What Are the Benefits and Risks of Forming an LLC?
If you have decided to start a business and are researching the available business entity types, you may repeatedly come across the terms “limited liability company” and “LLC,” but you might not understand what this type of entity is or whether it is right for you. A limited liability company (LLC) is a business entity that protects its owners, referred to as members, from being personally liable for the debts of the company. This, however, is not what makes the LLC special; several other entities also offer this protection. The LLC is unique because it combines various characteristics of other entity types, which together make it one of today’s most preferred legal structures for companies.
Benefits of an LLC
- Limited Liability. The most recognized characteristic of an LLC is its limited liability protection. This benefit allows LLC members to demarcate their personal assets and those of the entity, thereby enabling members to pursue business purposes with reduced risk to their personal property.
- Pass-Through Taxation. Another benefit of the LLC is the opportunity to avoid double taxation. Unlike other limited liability legal entities, the LLC is not taxed at both the entity and ownership levels; it is taxed only at the ownership level. In other words, the business’s taxes pass through to its owners. This unique benefit exists because the Internal Revenue Service (IRS) does not recognize the LLC as a separate legal entity for tax purposes. By default, the IRS classifies a single-member LLC as a disregarded entity that is taxed as a sole proprietorship, and it classifies and taxes a multimember LLC as a partnership. While an LLC’s default taxation is pass-through, LLCs can also elect to be recognized as a corporation for tax purposes. Note that if the LLC elects to be recognized by the IRS as a corporation, it will be subject to double taxation (once at the entity level, and a second time when the business income is distributed to its owners). Nevertheless, the ability to decide how to be taxed by the IRS is a desirable feature of the LLC.
- Customizable Management Structure. Unlike other business entities, the LLC does not mandate any particular management structure. Members can decide whether the company will be managed by the members themselves or by one or more managers (who may or may not be members). There is also no mandate regarding the number of people who can own or manage the LLC. The specific details regarding management are determined by the LLC’s operating agreement or, in its absence, state law. This allows LLC members to choose the management structure that works best for their LLC.
- Relaxed Compliance Requirements. An additional benefit of the LLC is less stringent compliance requirements. Unlike corporations, LLCs do not have required annual meetings and boards of directors. The documentation and reporting requirements are also more lenient. As a result, smaller businesses that do not run complex operations can enjoy a legal structure that meets their unique needs. If LLC members want to add mandates to their company, they can do so in the operating agreement.
Risks of an LLC
The benefits and risks of an LLC are opposite sides of the same coin. Essentially, there is a cost for flexibility. Each business owner must analyze their circumstances to determine whether the benefits outweigh the risks. The following are some of the key risks to consider:
- Loss of Limited Liability. Although an LLC enjoys limited liability, poor practices could result in an LLC losing its liability shield. If a company fails to properly maintain a separation between the company’s business assets and the members’ assets by keeping separate bank accounts, complying with state regulations, and maintaining proper records, a court may find grounds to pierce the veil and attack personal assets during litigation.
- Difficulty Obtaining Investors. The looser structure of an LLC can make it less appealing for investors because (a) it can be more challenging to ensure returns on investments absent structural elements like mandatory meetings and reports, which provide accountability; and (b) their interests are less liquid because there are often limits on transferability of LLC membership interests and an absence of interested buyers. If an LLC’s members eventually decide that a new entity type better suits their investors’ needs, they may find the process of converting the entity to be expensive and challenging.
- Pass-Through Taxation. Pass-through taxation can have drawbacks for LLC members because the tax on the members occurs whether dividends are paid to the members or not. That is, LLC owners must report the LLC’s profits and losses on their individual tax returns and must pay in proportion to the profits the company makes, even if those profits are not distributed to the members. As a result, members may elect to classify the LLC as a corporation for tax purposes.
If you need assistance deciding whether an LLC is the optimal legal structure for your business, or if you would like to learn more about other business entities like sole proprietorships, partnerships, and corporations, we can help. Schedule a meeting with our team of knowledgeable business attorneys. We can assist you in determining the right entity for your company, filing the proper documents with your secretary of state, and remaining compliant with applicable requirements.