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LLCs are typically used by individuals and small businesses that have trouble finding financing, because they offer tax benefits. LLCs also provide limited liability to shareholders. However, structuring an LLC is not easy and involves many complex rules and regulations which can be a downside in some cases.
A limited liability corporation, or LLC, is a popular corporate form for startups and small companies. The company structure primarily impacts legal responsibility and taxes, but it may also have an impact on the core of the business model and everyday operations in a variety of ways. The following are the primary factors that determine a company’s establishment and legal structure:
- Obligation to complete initial paperwork
- The company structure’s formality
- Ownership membership structure
- Money-raising possibilities
- Taxation of businesses
- In the case of a company loss, the extent of personal culpability
To further understand the possibilities for the formation and the effects on responsibility and tax burden, go to your Secretary of State’s website and look up formation structures. This is also where you’ll submit that formation and become legally established up with your state, which will have its own set of filing costs.
The Advantages and Disadvantages of a Limited Liability Company (LLC)
We’ll go through the benefits and drawbacks of forming a limited liability company (LLC) in this post.
Advantages of a Limited Liability Company
An LLC is a low-risk, safe, and cost-effective company structure for small enterprises, particularly for novice entrepreneurs getting their feet wet in self-employment. The following are some of the advantages of forming an LLC:
Filing Effortlessness
Filing an LLC is generally low-maintenance in terms of paperwork. This paperwork may be done online in less than an hour, depending on how sophisticated your Secretary of State’s website is. The cost of filing varies by state, from $40 in Kentucky to $500 in Massachusetts, but the procedure is quite simple, and many state websites provide an online link to help people through the process.
The following are the stages to forming an LLC:
1. Determine which state you will be filing in. Your filing state is most likely where you reside and will most likely do business. Because each state’s filing procedures and costs differ, the first step should be a visit to the Secretary of State’s website.
2. Give your LLC a name. If you don’t already have a company name, use our name generator tool and read about how to come up with one that is clever, crisp, and relevant.
3. Select an agent to act as your registered agent. This is the procedure of appointing someone to receive legal and regulatory documents on behalf of the company. The registered agent is the company’s formal and official contact. Some company owners choose to do this task themselves, but it’s worth looking into a fee-based registered agent service to provide more security, formality, and compliance to the business model.
This is considerably less expensive than it seems, and the reduced risk may pay for itself over time (or at least for the first year).
4. Create a business agreement. An operating agreement is similar to a business plan in that it is not necessarily essential but highly recommended. Even if your state doesn’t need it, it’s a good idea to document member duties ahead of time. This is particularly true if you’re forming an LLC with numerous members/owners, in which case clarifying duties is crucial.
5. Register your limited liability company (LLC) with your state. The articles of organization, which specify the essential company components such as the business name, location, and purpose, as well as the identification of the registered agent and management structure, are mostly completed when filing your LLC with your state.
6. Obtain an Employer Identification Number (EIN). The Employer Identification Number (EIN) or Tax Identification Number (TIN) of a company is its tax identification number. If the company owners want to recruit staff or create a business bank account, they must file this form.
7. Open a bank account for your company. This is more of a should-do than a must-do, but it is particularly vital in the case of an LLC, when having separate owner/business money is critical.
If you want a guided, user-friendly approach, skip the government portal and go right to Incfile, an accelerated site that will have your LLC up and operating in no time.
Credibility
There’s something to be said about a legal, state-issued stamp of approval on a company that declares it’s a legitimate corporation. An LLC is a more structured structure than a partnership or sole proprietorship, in addition to formalizing any company structure via state registration. This is because the benefits and legitimacy provided by an LLC—particularly the restricted liability—come with more formalities, obligations, and paperwork. Some firms convert from a sole proprietorship to LLC over time as a result of the increased protection and tax advantages that an LLC provides.
Separation of the owners from the firm is another distinguishing feature of a formal vs. informal structure. The owners of partnerships and sole proprietorships are not regarded as independent from the company’s obligations and activities. Owners and members of LLCs and corporations, on the other hand, are deemed distinct, which is why their personal assets are safeguarded in the event of a company failure. With that formality comes more protection and a lower risk of personal culpability.
Flexibility, Ownership, and Oversight of Membership
More benefits include unlimited ownership and flexible management in a single- or multi-member LLC. Individuals, partnerships, companies, trusts, and even other LLCs may be “Members” or “Owners” of an LLC. There are also numerous single-member LLCs, and these people may operate the firm anyway they want—whether they are hands-on or employ managers to do so. Member-Managed and Manager-Managed, respectively, are the two alternatives. Corporations, on the other hand, are controlled and managed by a board of directors or executives, rather than by their owners. As a result, the LLC provides a more streamlined and straightforward supervision structure.
If an LLC does not specify whether it is Member-Managed or Manager-Managed, it will default to Member-Managed in many states. This should be a deliberate decision that is established in the operating agreement from the start.
Cash is distributed quickly.
The simplicity with which profits are distributed to LLC members is a significant benefit. Instead of a salary, you’ll get “profit distributions” or a “draw of cash” from your part of the profit accounts. Another advantage is that neither the draws nor the business is taxed (more on that later); instead, you declare your part of the company profit on your personal tax returns at the end of the year.
