The thought of “being your own boss” is sure exciting and if you plan to do it by setting up your business and are ready with a business plan, the next crucial step is deciding the right business structure. This decision has far reaching repercussions for the business and thus requires careful selection. The factors like personal liability, regulations, tax treatment, etc are governed by the form of your business entity which could be a Sole Proprietorship, Corporation, Partnership, or a Limited Liability Company (LLC).
One of the easy, efficient and fast ways to start a company is to set up a Limited Liability Company (LLC). Let’s explore what exactly is an LLC, its suitability, advantages and disadvantages along with other fundamental factors which can help you decide if an LLC is right for you and your business.
What is a LLC?
The LLC is a relatively newer form of business entity in the U.S. It was Wyoming which enacted the first formal LLC statute in 1977. The act amalgamated the beneficial features of a partnership and corporations and was based on the 1982 German Code and the Panamanian LLC. Over the years, all states have passed legislation and even modified the acts to afford LLC its present form.
An LLC is a hybrid form of business entity which has selected features of a corporation and a partnership. It has been structured in a way to benefit from the pass-through taxation feature of a partnership along with allowing flexibility in operation and management and yet have limited liability like in the case of a corporation. In the U.S., the LLCs laws are governed by individual states but are recognized in all. The laws further vary across countries. The “owners” of the company in case of LLC are referred to as “members”. Usually a single person can start an LLC and there is no upper ceiling on the number of members. There are many established and well-known companies which are structured as LLCs. A few names are Chrysler Group LLC, Westinghouse Electric Company LLC, Dougherty & Company LLC, Blockbuster LLC. Some businesses like banks, insurance, medical services are ineligible to file as LLCs because of the “liability” protection given to LLCs.
- Limited Liability
This is one of the features of a LLC in which it resembles the corporations. LLC provides its owners a protective shield against business debt and liability. Let’s take an example, there is a shoe store “boot & boot” owned by Jimmy which loses its customers to one of the more fancy store around the corner. The business is not doing well and the company hasn’t paid rent for last 8 months and bills for three shipments of shoes. Thus “boot & boot” owes approximately $75,000 to its creditors who have filled a lawsuit against the company. The creditors have full right to claim the money owed from the company but have no right to Jimmy’s personal assets (bank deposits or gold or real estate). In an LLC, only the company’s assets can be liquidated to repay the debt and not the owners. This is a big advantage which is not provided by a sole proprietorship or partnership where owners and the business are legally considered the same adding vulnerability of personal assets.
The company is not taxed directly by IRS as a LLC is not considered a separate tax entity. Instead, the tax liability is on the members who pay through their personal income tax. Let’s look at an example. Say “boot & boot” has two members and has made net profits to the tune of $60,000 in a year. The net profits will be divided into two (number of members) and this amount will be taxed as their personal income depending upon their overall tax liability. Because of non recognition of LLC as a business entity for taxation purposes, the tax return has to be filed as a corporation, partnership or sole proprietorship. Remember that certain LLCs are automatically classified by IRS as a corporation for tax purposes, so be sure to know if your business falls in this category. Those LLCs which not automatically classified as a corporation can pick the business entity of choice by filing the Form 8832. The same form is used in case the LLC wants to change the classification status.
- Less Hassles
Among all forms of companies, start-up of a LLC is easier with lesser complexities, paperwork and costs. This form of company comes with a lot of operational ease with less record keeping and compliance issues. LLCs also provide a lot of freedom in management as there is no requirement of having a board of directors, annual meetings or maintaining strict record books. These features reduce unnecessary hassles and help save a lot of time and effort. The formation of an LLC broadly requires filing the “articles of organization” which is a document including basic information like business name, address, members. The filing is done with the Secretary of State for most states and has an associated filling fee. Next comes creating an Operating Agreement which though is not mandatory in most states but is recommended especially for multi-member LLCs. On registration of the business, other licenses and permits have to be obtained. Additionally, some states like Arizona and New York require publishing about the LLC formation in the local newspaper.
- Flexibility in Allocation
LLC provides a lot of flexibility when it comes to investing as well as profit sharing. In an LLC, members can opt to invest in a different proportion than their ownership percentage i.e. a person who owns 25% of the LLC, need not contribute money in the same proportion for initial investment. This can be done by creating an operating agreement which states percentages of company profits (and losses) for each member regardless of the amounts of their initial investments. So, it’s possible to have an outside investor put money in the business without ownership. The same applies to distribution of profits where LLC members have the flexibility to decide the allocation of profits. The distribution of profits can be in a different proportion than ownership. A certain member may take a bigger chunk of profits by consensus for the extra hours or effort he/she has put in carrying out the business.
While a limited liability company (LLC) offers an edge over some of the other forms of business entity, there are also some drawbacks which need to be looked at before selecting an LLC as the business structure.
- Limited Life
The life of an LLC is limited by the tenure of its members. While there can be variations across states, in most of them the business is dissolved or ceases to exist when a member departs an LLC further requiring the other members to complete the remaining business or legal obligations needed to close the business. The rest of the members can choose to set-up a new LLC or part ways. This weakness of an LLC can be overcome by including appropriate provisions in the operating agreement.
- Self Employment Taxes
The members of an LLC have to pay the self-employed tax contributions towards Medicare and Social Security as they are considered as self-employed. Due to this the net income of the business is subject to this tax. To avoid this, depending upon the business turnover and tax burden, the entity can choose to be taxed like a corporation if it works out more beneficial. Consult an accountant before making this choice.
The fee which is typically paid by an LLC as initial costs or ongoing charges is more than that for business entities like sole proprietorship or general partnership but less than what a C-corporation has to pay. The various types of fees include - applicable state filing fees, ongoing fees, annual report fees, etc.
- Precedent is Less
LLC is a relatively newer business structure and thus there have not been many law cases related to them. For this reason there is not much legal precedent or case law for LLCs as there is for the older forms. Having a certain legal precedence helps to act accordingly in the same given case scenario. There is more vulnerability as there are few established laws.
LLC is a good combination of protection with flexibility and tax benefits. It provides an array of taxation alternatives while shielding individual members from personal liability. LLCs are seen as apt for small businesses as there is less hassle and complexity in its functioning. However, consulting an accountant or lawyer for expert opinion is advisable before taking the final call.