IS AN LLC RIGHT FOR YOU?
It is great that you want to start your own company. Why wouldn’t you, if you have found the next “big” idea? The question is not whether you should start a company. It is whether or not starting a limited liability company is the way to go for you. As popular as limited liability companies are, how can you know whether this type of business structure, among all the others out there, is the right one for you? To gauge whether or not you should start an LLC, you need to be aware of both its advantages and disadvantages. Only when you evaluate these things can you make an informed decision and launch your company fully prepared.
THE ADVANTAGES OF USING AN LLC
Perhaps one of the most important advantages a limited liability company has to offer is that its owner has limited liability. The limited liability protection that this business structure bequeaths to its owner means that their assets are protected in the event that creditors come knocking on their business’ door. These assets can be anything from the owner’s home to their car, investments, and bank accounts (Wang, 2022). So long as the company in question is an LLC, a creditor cannot lay a hand on any of these personal assets. This holds true for bankruptcy scenarios just as it holds true for situations when you accrue some kind of debt.
Another significant benefit of an LLC is that it increases a business’s credibility (Dock David Treece, 2018). Starting a limited liability company basically means being recognized as a legitimate business entity by the state you live in. It means registering your LLC with your state, thereby formalizing its structure. It means sending the message to potential partners and customers that your company is both serious and professional.
Gaining this kind of credibility is something that will make dealing with financial institutions such as banks a great deal easier than it otherwise could have been. The truth is, a bank would be far more likely to extend credit to an LLC than it would to a sole proprietorship or partnership, which are individuals or partnerships that own unincorporated businesses.
As mentioned before, an LLC affords its owner a significant degree of flexibility where the management structure is concerned. An LLC can be managed by a single person, just as it can be managed by a group of owners, referred to as members, and a group of managers that are elected by the LLC’s members. Members of limited liability companies can include different individuals, trusts, corporations, and even other LLCs, which is a little crazy when you think about it (Dock David Treece, 2018). Of course, single-member LLCs’ management structures tend to be even more flexible than those of multi-member LLCs’.
One of the most stressful things a business entity has to deal with is taxes. Luckily, LLCs have certain tax advantages that make dealing with this perhaps daunting issue easier. LLCs are typically taxed as pass-through entities. That means that the profits and losses that come into an LLC pass directly to its owners. When tax season rolls around, the owner does not have to struggle with 50 different kinds of forms and staggering tax rates. Instead, they’ll be able to file their taxes at their individual income tax rate. In other words, they’ll be dealing with a much simpler process than other companies have to deal with and get to save a ton of money they otherwise would have had to spend. LLCs are sometimes even subject to certain tax deductions. One example of this is the fairly new Qualified Business Income (QBI) deduction. The QBI deduction allows LLC owners to deduct 20% from their company’s net income. This deduction comes on top of the standard business expense deductions that are applied to LLCs. So… see what I mean by saving a lot of money thanks to LLCs?
A final and tempting benefit of starting LLCs is that they tend to be very easy to set up and maintain, at least compared to other types of corporations. The process of setting up and filing for an LLC is simple and straightforward, as you will soon see. It is so straightforward, in fact, that you can finish filing all the necessary paperwork in as little as an hour.
DRAWBACKS OF USING AN LLC
Everything has its downsides, right alongside its upsides. An LLC is no exception. Starting and maintaining an LLC comes with its own unique set of drawbacks. The foremost among these drawbacks, or disadvantages, if you will, is that LLC owners have to pay self-employment taxes. Since LLC’s profits flow to its owner, the IRS considers the owner of an LLC to be “self-employed”. Given that, LLC owners are expected to pay self-employment taxes such as Medicare taxes and social security. The problem with this is that such taxes can add up over time. If you want to manage your money responsibly and in a way that will allow you to make more in the long run, you need to be aware of this fact before you launch your LLC.
Another drawback, or rather annoyance, that comes with starting a limited liability company is that you might have to file a form called “Doing Business As” (DBA). You will only have to file a DBA if you are living in certain states and if you want to use a name for your LLC that is different from your own. If your name is John Smith, for instance, and you have decided to found an LLC called the XYZ Company, you may have to file a DBA. To see if this is the case for you, you will need to check the requirements put forth by the state you live in.