Pass-Through Taxation
The advantage of “Pass-Through Taxation” goes hand in hand with the preceding bullet point. This simply implies that a business’s revenue or profit “passes through” to the owner’s personal tax return, avoiding corporate income tax and the risk of double taxation. In the long term, this may save LLC members a lot of money in taxes. Not to mention the fact that being taxed just once, on a personal tax return that one would submit anyhow, makes the taxes procedure simpler.
Potential tax deductions are another tax advantage of LLCs. A recent benefit known as the Qualified Business Income (QBI) deduction, which allows LLC owners to deduct 20% of their net income in addition to ordinary business cost deductions, is an example of one of these deductions.
Personal Liability is limited
This formation’s name describes how ownership is kept accountable. Your personal assets, including your home, automobile, savings accounts, heirlooms, and investments, are shielded from liability in the event of a company loss. This safeguard may spell the difference between losing your company and losing your shirt entirely. This feature alone is frequently enough to entice small company owners looking to reduce personal risks and safeguard valuable assets.
The terms “financial loss” and “business liabilities” may refer to a variety of things. Here are a few instances when an LLC might be a valuable tool in safeguarding members’ personal assets:
- Lawsuit
- Bankruptcy
- Failure of a business
- Defaulted obligations
- Unfulfilled responsibilities
However, limited liability is not without restrictions that expose owners and members to the business’s losses, such as in the following member-initiated situations:
- For a company loan or debt, a member provides a personal guarantee.
- Fraud and/or tax fraud are committed by a member.
- An individual is personally and directly harmed by a member.
- Member willfully commits a crime against the LLC or another person.
The disadvantages of becoming an LLC
Paperwork is simple, there is flexibility, and there is low liability: Doesn’t that all seem really appealing? However, there is a flip side to some of the advantages of forming an LLC: the disadvantages of registering as an LLC. Before developing your LLC, consider the following disadvantages:
Paperwork and maintenance
In order to maintain an LLC in good standing, certain states demand yearly reports. Fees (again, depending on the jurisdiction), reports, and tedious paperwork and filing procedures are occasionally associated with them. Furthermore, due to pass-through taxes to the owner’s personal tax return, owners/members must maintain separate financial records to prevent personal responsibility, which needs separate bank accounts.
Member Turnover’s Inflexibility
While an LLC is a solid and low-risk company formation choice, it can also be a difficult balance. That is, even while the membership/ownership structure is very adaptable, allowing for any number or kind of owners, a change to this infrastructure may need a re-filing of the LLC. When a member joins or quits an existing LLC in certain states, the LLC may be required to dissolve and reconstitute with new members.
In most situations, this move will need changes to existing operating agreements and articles of incorporation, as well as submitting Articles of Amendment with your state registration office and filing modified IRS papers. If a change in members affects your LLC, it’s a good idea to speak with an attorney beforehand to learn about the implications in your jurisdiction and your specific situation.
Investing Options are Limited
LLCs may raise funds in a variety of ways, beginning with ordinary stock and debt capital.
Equity Financing – The majority of equity financing for LLCs originates from initial member contributions. LLCs may raise equity capital from new members as a condition of membership or via periodic contributions in return for a portion of the firm.
Debt Financing – A kind of debt financing, many LLCs are originally or continuously supported by loans. Personal or informal loans, bank loans, lines of credit, and government loans and grants are all possibilities.
Fundraising and Crowdfunding — To support the launch or scale-up of a firm, an LLC may use private fundraising activities, peer-to-peer fundraising, and internet crowdfunding portals.
Investors from the outside (Angel and private) – Because LLCs do not have the ability to issue stock like corporations, the only way to invest in one is to become a contributing member and co-owner. LLCs are seen by outside investors as riskier ventures with a lot more red tape than a high-return corporate investment. While having more members in an LLC may result in more cash being invested on their behalf, it may also result in a dilution of the profit pool.
Miscellaneous taxes and a Tax Burden that Isn’t Aligned
Even while pass-through taxation is advantageous, there are additional taxes to consider when forming an LLC. The following are some examples:
- Taxes on Self-Employment
- Taxes on franchises (where applicable)
- Individual members fill out K1 forms to declare their share of ownership and tax liabilities.
- Taxes on Employment
- Taxes on individuals or corporations
- Excise taxes are a kind of tax that is imposed on goods and services.
Owners and members do not accept a salary and instead draw profit as a kind of profit-sharing, as stated under simple cash distribution. Members are then taxed on their individual shares of earnings, regardless of whether or not payments have been paid to them.
Guaranteed payments, which are given to LLC members for services done or money used, are an exception. This assures that LLC members are appropriately rewarded and financially secure, independent of or prior to the LLC’s prosperity. However, since these payments may not be properly equal to the corresponding member(s)’ ownership share, the IRS claims that it skews their income and may result in disproportionate (too high or too low) taxes.
Conclusion
If the disadvantages of creating an LLC exceeded the benefits, it would not be the most prevalent business filing in the nation. In recent years, LLC company registrations in the United States have surpassed all other entity kinds for the 16th year in a row. Consider your situation while evaluating alternative company formats, just like you would with any other business choice. Examine your company’s risks, paperwork, responsibility, membership structure, and tax consequences to determine which business structures are best for your company. Other frequent business structures include sole proprietorship, partnership, corporation, and cooperative, all of which you might consider for your company.
