Key Takeaways

  • Limited liability companies (LLCs) serve as a compromise between incorporation and general partnership. They combine the legal protections of corporations with the tax benefits of partnerships.

  • Among the potential benefits of this structure are limited liability, tax advantages, simple management, reduced obligations, and capability for different business forms.

  • LLCs could be ideal for small—to medium-sized businesses, startups, freelancers, real estate investors, and other partnerships.

  • Consider the pros and cons of an LLC before choosing the best business structure.

  • Post a job on UpCounsel to consult with an LLC formation lawyer in your state and get answers to your questions. 

 

LLC pros and cons should be considered before setting up the business structure. An LLC has pros such as flow-through taxation and limited liability protection. 
 

However, there are also disadvantages, such as the legal process of “piercing the corporate veil” and being forced to dissolve the LLC if a member leaves.
 

This article will explore the pros and cons of this business structure and possible scenarios in which forming an LLC would be especially advantageous. 


 

Overview of LLCs

LLCs are a popular business structure in the United States. They are increasingly common due to their ease of formation, flexibility, a wider array of protections, and other features unavailable through sole proprietorships or partnerships. 

Basic Features of an LLC

Limited liability companies have many features that make them appealing to business owners. 
 

Here are five of those features.
 

Limited Liability

Generally, members of an LLC aren’t personally responsible for the company’s debts and liabilities. Thus, individuals’ assets, such as their homes and savings, are protected from business claims and lawsuits.
 

Tax Flexibility

LLCs can elect corporate tax treatment. By default, they are treated as a pass-through entity, meaning earnings and losses are reported on the member's individual tax returns. 
 

This removes the double taxation corporations can be subject to (i.e., paying corporate taxes and then taxing dividends).
 

Streamlined Management Structure

The members of an LLC or managers chosen by them can oversee management, meaning less paperwork and red tape and providing management styles that suit the business.
 

Fewer Obligations

LLCs have fewer compliance requirements than corporations, meaning they are generally much easier to manage. There are fewer record-keeping requirements, meetings, etc.
 

Flexibility for a Variety of Business Types

LLCs can be single-member, multi-member, owned by other businesses, member-managed, or manager-managed.

Brief History and Origin of the LLC Structure

In the past, business owners relied on sole proprietors or partnerships. These legal arrangements provided little protection against the risk of personal liability for business debts. 
 

Becoming a corporation did offer limited liability, but this structure required adherence to an elaborate regulatory regime.
 

Then, limited liability companies were introduced to the United States in 1977. 
 

Founded in Wyoming, LLCs are a hybrid structure that offers liability protection comparable to that of corporations but without the burdensome incorporation requirements. 
 

They combine corporate flexibility and tax advantages with partnership-like ease of formation and ownership.
 

From the use of the structure in the 1970s, the structure became widespread after the IRS allowed LLCs to be treated as partnerships for tax purposes in 1988. This further encouraged entrepreneurs to use this structure.
 

LLCs are popular because they balance simplicity and legal protections. Creating an LLC involves steps such as:
 

For many entrepreneurs, the LLC business model provided both liability protection and operational flexibility. 


 

Pros of an LLC

A limited liability company has the ideal characteristic of flow-through income taxation—the business's income is part of the business owner's income without a separate tax. 
 

A limited liability company allows the owners to keep their personal property separate from the business and protects all assets from creditors, including cars, bank accounts, investments, and homes. 
 

Members of the LLC remain protected as long as personal finances are kept separate from business. 
 

“Piercing the corporate veil" prevents LLC members from always relying on this protection. This process occurs when members are held liable for illegal or fraudulent acts. 
 

The court pierces the veil and holds members accountable—this area of law is frequently changed or expanded upon. Taxes are easier to file with an LLC than with a corporation. 


 

Cons of an LLC

An LLC has its limitations as well. For example, a judge's ruling can determine that your LLC doesn't protect your personal assets. 
 

As mentioned before, you can put yourself at risk of “piercing the corporate veil” if you don't distinctly separate your personal assets from your business or if you operate in a fraudulent manner that results in losses.
 

According to the IRS, LLCs and partnerships receive the same tax treatment unless members choose to be taxed as corporations. 
 

There are situations that would cause an owner to dissolve the LLC, such as if a member leaves or goes bankrupt—the remaining partners are to handle legal and financial obligations to eliminate the business.

 

Comparing LLCs to Other Business Structures

Next, let’s examine how LLCs compare to three other business structures: sole proprietorships, S corporations, and C corporations. 

What Is a Sole Proprietorship? 

A sole proprietor is a person who runs a business independently and is the owner. This business type is unincorporated—you no longer have the sole proprietorship if you elect to become an LLC. 
 

