37 - Understanding LLCs

Scale Your Small Business

This week, we’re answering the question “what is an LLC?” An LLC, or limited liability corporation, is one type of legal entity that can be formed to operate your business. It can certainly be intimidating to consider making this switch, but it's important that you know what it is. Today, we’re going to break down the pros and cons of becoming an LLC.

As we saw before, an LLC is or limited liability corporation is one type of legal entity that can be formed to operate your business. LLCs are popular because they provide the same limited liability as a corporation, but are easier and cheaper to run. If you're starting a business or currently running a business as a sole proprietor, you might consider forming an LLC. This is especially true if you are concerned about limiting your personal legal liability, as much as possible.

First, let’s go over the benefits of starting an LLC for your business.

Number one is personal asset protection. As its name states, an LLC provides you and/or your business owners with limited liability. That means that you, the LLC owner, are generally not personally liable for any debts incurred by your LLC business or most business-related lawsuits. Because you're not personally liable, creditors or people who file lawsuits against your LLCs can't collect against your personal assets, like your personal bank accounts, personal car loans. They're limited to collecting your LLC's assets, like the LLC's bank account.

The second benefit of an LLC is pass-through taxation. The profits or losses that the business incurs pass through the business to the owner's personal tax return, such profits are taxed under the owner's personal tax return. Single-member LLCs are usually taxed the same as sole proprietors. The owner reports the LLC's profits, losses, deductions, or schedule Cs and files it with his or her personal tax return. An LLC with two or more members is usually treated as a partnership for tax purposes. The profits or losses are reported on the owner's personal tax returns and taxed at their personal rates. Because LLCs are usually pass-through entities, their owners can qualify for special pass-through tax deductions. This deduction took effect in 2018 and is scheduled to continue through 2025. Again, consult your tax professional for specifics, anything to do with tax laws.

One note about taxes: LLCs can also choose how they want to be taxed. They are usually taxed as sole proprietorships or partnerships, but multi-member LLCs or sole proprietor LLCs have the option of choosing to be taxed like a corporation. This is easily accomplished by filing a document called an election with the IRS. With corporate taxation, the corporation pays taxes on the business profits at the corporate tax rate. With S-corporation treatment, the LLC remains a pass-through entity with profits passed through the business to the owners to be taxed at their individual tax rates. But such distributions are not subject to social security and Medicare taxes.

Number three, simplicity. An LLC is the simplest business entity to form and operate. Unlike with a corporation, it's not necessary to have officers, directors, a board or shareholder meetings or other administrative burdens that sometimes come with having a corporation.

Fourth is flexibility. LLCs provide enormous flexibility when it comes to ownership, management, and taxation, there's no minimum or maximum limits on the number of owners, also called members. Many LLCs only have one member, like me, but an LLC can have five, 10 or hundreds of members. LLCs can be managed by their members, that is, all the owners share responsibility for the day-to-day running of businesses. They also have the option of designating one or more managers to run the business. Managers can be designated members, non-members, or a combination of anything in between.

Forming an LLC to own and run your business helps give you credibility, it reassures customers that yours is a real business. You'll also have an official name to use!

Now, let’s talk about some possible downsides to an LLC.

Number one: cost. It generally costs more to form and operate an LLC than to just be a sole proprietor or a partnership. Filing fees must be paid to legally establish the LLC. Although not legally required, it is highly desirable for LLCs to adopt a written LLC operating agreement, laying out how the LLC will be governed. Once the LLC is formed annual fees and taxes will be paid to the state. This can vary from state to state, so again, check with your expert team and your state laws.

Number two is investment disadvantages. LLCs are not ideal for business owners who seek outside investors. This is particularly true if you're looking for funding from venture capitalists who ordinarily will only fund corporations. Corporations work best for outside investments because stock can be issued in exchange for investor’s money. Outside investors can invest in LLCs and receive LLC ownership interests, but this can be more complicated than with a corporation.

Key Takeaways

Pros of LLCs:

• Personal Asset protection. As its name states, an LLC provides you and/or your business owners with limited liability. That means that you, the LLC owner, are generally not personally liable for any debts incurred by your LLC business or most business-related lawsuits.

• Pass-through Taxation. The second benefit of an LLC is pass-through taxation. The profits or losses that the business incurs pass through the business to the owner's personal tax return, such profits are taxed under the owner's personal tax return.

• Simplicity. An LLC is the simplest business entity to form and operate. Unlike with a corporation, it's not necessary to have officers, directors, a board or shareholder meetings, or other administrative burdens that sometimes come with having a corporation.

• Flexibility. LLCs provide enormous flexibility when it comes to ownership, management, and taxation, there's no minimum or maximum limits on the number of owners, also called members.

• Credibility. It reassures customers that yours is a real business. You'll also have an official name to use!

Cons of LLCs

• Cost. It generally costs more to form and operate an LLC than to just be a sole proprietor or a partnership. Filing fees must be paid to legally establish the LLC.

Investment disadvantages. LLCs are not ideal for business owners who seek outside investors. This is particularly true if you're looking for funding from venture capitalists who ordinarily will only fund corporations.