A Limited Liability Company (LLC) is the US – specific form of a private limited company. It is a business structure that can combine the pass – through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation under state law; it is a legal form of a company that provides limited liability to its owners in many jurisdictions.
LLCs are well known for the flexibility that they provide to business owners; depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not – for – profit.
In certain U.S. states (for example, Texas), businesses that provide professional services requiring a state professional license, such as legal or medical services, may not be allowed to form an LLC but may be required to form a similar entity called a professional limited liability company (PLLC).
Table of Content
- Characteristics of an LLC
- 1. LLCs Are Subject To Fewer Regulations Than Traditional Corporations
- 2. An LLC is Treated By Default As A Pass-Through Business Entity
- 3. Choice of Tax Regime
- 6. Treated as Entities Separate From Their Members
- i. No Detailed Governance and Protective Provisions for The Members of a Limited Liability Company
- ii. Difficulty in Raising Financial Capital
- iii. Attracts Franchise Tax
- iv. Attracts Higher Renewal Fees
- v. Unfavorable Tax Jurisdiction Outside the United States
Characteristics of an LLC
An LLC is a hybrid legal entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). An LLC is a type of unincorporated association distinct from a corporation.
The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass – through income taxation. As a business entity, an LLC is often more flexible than a corporation and may be well – suited for companies with a single owner.
Interestingly the pros of a Limited Liability Company (LLC) often outweigh any perceived cons but irrespective of how attractive and easy to set up a business legal entity or structure is, there are always pros and cons of owning such business status hence the need to weigh your options before choosing one. In this article, we will be looking at the pros and cons of owning a Limited Liability Company.
Pros of Owning a Limited Liability Company
1. LLCs Are Subject To Fewer Regulations Than Traditional Corporations
LLCs are subject to fewer regulations than traditional corporations, and thus may allow members to create a more flexible management structure than is possible with other corporate forms.
As long as the LLC remains within the confines of state law, the operating agreement is responsible for the flexibility the members of the LLC have in deciding how their LLC will be governed. State statutes typically provide automatic or “default” rules for how an LLC will be governed unless the operating agreement provides otherwise, as permitted by statute in the state where the LLC was organized.
2. An LLC is Treated By Default As A Pass-Through Business Entity
For U.S. federal income tax purposes, an LLC is treated by default as a pass-through entity. If there is only one member in the company, the LLC is treated as a “disregarded entity” for tax purposes (unless another tax status is elected), and an individual owner would report the LLC’s income or loss on Schedule C of his or her individual tax return.
Thus, income from the LLC is taxed at the individual tax rates. The default tax status for LLCs with multiple members is as a partnership, which is required to report income and loss on IRS Form 1065.
Under partnership tax treatment, each member of the LLC, as is the case for all partners of a partnership, annually receives a Form K – 1 reporting the member’s distributive share of the LLC’s income or loss that is then reported on the member’s individual income tax return.
On the other hand, income from corporations is taxed twice: once at the corporate entity level and again when distributed to shareholders. Thus, more tax savings often result if a business is formed as an LLC rather than a corporation.
3. Choice of Tax Regime
Another advantage of starting an LLC is the company can elect to be taxed as a sole proprietor, partnership, S corporation or C corporation (as long as they would otherwise qualify for such tax treatment), providing for a great deal of flexibility.
Please note that a limited liability company with multiple members that elects to be taxed as partnership may specially allocate the members’ distributive share of income, gain, loss, deduction, or credit via the company operating agreement on a basis other than the ownership percentage of each member so long as the rules contained in Treasury Regulation (26 CFR) 1.704 – 1 are met. S corporations may not specially allocate profits, losses and other tax items under US tax law.
4. Enjoys Limited Liability
Owning a Limited Liability Company (an LLC) limits your potential liability as a business owner. For example, if a customer gets hurt using a product produced by your company or gets hurt when they are in any property owned by your company, an LLC can prevent a would-be plaintiff from going after your personal assets.
Interestingly, some of the liabilities that LLC owners can be shielded against include Unpaid business debts (Unless you personally guarantee them), Vendor disputes (If they try to bill more than you owe) and of course Damages (especially if someone is hurt by your business or on property you own).
