You’ve decided to venture into the world of entrepreneurship. This is an exciting time! Chances are you’re going to have a flurry of activity going on in the upcoming weeks and months with many important steps to take along the way. One of the most crucial decisions you’ll need to make early on as you launch your company is to determine which business structure you should choose.
This isn’t a decision to take lightly, but you do have several possibilities to consider. One of the most common structures entrepreneurs choose is the LLC. It’s a good option but like anything else, does have its pros and cons. Also, it is important to keep in mind that regulations governing LLCs vary from state to state, so you’ll want to carefully read any laws associated with the state(s) you plan to operate in before you register your new company as an LLC.
Let’s take a closer look at what LLCs are and some benefits and drawbacks that come with becoming an LLC.
What is an LLC?
LLC stands for “limited liability company” and is a popular business structure for small businesses. Owners of LLCs are referred to as “members”.
People often view LLCs as a hybrid type of business since they combine features that normally characterize those associated with a corporation with other attributes that typically align with partnerships or sole proprietorships. If you register your startup as an LLC, you can enjoy the best of both worlds, so to speak.
However, like any other major decision you’ll be making on your journey to becoming a business owner, you’ll want to carefully weigh the pros and cons of an LLC before committing to it. There is no one-size-fits-all best solution to business formation.
Let’s dig in and look at the advantages and disadvantages of selecting an LLC business structure.
Advantages of Creating Your Business as an LLC
New business startups often opt to select the structure of an LLC due to the numerous advantages they can receive. The following are a few reasons you might want to consider taking the LLC route when registering your new company.
Easy to Establish
Unlike forming a corporation, setting up an LLC is a fairly easy and straightforward process when it comes to paperwork. Most business owners can do this easily online and state websites typically provide step-by-step directions. Additionally, states generally follow a similar process, although the fees to register LLCs can drastically vary.
Limit Personal Liability
Registering as an LLC limits your personal liability in the event legal action is taken against your company. With an LLC business, your assets are, in most cases, off-limits in the following types of scenarios.
- A party sues your business
- A company tries to collect on a debt
- LLC files for bankruptcy
- Doesn’t otherwise meet a financial or legal obligation
In other words, no one can go after the business owner’s assets. Under the sole proprietorship and partnership structures, a business owner and their business are essentially the same, whereas, in an LLC, the owner (member) and business are treated as two separate legal entities.
An LLC provides entrepreneurs with a strong layer of protection against the above scenarios, empowering them to keep their assets intact.
Simple to Maintain
When contrasting LLCs vs. corporation structures, LLCs are far easier to launch and maintain. As an LLC, you can easily file your annual report, obtain any required licenses, and address everyday issues. On the other hand, corporations are held to much higher standards as they must hold meetings with their boards and shareholders, in addition to the other work they must do to maintain their business structure.
LLC Gives Off a Professional Vibe
Businesses that register with the “LLC” denotation at the end of their business name often sound more professional than a company that doesn’t. This has nothing to do with professionalism. Many sole proprietorships and partnerships are highly reliable and professional.
The benefit here is how, as a new business owner, you can capitalize on branding and enhance the public perception of your brand. Think about how “Elite Plumbing, LLC” might sound vs. “John Smith Plumbing”; there is a good chance more people might be drawn to what sounds like a robust company as opposed to someone working out of their home as a side hustle.
The bottom line is, regardless of skill or expertise, people often tend to perceive formal name appearances as “better” and, therefore, more credible.
Disadvantages of Creating Your Business as an LLC
While the LLC business structure offers several appealing benefits, it’s important not to discount any potential disadvantages when making your business decisions. Some of these may be dealbreakers and make other types of business structures more appealing.
One of the biggest drawbacks of registering your business as an LLC is the high startup costs. What you pay will vary by state and the differences can be pretty drastic.
For instance, for an LLC in New York, you’ll pay a $200 filing fee just to initially file to register for an LLC. This doesn’t take into account what you’ll pay in subsequent years. What you’ll owe can vary from $25 to $4,500, depending on your LLC’s gross income. On the other hand, if you register an LLC in Arkansas, you would pay $45 and, in subsequent years, pay a franchise tax of $150 per year (unless you meet certain criteria that would require additional fees, but still cheaper).
As a startup, you’ll want to carefully consider where you’ll advocate your funds and whether the advantages of registering an LLC outweigh the expenses.
Less Ability to Raise Capital
Funding is another factor to think about since LLCs have limited investment opportunities. Corporations can issue stock to gain funding, whereas an LLC is not able to issue shares privately or publicly. This means the LLC will have to creatively find other methods of raising money as opposed to selling shares.
For LLC members, this could prove challenging if they need more capital than they can receive through equity financing, debt financing, or fundraising/crowdfunding. To invest in an LLC, the investor must become a contributing member, thus a co-owner of the company. While on the surface, this might sound OK, owners must keep in mind this will dilute the profits of the original owners.
Potentially Higher Taxes
Taxes to be paid to federal and state governments will vary from state to state, along with the type of business formation structure chosen. Depending upon how profitable the LLC is, its owners could potentially pay more taxes for Social Security and Medicare since the company’s profits will be taxed. Self-employment taxes are a big drawback for some entrepreneurs.
On the other hand, corporations are only required to pay Social Security and Medicare taxes on salaries, not their profits. Sole proprietorships and partnerships are taxed as personal income for owner salaries. LLC owners are also required to pay self-employment taxes.
Decreased Fringe Benefits
Any fringe benefits your employees receive, including but not limited to healthcare insurance, group insurance, medical reimbursement plans, and even parking perks are treated as taxable income. Employees of corporations do not have to report these types of fringe benefits as taxable income. If you’re looking to hire multiple employees, this might be a deterrent to attracting top talent.
Limited Liability Protection Limitations
While the LLC structure protects its members and empowers them to keep their assets protected, it’s not a given. Members can put themselves at risk if they are not meticulous about keeping their business and personal transactions completely separate. If a legal situation emerges, a judge can rule against the LLC member and rule that their assets are not off-limits, especially if a situation involves fraud.
Is an LLC the Right Choice for Your Business?
To determine whether an LLC is the right type of business formation structure for your company, you’ll want to carefully consider the above pros and cons, along with performing your due diligence about other potential ways you’ll be impacted by the type of structure you choose.
Before registering your business, it’s a good idea to speak with either an accountant or a business attorney who is well-versed in your state’s laws. Working with a professional can help because they can help you to identify ways to legally mitigate any negative impacts on your profits and tax obligations. Additionally, you may be eligible to register in a state that is more favorable to forming an LLC.
Motley Fool reports LLCs are the most popular structure amongst small and medium businesses in the U.S. with about 35% of SMBs registering as LLCs. For many, it’s clear that the benefits of forming an LLC far outweigh the drawbacks, but it’s not for everyone.
Therefore, it’s important that you carefully weigh all the pros and cons before making a final decision.