What is an LLC?
A limited liability company (LLC) is a business structure that is owned by its members. Like a corporation, they receive personal liability protection in the event that the LLC suffers losses. However, they also benefit from pass-through taxation like a sole proprietorship or a partnership does.
Advantages of Forming an LLC
An LLC structure is popular among many small businesses. Here are some of the best benefits of choosing an LLC:
Simple Formation & Maintenance
LLCs are overall easier to form than corporations and require less maintenance paperwork. The most common requirement for LLCs is that they must file a formation document (such as the Articles of Organization or a Certificate of Formation). Some states do not even require that LLCs file periodic reports (such as an annual report or a biennial report).
While LLCs should have an operating agreement for their business, it is often not required.
On the other hand, corporations are often legally required to hold an annual shareholder meeting, record meeting minutes, maintain shareholder records, record important business resolutions, file an annual report, and pay an annual fee.
In short, the more laidback structure of an LLC may be more appealing to small business owners in the face of all of the corporate regulations.
Personal Liability Protection
Unlike informal business structures, an LLC benefits from personal asset protection. This means that if your business is sued or suffers losses, the owners' personal assets -- including houses, cars, and personal funds -- are not held personally responsible for the LLC.
There are of course limits to this protection: if an LLC owner fails to separate their business and personal finances or commits fraud, they risk losing that protection and risk piercing the corporate veil.
By default, a single-member LLC is taxed as a disregarded entity and a multi-member LLC is taxed as a partnership. This means that LLCs automatically benefit from pass-through taxation, where the LLC's profits pass through to each owner's individual tax return. The LLC is not taxed as a business entity, meaning that the owners can avoid double taxation.
However, LLCs can also elect to be taxed as either a C corporation (C corp) or an S corporation (S corp). There are benefits to corporate taxation: single-member LLCs may find that a corporate tax structure strengthens their line between personal and business finances. The corporate tax rate may also prove to be more beneficial to some LLCs.
In any case, an LLC has the flexibility to choose the tax structure that best fits them.
Management and Ownership Flexibility
LLCs have few restrictions on the number of owners they can have as well as how the LLC is managed. An LLC can choose to be member-managed or manager-managed -- that is, whether the LLC is managed by its members (owners) or by an appointed manager.
In contrast, a corporation must have a board of directors that are elected by shareholders annually. These annual meetings must also be used to conduct company business. An LLC does not have to follow these formal regulations and the owners have more choice in the management structure of their business.
Disadvantages of Forming an LLC
While there are many benefits of creating an LLC, there are also some drawbacks that businesses should be aware of:
Because of their default pass-through structure, the owners of an LLC must individually pay taxes on their share of the LLC's income. These self-employment taxes can prove to be higher than they would be in a corporate structure.
All LLC investors pay tax on the earnings of the LLC regardless of whether they received a distribution. Investors must also wait to file their personal taxes until they receive their K-1 form from the LLC. Because of this hassle, investors are often less likely to fund LLCs.
For comparison, C corp investors only have to pay taxes when they receive dividends from the business and are able to follow a more straightforward tax filing process. This simplicity makes C corps more appealing to investors.
Sole Proprietorship vs. LLC
A sole proprietorship is the simplest business structure that is not considered a legal entity from its owner. Because of this, a sole proprietor gets 100% of the business profits as well as 100% of the business debts, meaning that there is no personal asset protection.
What's the Difference?
Single-member LLCs -- LLCs with only one owner -- are taxed like sole proprietorships by default and are considered disregarded entities by the IRS. In this way, a single-member LLC can benefit from pass-through taxation like a sole proprietorship while still benefiting from personal asset protection.
A single-member LLC can also find that it is easier to build credit and raise capital. Once the LLC is formed, it can begin to build its business credit and access business loans.
On the other hand, a sole proprietor must use their personal credit line to fund their business. Even if they file for a DBA (doing business as) name and create a dedicated business bank account, they are still personally liable to their creditors.
For more examples, visit our LLC vs. Sole Proprietorship guide.
Partnership vs. LLC
A partnership is an informal business structure with two or more individual owners. Like sole proprietorships, a general partnership is a pass-through entity that reports all business gains and losses on each owner's individual tax return.
What's the Difference?
Multi-member LLCs - LLCs with two or more owners -- are automatically taxed like general partnerships by default. Again, a multi-member LLC benefits from the same pass-through taxation as a general partnership but also benefits from personal asset protection.
While a general partnership requires less paperwork than an LLC, its structure does not give its owners any protection in the event that the business is sued.
A partnership can obtain some limited liability protection through a limited partnership (LP) or limited liability partnership (LLP) structure, but these are not as available in all states like the LLC structure.
For more examples, visit our LLC vs. Partnership guide.
What Structure Should You Choose?
There are many benefits to choosing an LLC as your business structure, including flexible taxation and personal asset protection. However, there are also certain things to consider before making your final choice:
- What will your profit and risk level be?
- Is being investor-friendly important to you?
- Do you want to maintain a complex business structure?
Above all, we recommend consulting with a professional to find the business structure that is best for you.
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