partnerships allow for pass-through taxation, meaning that the profits and losses of the business pass through to the owners’ tax returns. However, the losses incurred can only offset the amount of investment made by the owners. If the LLC has opted to be taxed as a partnership, it is required to file Form 1065. On the other hand, if the members have elected to be taxed as a corporation, they must file Form 1120.

An LLC can establish a business continuation agreement to ensure a smooth transfer of interests in case of an owner’s departure or death. This agreement will help the business continue its operations seamlessly, even in the owner’s absence. Such an agreement is necessary for the remaining owners to be able to dissolve the LLC and set up a new one.

The Bottom Line

The term “limited liability” implies that a company’s assets and liabilities are distinct from its owners’ personal assets and liabilities. In case a company declares bankruptcy, the creditors have no claim over the personal assets of the owners but only the business’s assets. This feature of LLCs offers a degree of protection to business owners and mitigates their financial risks.

Apart from shielding the owners’ assets from the company’s debts and obligations, LLCs offer additional benefits such as simplified taxation and a straightforward formation process. Consequently, LLCs are the most prevalent type of business entity in the United States.