An LLC, or Limited Liability Company, is a legal business entity that combines the benefits of a corporation and a partnership or sole proprietorship. It provides limited liability protection to its owners, known as members, while offering flexibility in terms of management and taxation.
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The main reason business owners choose to form an LLC is for liability protection. In a sole proprietorship or general partnership, the owners of the business have unlimited liability. If someone were to sue the business, they could come after the owners’ personal assets. An LLC separates the business assets of the company from the personal assets of the owner. If someone were to sue an LLC, they could only go after the assets of the business.
The other reason why business owners choose to form an LLC is that profits can be directly passed to the owners and investors without being double taxed like a C-corporation.
An LLC is a legal designation, not a tax designation
By default, your LLC is treated as a “pass-through” entity, meaning your business’ income and losses pass through to your personal tax return. However, you can also make another election with your LLC to be taxed as an S corporation, C corporation, or partnership, each having different tax implications.
Pros of running a business as an LLC
Limited liability protection
One of the biggest benefits of an LLC, compared to entities like sole proprietorships and general partnerships, is the limited liability protection it provides to its members. This means that the personal assets of the members are generally shielded from the debts, liabilities, and legal obligations of the business.
Flexibility in management and ownership
LLCs offer flexibility in terms of management and ownership structures. Members can be individuals or even other legal entities, such as corporations or partnerships. Unlike corporations, LLCs are not bound by strict rules regarding the appointment of officers and directors. Members can determine the management structure that best suits their needs and allocate decision-making authority as outlined in the operating agreement.
Pass-through taxation
By default, LLCs are treated as pass-through entities for tax purposes. This means that the LLC itself does not pay federal income taxes. Instead, profits and losses are “passed through” to the members, and they report their share of the LLC’s income or loss on their individual tax returns. This avoids the issue of double taxation that C-corporations face, where the company’s profits are taxed at the corporate level and then again as individual shareholders receive dividends.
Also read: How to File Taxes as a Sole Proprietorship (Forms, Deductions, And Deadlines)
Flexible profit distribution
Unlike a partnership, in an LLC, members have the flexibility to distribute profits in a manner different from their ownership percentages. This allows for customized profit-sharing arrangements that may be based on factors such as capital contributions, agreed-upon percentages, or a combination of factors. This flexibility can be beneficial when members have varying levels of involvement, investment, or when they want to reward certain members for their contributions or efforts.
Credibility and professionalism
Forming an LLC can enhance the credibility and professionalism of a business. Compared to sole proprietorships or general partnerships, an LLC carries a more formalized structure and legal recognition. This can be advantageous when seeking financing, entering into contracts, or attracting business partners and clients.
Cons of running a business as an LLC
Formation and maintenance requirements
Forming and maintaining an LLC typically involves more paperwork and legal requirements compared to sole proprietorships or partnerships. This includes filing articles of organization with the appropriate state agency, creating an operating agreement, obtaining necessary licenses and permits, and complying with ongoing reporting and record-keeping obligations.
Self-employment taxes
Although LLCs offer pass-through taxation, members are generally subject to self-employment taxes on their share of the LLC’s income. This is because members of an LLC are considered self-employed individuals and are responsible for paying both the employer and employee portions of Social Security and Medicare taxes.
Limited life span
In most jurisdictions,LLCs have a limited life span, which means that the existence of the LLC may terminate upon the withdrawal, death, or bankruptcy of a member, unless otherwise specified in the operating agreement. This limited continuity can pose challenges in terms of business succession planning and long-term stability. However, it’s worth noting that some jurisdictions allow for perpetual existence of LLCs, mitigating this drawback to some extent.
Additional compliance requirements
LLCs are subject to various compliance obligations, such as filing annual reports, maintaining proper records, holding regular meetings, and adhering to state regulations. Failure to comply with these requirements can result in penalties, loss of limited liability protection, or even the dissolution of the LLC.
Limited raising of capital
Compared to corporations, LLCs may face limitations when it comes to raising capital. While LLCs can admit new members and allow for additional capital contributions, the flexibility and ease of raising funds through the sale of shares or issuing stock certificates that corporations enjoy may be more limited for LLCs. This can make it challenging for LLCs to attract substantial investments or go public in the same way corporations can.
Also read: What Are The Different Types Of Business Entities?