Speaking generally, you will obviously need to comply with the laws of your state when you are founding and managing your LLC. As every state has slightly different rules about different things, you need to familiarize yourself with the state laws that may pertain to you and your LLC. It also means that you will have to register your LLC with the state and file annual reports about it. Failure to do so or to abide by any state laws will result in your having to pay certain fines. It may also result in the dissolution of your LLC, even if you weren’t aware of the laws you had to obey.
While one of the great benefits of LLCs is that they usually offer their owners protection for their assets, there are sometimes exceptions. The thing is, the protection that you get from limited liability is not absolute. Certain situations, like failing to comply with state laws, for instance, can easily put your assets at risk. This is yet another reason why you should familiarize yourself with state laws. Only by doing so can you truly protect yourself, after all.
If you are going to start a limited liability company, you need to know that you will have to start keeping very detailed records. You’ll need to keep a thorough record of your financial transactions and activities. This is important for both tax season and the annual reports you will be filing later on. Keeping a record of your financial transactions means keeping track of all your income and expenses—including a dinner you take a client out to. But that is not all. You will also have to keep detailed records of all your meetings as well as all the decisions that are made by your LLC. Failing to keep records of either or both of these things might well lead to various penalties and even to the dissolution of your LLC.
While starting an LLC is a fairly simple process, running one is less so. In fact, running an LLC can be a rather complex ordeal compared to running other types of companies. This is because LLCs have to follow more rules and regulations than other types of companies. That LLCs have to file their articles of organization with the state they are in or that they might have to hold annual meetings and keep detailed records of them are good examples of this. In addition to that, LLCs might have to file special tax returns and comply with state laws about employee benefits. That’s a lot of things to juggle and a lot of forms to file—hence the complexity of managing LLCs.
To manage all these complexities, some LLC owners end up having to seek professional help. While this is understandable—you want to make sure you are doing everything right, after all—it can also be rather costly. Still, it is better to consult an expert when you are unsure of something than to risk getting penalized for doing something you did not know you should not be doing.
One factor that causes many people to become hesitant about starting an LLC is that forming and managing one can be a rather costly endeavor (Huston, 2021). To start, you typically have to spend more money to start an LLC than you would have to spend to start any other company. This is partly because states charge an initial formation fee when you register your limited liability company. Naturally, what that fee amounts to changes from state to state. Some states also require you to pay ongoing fees, such as franchise tax fees or the annual report. Once you do start an LLC, the complexities you have sometimes lead you to seek professional help, as we said. This only adds to the costs that LLCs bring.
You might think that starting an LLC is worth the cost, and you might even be right. But then you factor in LLCs’ limited lifespan. LLCs have limited lifespans because they end up dissolving when their owners leave the business or pass away. Put simply, an LLC dies along with its owner unless specific plans exist establishing what will become of the LLC after its owner leaves. If you want to start an LLC and want it to continue on after you—in other words, if you want your LLC to be a legacy—then you might want to consider working on such a plan.
The final drawback to LLCs is that they can be difficult to raise capital for. This is because some investors, like venture capitalists, tend to be reluctant to invest in LLCs. The reason for this is that such investors have tax-exempt partners who do not want to receive any kind of business outcome given the status that they hold. Many other investors refrain from investing in LLCs because they have to spend a lot more time diligently reviewing the many documents that LLCs have to keep, and time, as they say, is money (DeGroot, 2020).
SHOULD YOUR BUSINESS BE AN LLC?
Now that you know all the pros and cons that an LLC brings with it, you are faced with a simple question: should the business you want to start be an LLC or a different kind of corporation? The answer to that question depends on you and you alone, because there is no “right” answer to give.
There’s only what’s right for you. Everyone who is considering these pros and cons has to weigh them and decide for themselves. One person might decide that an LLC is the right format for them, while another might go for something else entirely. Both should take certain factors into account when deciding, though, as should you.
The first factor you need to consider when trying to decide if you want to start an LLC or not is your own financial situation. As you have seen, starting an LLC can be costly, so you need to be sure that this is a cost you can incur without straining your finances. Similarly, you need to consider what your business goals are and what kind of business structure you want. If you want a business with a simple structure that is relatively low-cost to start up, then a limited liability company is not necessarily the right business model for you. If, on the other hand, you want liability protection and a flexible management style, then an LLC might be just what you need.
What if you are not sure what you want, though? If that is the case, then you can ask yourself a series of questions to gain clarity on your wants, needs, and goals:
- What is my business goal? What kind of structure does my business have?
- What are my business’ financial needs?
- What are the tax implications—both state and federal—that come with an LLC?
- What are the risks I’ll be facing if I start an LLC?