Why are LLCs so popular?
Although the traditional C corporation is likely the first type of business that comes to mind when considering business entities, it is actually far less popular than you might think. By some estimates, there are roughly 21.6 million LLCs in the United States. In comparison, there are approximately 1.7 million traditional C corporations. These numbers reflect the fact that operating a C-corp is typically more costly than operating an LLC.
Additionally, LLCs are more popular because they are easier to form, and easier to run than a corporation. They provide much more flexibility when it comes to taxes, and they have limited liability for owners too.
What are the advantages of forming an LLC?
LLCs give you a great combination of tax flexibility and liability protection. They shield owners, known as members, from personal liability while affording them an array of tax options.
Tax flexibility
The IRS does not consider an LLC to be a distinct separate entity for tax purposes. This means that, at least initially, the IRS will not tax the LLC directly. Instead, members of the LLC get to determine how they want to be taxed. There are several options:
- Single member LLC: This structure is taxed like a sole proprietorship. Profits or losses from the business are not taxed directly but instead are taxed through the single member's personal federal tax return.
- Partners in an LLC: Members elect to be treated like a traditional partnership for tax purposes.
- LLC filing as a Corporation: The members of the organization may also choose to file as if they were a corporation.
Generally, members of an LLC make an LLC Operating Agreement that outlines how the LLC is treated for tax purposes. Some LLCs are automatically classified as corporations by the IRS.
Limited liability
Like corporations, LLCs provide their members protection from liability. This means that members are typically not personally liable for debts or court judgments incurred against the LLC. Creditors are foreclosed from seeking the personal assets of the LLCs members, and can only seek the payment from the accounts and assets owned by the LLC. It is a meaningful shield not provided in a sole proprietorship or traditional partnership where owners are personally responsible for all debts.
Less paperwork
Compared with C-corps or S-corps, LLCs require less paperwork. Using an LLC Operating Agreement, business owners can create rules that govern how a business runs. Without an Operating Agreement, companies are subject to the default rules in the state they operate. With less stringent requirements for compliance and less necessary paperwork, LLCs are easier to form and easier to keep in good legal standing.
What are the disadvantages of forming an LLC?
Some businesses may not be best served by an LLC. For example, businesses considering rapid growth, taking on multiple investors, or offering equity as compensation may be better served by forming a corporation. For future LLC owners, the following issues are often worth considering.
Self-employment taxes
Unless you choose to be taxed like a corporation, LLCs are usually subject to self-employment taxes. This means that the profits of the LLC won't be taxed at the corporate level and at the individual level when paid out to owners. Taxes pass through to its members who account for those profits or losses on their personal federal tax returns. Sometimes, these taxes are higher than they would be at the corporate level as individual members pay their own Medicare and Social Security. For this reason, after starting an LLC, it's important to understand any new tax obligations to avoid paying needless penalties.
Confusion about roles
Whereas corporations have specific roles, like directors, managers, and employees, LLCs may not have as clearly defined roles. LLCs do have members and also often have member-managers. This can sometimes make it difficult for members, workers and investors to know who's in charge or who can sign certain contracts. This confusion, however, can be avoided by creating a clear management structure in an LLC Operating Agreement.
Limited life
In some states, if a member departs the LLC, the LLC ceases to exist. This is unlike a corporation whose identity is unaffected by the comings and goings of shareholders. An LLC, however, can combat this weakness in its Operating Agreement.
Transfer restrictions
Although restricting membership transfer can sometimes be a benefit, it can also be a challenge to attract new owners or investors. Transferring membership interests in an LLC is more challenging than just buying and selling stocks in a corporation.
Is an LLC really necessary?
It depends. Limiting liability and asset protection is a huge advantage for business owners. If you are creating a single-member LLC, be sure that your state recognizes these as limiting liability. If they do not, one of the main advantages that you were seeking may not be available.
If you are going to create a business entity, LLCs have a lot of advantages over other similar types of businesses. If you are unsure about whether creating an LLC is a good option for you, reach out to a Rocket Lawyer network attorney for affordable legal advice. If you're ready to start your business as an LLC, S-corp, C-corp, or Nonprofit, let Rocket Lawyer Business Pros do the heavy lifting for you.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.
