Why Start an LLC

Understanding the disadvantages of an LLC is important in determining the right legal entity for your company. The structure of your business will determine how it is taxed, your level of personal liability, and the state and federal regulations you must follow. An LLC (limited liability company) protects the business owner from personal liability while providing ease of establishment. The personal assets of LLC owners (called members) are protected from business debts and legal judgments. Creditors may not seize the owner's house, car, or other property to pay business debts. This type of protection is not provided by a partnership or sole proprietorship.

Despite this shield from personal liability, the LLC is not considered a separate taxation entity by the IRS and is not taxed directly. LLC owners can choose from one of the following taxation methods:

  • A single-member LLC is considered a sole proprietorship, and business profits or losses are reported on the owner's individual tax return.
  • Multiple-member LLCs can opt to be taxed in the same way as traditional partnerships.
  • Any LLC can opt for tax treatment as a corporation.

Forming and maintaining an LLC requires less paperwork and fewer compliance measures, so it's relatively easy to keep this type of business entity in good legal standing.

Disadvantages of an LLC

An LLC has more administrative requirements than either a limited partnership or sole proprietorship. While corporations are governed by statutory requirements, little legislation exists for LLC operation, which necessitates the creation of an LLC agreement. The IRS requires that an LLC receive just two of the four main benefits of a traditional corporate structure. These include:

  • Liability limited by business assets
  • The ability of the business to remain in existence if a shareholder departments
  • The creation of a centralized management structure
  • Flexible asset transfer

For example, an LLC can put provisions in place to prevent automatic termination with the departure of an owner, but this would violate IRS regulations.

In some cases, LLC taxes are more complex than corporate taxes. In many states, an LLC is subject to an additional tax known as a capital values or franchise tax; this fee allows the owner to benefit from limited liability. This tax is not charged to corporations. Some states charge flat fees, while other states require LLCs to pay percentages of profits and revenue.

If your LLC works with international companies, you may be treated as a corporation in those countries rather than as a pass-through entity. In addition, when an LLC shows a profit for a specific time period, the member is taxed on those profits even if the share is reinvested or distributed to shareholders. LLC members who do not participate in company management do not receive tax benefits from LLC income

Those members who do work for the LLC are considered self-employed and will be charged for Social Security and Medicare tax, often at a higher rate than the corporate taxation rate. An LLC owner may also be responsible for paying for unemployment compensation, which would not be required if he or she was a sole proprietor. As a result, these members have no incentive to reinvest profits in the business.

LLC establishment carries substantial filing fees. You may need to publish a letter of intent to form an LLC in the local newspaper, which can be quite expensive in some cities.

LLCs have a flexible management structure and are not subject to requirements to hold annual meetings or have a board of directors. However, this can be a disadvantage if a lack of standard operating procedure results in poor management. 

Checks written to an LLC must be deposited into a business account and may not be cashed. Banks may charge a higher fee for an LLC than they would for a sole proprietor.

LLC owners must keep careful records and meeting minutes to ensure that personal and business assets are maintained separately.

Operating Agreement

The operating agreement for an LLC delineates each member's ownership percentage, rights, and responsibilities. While an operating agreement is not legally required, having one can be helpful in settling disputes down the road. 

If you need help with deciding whether an LLC is the right structure for your business, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.