What Are the Pros and Cons of a Limited Liability Company?

A limited liability company offers a combination of benefits and drawbacks. LLC provides tax flexibility and ease of formation. However, the drawbacks show that LLC comes with self-employment taxes and potential compliance complexities.

LLCs provide the privilege of shielding personal assets from business debts and liabilities. This means that the owners are personally not liable for the company’s obligations. LLCs have the liberty to choose how they are taxed, allowing pass-through taxation, where the profits are taxed at the individual member level. Further, they can also elect to be taxed as a corporation or partnership, allowing flexibility to reduce tax liability.

What is a Limited Liability Company (LLC)?

A Limited Liability Company (LLC) is a business structure that combines the liability protection of a corporation with the tax benefits of a partnership. Thus, It shields owners from personal liability for business debt and obligations.

In an LLC, the business is treated as a separate entity from its owner. This indicates that the personal assets of the members are protected from business debts and lawsuits. LLCs are generally flexible in terms of taxation and management, allowing businesses to choose their preferred operations and profit structure.

LLCs can be created to be taxed as either sole proprietorship, partnership, or corporation. It depends on the owner’s preferences and business needs. They are easier to form and operate than a corporation, with fewer regulatory requirements. For example, an LLC can be a small business, a real estate, or a professional service firm.

In terms of taxes related to LLCs, the accountants ensure compliance with tax regulations, manage tax obligations, and advise on tax-efficient strategies for the company's financial benefit. Accountants prepare and analyze the company's financial transactions. They create balance sheets, profit and loss accounts, and cash flow statements. These activities offer detailed insights into the business’s financial health.

How to Create an LLC?

To form an LLC, an individual needs to choose a state or business name, appoint a registered agent, file the Articles of Organization, and obtain an Employer Identification Number (EIN) from the IRS. The steps to create a successful LLC are:

• Choose a State: First, select a state in which the LLC will be operating, as different states have varying requirements and fees. Next, consider factors like business location, tax implications, and ease of doing business when making business-related decisions.
• Select a Business Name: Choose an unique and distinct name for the LLC that is not in use already in the chosen state. Then, ensure the name complies with any state-specific naming requirements.
• Appoint a Registered Agent: Designate a registered agent who can receive official legal documents on behalf of the LLC. The agent must have a physical street address in the state where the LLC is formed.
• File the Article of Organization: File a completed Article of Organization with the relevant state agency, usually the Secretary of State’s office. Thus, such a document establishes the LLC as a legal entity ready to operate.
• Create an Operating Agreement: This step is optional for LLC owners, but it is highly recommended. Creating an operating agreement explains the internal rules and operation of the LLC. This document outlines ownership, management, and other important aspects of the business.
• Keep the LLC Active: Fulfill all annual reporting requirements and pay application fees to maintain the LLC in good standing. The LLC will be dissolved or pay penalties if the owner fails to follow these steps.

Advantages of LLC

An LLC offers a wide range of advantages, from its management structure to liability protection. As LLCs are separate entities from their owners, they are personally protected from liabilities and debts. Let’s look at the advantages of forming an LLC.

• Flexible Taxation: The LLC owners get the privilege of how they are taxed. They can be taxed based on partnership, proprietorship, S corporation, or C corporation. This flexibility allows LLCs to choose a tax structure that benefits business needs and increases tax savings. Pass-through taxation is when profits and losses flow directly to the owners’ personal income tax returns. It is considered a common option to avoid double taxation.
• Easy Formation and Management: LLCs are generally much easier and less expensive to form than corporations. The formation step includes fewer regulatory requirements and paperwork. It offers management flexibility, allowing members to determine the way they want to operate. The management option only consists of a member-managed or manager-managed structure. LLCs also come with flexibility in ownership structure as single members or multiple members form it.

Disadvantages of LLC

Although LLC has multiple advantages, it also has some drawbacks, such as paying employment taxes, confusing roles, and difficulty in raising capital compared to corporations. Here are some disadvantages to focus on:

1. Taxation and Financial Considerations

• Self-Employment Taxes: LLC members are often taxed as self-employed. This means they pay both the members and employees portions of Social Security and Medicare taxes on their profits. These additional expenses increase their tax burden.
• Pass-Through Taxation: While LLCs try to avoid double taxation, members still include profits in their income taxes. This can lead to higher overall tax obligations.
• Capital Gain Tax: Profits from the sales of LLC assets are subjected to capital gain tax. This initiation can be higher than the tax rate for ordinary income.

2. Operational and Legal Issues

• Limited Company Life: In some states, LLCs are dissolved due to bankruptcy or the death of the owner, disrupting the business operations.
• Confusing Roles: Lack of a well-defined operating agreement leads to unclear roles and responsibilities among the members. This confusion between members causes disputes and mismanagement.
• Difficulty in Raising Capital: Most LLCs find it challenging to raise capital since they cannot issue stocks, and it becomes difficult to attract investors.
• Transferability Restrictions: Transferring membership interest requires the consent of all eligible members, which is disadvantageous for some LLCs.
• Personal Liabilities: Liability protection of some LLCs is an absolute option. Members are still liable if they engage in misconduct or fail to maintain proper business practices.

LLC vs Corporation

Both LLCs and corporations offer liability protection but differ in ownership, taxation, management, and formalities. LLCs consist of a simple structure and flexible management. However, corporations have a more complex structure, potential for double taxation, and are best at raising capital and public offerings. The differences are:

1. Taxation

• LLC: LLCs are taxed as pass-through entities, meaning profits and losses flow directly to the owners’ personal income tax returns. They also get the option to avoid double taxation and choose to be taxed as a corporation.
• Corporation: They are bound to follow corporate taxes, and the profits are distributed among the shareholders. Such initiation is considered as double taxation unless they are elected as an S corporation.

2. Management

• LLC: It allows more flexibility in management structure, allowing members to manage daily operations directly or appoint managers.
• Corporations: Corporations include a more complex and formal hierarchy with a board of directors elected by shareholders. Later, the board of directors appointed officers to manage the company.

3. Liability Protection

• LLC: LLCs provide limited liability, meaning the personal assets of the owners are protected from business debts and other liabilities.
• Corporations: Corporations also provide limited liability, but they protect shareholders from personal liability for the corporation’s debts.

LLC vs. Partnership

It is a known fact that LLC offers protection to the owner’s liability, but this benefit is not for partnership. This means partners are personally liable for all business debts. LLCs have their legal entities, whereas partnerships don’t have that privilege. Thus, the sole differences are:

• LLC: LLC owners are not personally liable for the debts and obligations of the business. As an LLC is a separate legal entity from its owner, it can still own property, enter into a contract, and be sued in its name. The formation of an LLC is done by filling the “Article of Organization” with the state. LLCs are taxed as pass-through entities, meaning that profits and losses are passed through the owners' tax returns.
• Partnership: Partners are personally liable for all debts and obligations in a partnership contract. It does not have any separate legal entity other than partners. Moreover, the partnership is created through legal agreements between two parties. Like LLCs, partnerships are also taxed as pass-through entities. Partners are only obliged to have management and decision-making duties in a business.

Conclusion

Limited Liability Company offers a strong balance between liability protection, tax flexibility, and ease of management. Thus, it makes LLCs a popular choice for small and medium-sized businesses.

As few owners manage LLCs, it is obvious to hire a tax accountant in Houston for work like compliance with tax regulations, preparing tax returns, creating tax strategies, and managing tax databases. They help LLCs to reduce tax liabilities legally.