Companies may wonder what are the disadvantages of an LLC. The definition of an LLC, or limited liability company, is a business entity that combines the simplicity and flexibility of a partnership with the limited liability protection that a corporation has.

What is an LLC?

The managers and members have a separate legal existence from the LLC. The LLC can accumulate debts and assets, be sued, enter into contracts, and begin a lawsuit. Deciding on what type of business entity to form will affect how the company pays its taxes, the type of regulations encountered, and the members' liability.

One of the most popular choices for business entities is limited liability companies. They have many of the same qualities that a C corporation or S corporation have, but there is less paperwork that is required and more flexibility. The Internal Revenue Service doesn't tax the LLC directly because it's not considered a distinctly separate entity. It's up to the members to decide how they want to be taxed. A single-member LLC gets taxed similarly to a sole proprietorship, where the taxes pass-through to the member's tax return.

Disadvantages of an LLC

There are several advantages to forming a limited liability company, such as the members being protected from bankruptcies and debt. However, there are disadvantages to an LLC as well. Unless the company decides to get taxed as a corporation, limited liability companies are typically subject to self-employment taxes. This means that the LLC's profits won't get taxed on a corporate level, but instead pass-through to the members who will report them on their tax returns. Taxes can often be higher here than they would at the corporate level.

Members will need to pay for items like social security and Medicare. If a limited liability company is started, this is why it's smart to consult with an accountant or lawyer first. They can help decide which business entity and tax structure are best. A partnership needs to have a minimum of two people to have pass-through taxation. If there is only one member who chooses to be an LLC, they must file as a corporation or sole proprietorship.

If 50 percent of the profits and capital are exchanged and sold within a year, the LLC will lose its federal tax exemption status. Corporations have the following roles:

  • Managers
  • Employees
  • Directors

However, LLCs do not have these specific roles. There can be confusion about roles in the company, and investors will want to know who can sign contracts, who is in charge, and so on. Creating an operating agreement that clearly defines these roles can be helpful.

If a member decides to leave the LLC, sometimes the company will cease to exist. It's not like a corporation, whose identity stays the same regardless of the comings and goings of shareholders. This is another issue that can be defined in the operating agreement. Checks that are made out to an LLC must get deposited into the corporate account and can't be cashed. Sometimes there are higher fees for companies that are incorporated.

A limited liability company is also more expensive to run than a partnership or sole proprietorship. General partnerships and proprietorships don't have yearly or start-up fees. The owners of an LLC must be sure to keep the LLC's business separate from their personal business. The limited liability company needs to have minutes of meetings and its own records. The money should also be kept separately and not in the same account.

LLC members have the same limited liability protection that the owners of a corporation do. This means the personal assets of the members won't be liquidated to cover lawsuits or debts that are brought against the company. However, members aren't protected from liability in every case. If they say they'll repay a debt personally, commit fraud, cause harm to another person, or supervise another employee's actions negligently, they will be held liable.

A business needs to make periodic filings with the state. Some businesses aren't eligible to operate as a limited liability company because of the liability protection that members have.

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