Starting a Limited Liability Company LLC: Advantages and Disadvantages

If you are self-employed, or otherwise make money in your spare time, forming a Limited Liability Company (LLC) may be a good business option for you. The LLC was invented in 1977 by the state of Wyoming as a way to address the needs of businesses that wanted to be taxed and managed like partnerships, yet protected from personal liabilities like corporations. Before long, every state had adopted the idea of the LLC. Then, in 1997, a further boost occurred when the IRS allowed single-person LLCs to exist and be taxed as partnerships. Currently, almost all states allow one-person LLCs.

To better understand the terminology of LLCs and know how these companies compare against partnerships, corporations, and other businesses, here are some word definitions:

Sole proprietorship/partnership: The owner is personally responsible for all debts and liabilities of the business. Business profits are included and taxed with personal income.

Limited liability: The owner has limited personal liability for the debts and liabilities of the business. Business profits are separately totaled and taxed.

Corporation (S): More formalized business structure wherein the shareholders are not personally responsible for the debts and liabilities of the business. Profits are not subject to Social Security and Medicare taxes unless they are paid out as a salary to shareholders.

Corporation (C): Identical to the S Corporation, except that the business is taxed twice: once on overall profits, and then again on profits that are paid out to shareholders in the form of salaries.

What are some of the main advantages of forming an LLC?

Less formality: In a corporation, creditors may "pierce the corporate veil" and hold shareholders responsible for any impropriety. An LLC is designed to be more of a safe haven for business owners, protecting them from personal liability without the need for excessive legal formalities and record-keeping (e.g., payroll tax returns).

Prestige: Clients and other businesses are much more likely to treat an LLC as a legitimate business venture compared with a sole proprietorship/partnership. Also, banks and credit unions are more likely to provide loans to LLCs compared with sole proprietorships/partnerships.

Separate entity: An LLC is considered a separate entity and can be transferred or sold to someone else or inherited. In a sole proprietorship/partnership, the business is considered a part of the owner. If the owner dies, the business ends with him or her.

Allocation: An LLC can make special allocations of profits and losses amongst its members. S corporations have only one class of ownership, with profits and losses allocated according to the percentage of ownership.

Ownership: Unlike owners of corporations, LLC owners can be foreign persons, corporations, or trusts.

Membership: An LLC can have an infinite amount of members. An S corporation is limited to 75 members.

Deductions: Money borrowed by an LLC usually lowers the tax liability of its owner via loss deductions. This is not the case with an S corporation.

What are some disadvantages of an LLC?

Cost: Compared with a sole proprietorship/partnership, an LLC is charged a yearly fee by the state for its operation.

Taxes: An LLC owner must pay unemployment compensation on all employees, including him or herself. Social Security and Medicare taxes (15.3%) must be paid on business profits not distributed as salaries.

Accounting: Although not completely mandatory, an LLC should keep separate checking and credit card accounts. This helps justify its profits and losses to the IRS and prevent audits.

So, what is the bottom line on starting an LLC if you own a business or are otherwise earning income on the side? First of all, take into account your actual business earnings. If your income is under $100,000/year, your payroll taxes will be just over $15,000. Incomes over $100,000/year are charged only 2.9% in additional payroll taxes after the initial $100,000. Thus, if you are earning a $30,000 profit on your business, forming an LLC may not be the best move.

Also, consider whether or not you have the time and patience to keep separate accounting records, as well as checking and credit card accounts for your business. Keep in mind that the IRS will not only require that you file a separate tax return for your LLC, but may even audit you and physically inspect your business.

On the other hand, if you have a significant amount of debt due to investments in capital equipment and other business expenditures, or if your business exposes you to significant personal liability (e.g., safety lawsuits), then forming an LLC may be in your best interest. An LLC is also a good idea if there are many partners running the business, since an LLC insulates each member from the detrimental business decisions of the other member/s.