The limited liability company (LLC) model has become a popular choice for those starting businesses. However, when deciding whether to form your business as an LLC, you should make an informed choice that accounts for the positive and negative aspects of the entity type.
The pros involved with operating as an LLC include limited personal financial liability for members, favorable pass-through taxation, ease of formation, special profit allocation, and ease of ownership transfer. Cons include difficulty raising capital and high renewal fees.
An LLC, as its name implies, provides its members, or owners, with limited liability. This means that the members of an LLC are legally distinguishable between their personal assets and the assets of the business. Unlike a sole proprietorship, which leaves an owner's personal assets vulnerable to creditors, an LLC shields member assets so that a creditor to the business can only collect from business assets.
The LLC model avoids the double taxation scenario seen by other corporate models. Other corporate models pay corporate tax on company profits; then owners and employees, when they receive salary or other distributions from the company, pay personal income tax on what they receive. In contrast, an LLC has pass-through taxation, meaning that the LLC does not pay corporate taxes on profits earned—such profits pass through to the members, who pay personal incomes taxes on salary and other distributions received from the LLC.
Ease of Formation
In most states, forming an LLC is quite easy. Members draft articles of organization, fill out the necessary formation documents, and submit those documents to the Secretary of State (or comparable authority). When filing those documents, the new entity usually pays a fee. This contrasts with other corporate models whose formation generally requires substantially more paperwork.
An LLC allows its members to draft an operating agreement as they see fit. Special allocation refers to the ability of a member to receive a profit distribution that is greater than his or her ownership stake. The operating agreement can specify, for example, that a specific member with a 25 percent interest in the company receives 50 percent of the profit.
Other corporate constructs, on the other hand, have no such flexibility. Under those models, profit distribution parallels how many shares the owner holds.
Ease of Transfer
In many states, an operating agreement controls how a potential transfer of ownership occurs. An operating agreement that allows for transfer flexibility eases a transfer when a member dies or wishes to leave the business. Many LLCs are family businesses, which, if used properly, can seamlessly transfer ownership from one generation to the next.
Difficulties in Raising Capital
LLCs do not issue stock, which can be a powerful tool when raising capital. If a company wants to invest in a certain project but lacks money to invest, one avenue of raising capital without taking out a bank loan is to sell shares of the company.
LLCs, in contrast, cannot issue shares, and therefore have no such access to these types of funds. If an LLC wants to invest in a project but lacks required capital, it will need to search for alternative ways of fundraising. Their options tend to be more expensive and time consuming.
Higher Renewal Fees
In most states, LLCs and other corporations must renew their licenses each year with the Secretary of State. The fees for renewing an LLC are typically higher than renewal fees for other corporate outfits.
LLCs provide users with significant advantages, but they also have clear disadvantages. If a business values easy formation and pass-through taxation, an LLC is a good option. However, it won't be able to sell shares to raise capital and might incur high annual fees from the state.
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