A limited liability company (LLC) is a special form of business organization governed by individual state law that combines the limited liability of incorporation with the flexibility and simplicity of sole proprietorship. While organizing as an LLC brings a host of advantages to certain enterprises, not every business will benefit. Deciding whether to organize as an LLC requires an understanding of the form's advantages and drawbacks.
The ultimate goal of business owners who organize as an LLC is securing protection from liability that may arise from operating the enterprise. By setting up an LLC and following state law regarding the formalities and operation of the form, an owner, or "member," can protect her personal assets from lawsuits caused by employee negligence, fraud or other misconduct. Limited liability is also available in corporations; however, since an individual member is always liable for her own acts, limited liability does not help a business consisting of a single person doing all the work.
An LLC enables members to avoid the double taxation inherent in corporations, where the company pays corporate taxes and then the shareholders pay income taxes. Pass-through taxation is treatment given to the LLC without the heavy regulations attendant to S-corporations. Additionally, the profits of a multiple-owner LLC are not considered earned income under federal tax rules, thus avoiding the self-employment tax. The managing member's share of the profits is considered earned income, however, and this erodes the tax advantage of an LLC versus a sole proprietorship for a single owner.
Observance of Formalities
LLCs are governed by individual state laws, which specify rules for creating and maintaining the company. While LLC regulations are generally less stringent than those for corporations, failure to observe them could lead to a loss of the limited liability that makes the LLC form so valuable to many businesses. As such, the sole owner who feels that the burden of observing state law regarding LLC creation and operation outweighs the advantages of limited liability, may see no advantage to the LLC form over a sole proprietorship.
Transfer of Ownership
Selling a business organized as a sole proprietorship is a simpler endeavor than selling an LLC. State law often limits an LLC member's ability to sell or transfer his interest in the company, with further restrictions often created by the operating agreement. Furthermore, an LLC transfer may result in tax complications. A.J. Rollins of Wagner, Johnston and Rosenthal, P.C.notes that an LLC sale that produces losses in excess of the investment in the company can create a taxable gain and if the LLC has unrealized receivables or appreciated inventory, the seller could be required to report it as ordinary income.