Please note that LLCs liability protection is similar to S – Corps and C – Corps and in contrast to sole proprietorship owners who have unlimited personal liability for the debts and actions of their business. Under a sole proprietorship, if your business borrows or loses money, you are personally liable for those debts. In an LLC, you are only liable if you provide additional personal guarantees.
5. Enjoys Flexible Membership
Another advantage of owning a Limited Liability Company (an LLC) is the fact that this form of business structure allows for flexible membership. This means that members of an LLC may include individuals, partnerships, trusts, estates, organizations, or other business entities, and most states do not limit the type or number of members.
For some business ventures, such as real estate investment, each property can be owned by a separate LLC, thereby shielding the owners and their other properties from cross – liability. LLCs in some states can be set up with just one natural person involved.
6. Treated as Entities Separate From Their Members
Limited Liability Companies (LLCs) in most states in the United States are treated as entities separate from their members. However, in some jurisdictions such as Connecticut, case law has determined that owners were not required to plead facts sufficient to pierce the corporate veil and LLC members can be personally liable for operation of the LLC). They also enjoy less risk of being “stolen” by fire – sale acquisitions (more protection against “hungry” investors).
Cons of Starting an LLC;
i. No Detailed Governance and Protective Provisions for The Members of a Limited Liability Company
Although there is no statutory requirement for an operating agreement in most jurisdictions, members of a multiple member LLC who operate without one may encounter problems.
Unlike state laws regarding stock corporations, which are very well developed and provide for a variety of governance and protective provisions for the corporation and its shareholders, most states do not dictate detailed governance and protective provisions for the members of a limited liability company.
In the absence of such statutory provisions, members of an LLC must establish governance and protective provisions pursuant to an operating agreement or similar governing document.
It may be more difficult to raise financial capital for an LLC as investors may be more comfortable investing funds in the better – understood corporate form with a view toward an eventual IPO. One possible solution may be to form a new corporation and merge into it, dissolving the LLC and converting into a corporation.
iii. Attracts Franchise Tax
A good number of states in the US such as Alabama, California, Kentucky, New York, Pennsylvania, Tennessee, and Texas et al levy a franchise tax or capital values tax on LLCs. This franchise or business privilege tax is the fee the LLC pays the state for the benefit of limited liability.
The franchise tax can be an amount based on revenue, an amount based on profits, or an amount based on the number of owners or the amount of capital employed in the state, or some combination of those factors, or simply a flat fee, as in Delaware.
Please note that effective in Texas for 2007, the franchise tax is replaced with the Texas Business Margin Tax. This is paid as: tax payable = revenues minus some expenses with an apportionment factor. In most states, however, the fee is nominal and only a handful charge a tax comparable to the tax imposed on corporations.
So also, in California, both foreign and domestic LLCs, corporations, and trusts, whether for – profit or non – profit—unless the entity is tax exempt—must at least pay a minimum income tax of $800 per year to the Franchise Tax Board; and no foreign LLC, corporation or trust may conduct business in California unless it is duly registered with the California Secretary of State.
iv. Attracts Higher Renewal Fees
Another disadvantage of owning a Limited Liability Company (LLC) is that the renewal fees may also be higher. Maryland, for example, charges a stock or nonstock corporation $120 for the initial charter, and $100 for an LLC. The fee for filing the annual report the following year is $300 for stock – corporations and LLCs. The fee is zero for non – stock corporations.
In addition, certain states, such as New York, impose a publication requirement upon formation of the LLC which requires that the members of the LLC publish a notice in newspapers in the geographic region that the LLC will be located that it is being formed. For LLCs located in major metropolitan areas (e.g., New York City), the cost of publication can be significant.
v. Unfavorable Tax Jurisdiction Outside the United States
Limited Liability Companies are confronted with unfavorable tax jurisdiction outside the United States of America. Taxing jurisdictions outside the US are likely to treat a US LLC as a corporation, regardless of its treatment for US tax purposes—for example a US LLC doing business outside the US or as a resident of a foreign jurisdiction. This is very likely where the country (such as Canada) does not recognize LLCs as an authorized form of business entity in that country.
It is also important to point out that the management structure of an LLC may not be clearly stated. Unlike corporations, they are not required to have a board of directors or officers. So also, the principals of LLCs use many different titles—e.g., member, manager, managing member, managing director, chief executive officer, president, and partner. As such, it can be difficult to determine who actually has the authority to enter into a contract on the LLC’s behalf.