What are the advantages and disadvantages of an LLC?
What is an LLC?
A Limited Liability Company or LLC is a unique business entity unlike a sole proprietorship, a partnership or a corporation. An LLC is a hybrid legal entity that has the characteristics of both a corporation and that of a partnership or sole proprietorship.
The unique feature of an LLC is that this legal entity has the liability protections of a corporation, such that the owners of an LLC are not liable for the debts of the LLC while having the tax advantages of a sole proprietorship or a partnership via a concept called the pass-through taxation similar to a partnership.
Such flexibility and ability to mold are ideal for many forms of businesses to get legal protection and a cap on liability and the ability to choose either to use a tax structure of a sole proprietorship or partnership or that of a corporation.
An LLC is particularly attractive for professional practitioners with high liability claims and expensive personal injury insurance bills and requires a state license to practice such as doctors and lawyers. In some states such as Texas or California, professionals are not allowed to operate as an LLC. However, those states typically have other entities that serve a similar purpose such as a professional corporation or a professional limited liability company (PLLC).
Because of its hybrid nature as a legal business entity where its owners can enjoy both the protection of limited liability like a state chartered corporation could while simultaneously being able to file its taxes like a sole proprietor or a partnership (when it has multiple owners), it is often very attractive for a single owner. It is mainly because of the single owners’ ability to include personal and other itemized expenses on the tax filing while enjoying the legal protection of limited liability.
Despite having some similar features between an LLC and a corporation, the terminology and processes that are used in terms of the two business entities can vary in various states in the US (who essentially sanction forming of these entities). Since a corporation is a legal entity of its own with its own identification and taxation regiment when formed, its founding document is called its “article of incorporation”, whereas an LLC is formed using “articles of organization.”
Likewise, its internal regulations are called "operating agreement" versus "bylaws" for a corporation and the owners of rights to an LLC are called its members rather than shareholders for a corporation. And the percentage that each member owns of an LLC is termed as "units" or simply percentage rather than "shares of stock" as done in case of a corporation.
LLCs tend to have the most liberal ownership rules in most states. This means that anyone can be a member (owner) of an LLC, including, foreigners, foreign business entities, individuals, corporations, and even other LLCs. One group of businesses, however, can't be members of an LLC, which are banks and insurance companies.
Advantages of Forming an LLC:
As discussed above the members of an LLC are not held liable for either the debts of or any judgments rendered against an LLC. This along with the fact that in case of bankruptcy the personal savings, vehicles, property or other assets of the owners or multiple members of an LLC are safe from being accessed is one of the prime benefits of forming this sort of a legal business entity. These protections, however, vary by state since the state is the one that sanctions the structure of this business entity. This sets an LLC apart from other types of businesses like the sole proprietorship or a partnership where such protections are not available.
One of the biggest advantages of forming an LLC as a business entity aside from limited liability is that depending on the choice of its members, the earnings from an LLC can pass through to one or several of its members/partners. This help in avoiding being taxed as a separate entity from its owner and avoiding corporate tax rates.
Unlike the case when you form a corporation, an LLC is not a separate entity from its owners or members. Therefore, the IRS would not tax the LLC itself. Instead, the members of the LLC can determine how they want to be taxed. Here are some of the options available:
- Single Member:This is structured very much like a sole proprietorship where the single member LLC is not taxed rather the single member owner is taxed via his personal tax return. Whatever profit or loss the LLC has made flow directly into the owner’s/member’s income and taxed as such.
- Partners/Members in an LLC: The partners or the members of an LLC have the flexibility to be taxed just like a traditional partnership where the taxable income is the declared share of the income of the LLC.
- LLC taxed as a corporation:The best part of having an LLC is the ability for the LLC members to declare and have the LLC be treated as a corporation and be taxed as a separate entity from the members.
Less paperwork than an S-corp or C-corp:
It is the flexibility of a business entity on a state level that makes an LLC so attractive for various investors. As an LLC the paperwork needed and the formalities to be fulfilled are a lot lower than that of a corporation. This way you can form an LLC with the least paperwork and minimum hassle and maintain it in good legal standing without all the headache of a C-Corp or an S-Corp.
It is important however to draw up an LLC Operating Agreement to define the basic rules that govern your business. In absence of such a document, your LLC entity will be subject to onerous default rules that are established in the state where the LLC is registered.
Protection for Investors:
Along with the members outside investors or quiet partners are also benefited due to limited liability and the investors themselves not getting on the hook due to litigation against the LLC.
Disadvantages of Forming an LLC:
While there are several advantages of forming an LLC, there are also some flaws that make it unsuitable for adoption for certain kinds of businesses. These disadvantages are listed as follows:
Lack of Ample Governance:
Being a recently formed legal business entity and a very favorable and flexible treatment of States in terms of minimal legal impediments about how an LLC should operate is a good thing. But, this puts the onus on the parties operating an LLC to stipulate all the elements of how it is supposed to operate and deal with all situations that can occur in a business. In the event that no stipulations are made in the LLC Operating Agreement about a specific scenario, it is left to the state rules that act as a default governing principle. This can be very unattractive for business partners such as vendors and customers who are unwilling to take a risk on a business with no enforceable state authority.
Treatment of LLC on the Federal Level and Choice: of Court:
LLCs are only recognized on the state level and are governed by the laws of the state where they were formed. On the federal level, LLCs are treated as partnerships and when a dispute is formed during inter-state transactions, it has little choice as to which court will hear and decide the matter making an LLC vulnerable.
If an LLC decides to be a global business, an American LLC is recognized as a corporation in most global markets taking away the flexibility and the tax advantage that the LLCs offer.
In conclusion, LLCs are a very beneficial and flexible business entity where it comes to operating at an intra-state level, but one should be mindful of the consequences of case law and treatment of LLCs on a federal and global level.