The structure of a sole proprietorship is relatively straightforward;
 

  • There isn't any need to submit a formal document to establish your sole proprietorship. 

  • You remain a sole proprietor if you sell your services alone. For example, if you're a copywriter working by yourself, you're a sole proprietor. 

  • Regarding taxes, there isn't a difference between you and the business you own, so you're taxed a single time as one entity. This involves using a Standard Form 1040 and a Schedule C. 
     

A sole proprietorship is ideal if you decide to go into business alone. 
 

This structure appeals to some because they gain complete control of the business. Unlike an LLC, a sole proprietorship does not require complex legal agreements to determine ownership.

What Is an S Corporation?

The federal government taxes an S corporation in a specific way. The IRS treats it as a pass-through entity, but what does that mean exactly? 
 

S corporations are capable of distributing stock just like corporations. S corporation owners are shareholders and enjoy liability protection like an incorporated business.
 

This means that if something bad happens in business, it will not affect your personal or any shareholder's bank account. The sole proprietorship and the S corporation are not the same but share commonalities. 
 

S corporations don't involve “double taxation” on individuals and the corporation; every shareholder is subject to their tax rate.

What Is a C Corporation?

A C corporation is taxed entirely apart from its owners. Businesses are incorporated differently in all 50 states. 
 

All C corporations must produce financial statements. The business owners and the corporation are taxed completely separately regarding a C corporation.
 

Shareholders of an S corporation are taxed individually based on their shares. The owners are not held personally liable when the business has to deal with legal issues or debt. 
 

Generally, it's good for business owners to have a separate business. Owners can obtain capital by selling stock, and employees can receive stock benefits by buying at a fixed-in price.


 

Who Should Consider an LLC?

Some businesses suit an LLC formation better than others.
 

Here are a few ideal candidates for forming an LLC: 

Small to Medium-Sized Business Owners

Entrepreneurs Starting a New Venture 

If you want to start a small business or a startup, it might make sense to form an LLC. It can shield your assets from the business’s liabilities in case your business gets into debt or is taken to court.
 

Freelancers and Independent Contractors

An LLC (limited liability company) is a good option for consultants, graphic designers, writers, and freelancers. It protects personal assets and can save taxes. 
 

Rental Properties

Real estate investors frequently set up LLCs to avoid having their assets attached to their rental properties in the event of a lawsuit from tenants or claims of property damage. 
 

Partnerships

Business partners who want to start a business might consider forming an LLC to formalize their relationship. 
 

If someone wants to create a company but is concerned about being responsible for business debts, the LLC shields the owner from personal financial responsibility, but business assets are still vulnerable.


 

LLC Scenarios

Here are four possible scenarios in which forming an LLC could be advantageous. 

  1. Startup Tech Company

A group of tech entrepreneurs is creating a new mobile app. To minimize personal liability while maintaining flexibility in their management and tax structure, they are creating an LLC as a business entity.
 

If a user sues the company for destroying their business, the LLC shields the founders’ assets so they can work on the problem without jeopardizing personal assets like their homes or 401ks.

  1. Freelance Graphic Designer

A freelancer working as a sole proprietor decides it’s time to incorporate her business as an LLC so she can track business income and expenses and limit her liability.
 

The entrepreneur can write off business expenses such as software and office supplies as expenses, which reduces taxable income. If a client is unhappy with the project and threatens to take the business to court, only the owner's business assets are at risk. 

  1. Real Estate Investment Group

Investors pool money to buy multiple rental properties. The rental properties the investors buy will be managed by an LLC consisting of all the investors.
 

Each owner is protected from personal lawsuit liability for injuries by the properties' tenants and is rewarded with pass-through taxation. This means the profits are reported on the individual’s federal tax return, avoiding corporate tax.

  1. E-Commerce Business

A person starts an online craft business. Over time, their business has grown, and they have converted their online operation into an LLC.
 

The LLC helps the business run more smoothly. It creates a clear structure, which is helpful when it comes to tax and liability time. 
 

If someone who bought one of their products sued and said it was defective, this business structure would protect their personal finances.

 

Conclusion: Is an LLC Right for You?

Choosing the optimal business structure is not a decision to be made lightly. This article serves as a helpful starting point, but know that expert help is available.

 

If you need help understanding the pros and cons of an LLC, post a job on UpCounsel's marketplace. You can find a business lawyer in your state who will help you with everything you need to know. 
 

UpCounsel accepts only the top 5% of lawyers on its site. 
 

Lawyers on UpCounsel come from law schools such as Yale Law and Harvard Law, averaging 14 years of experience. Lawyers with UpCounsel also work with or on behalf of companies like Airbnb, Menlo Ventures, and Google.