Going off on your own and starting your own business is brave.
Not only are you taking on the risk of failure, but building a business from scratch can feel like a tangle of paperwork, legal documents, and confusing advice. When what you really want to do is start your own consulting company, sell pies, or whatever it is you’re passionate about, business logistics might feel cumbersome and frustrating.
One of the first questions any new business might want to ask is whether it should structure itself. Your business structure could affect lots of things, but two of the main considerations are usually taxes and liability.
Enter the Limited Liability Company (LLC). An LLC is considered to be a relatively simple, flexible, and inexpensive business structure that is available to business owners in all 50 states.
Many businesses will file as an LLC entity because it provides owners with the security of limited liability. It’s right there in the name! The liability of a member of an LLC is limited to their stake of investment in the business —in most cases, a member’s personal property is protected.
Is creating an LLC right for you? Below, we cover the main pros and cons of LLC formation to help you determine whether or not it may be beneficial to establish an LLC for your business.
What Is an LLC?
Before discussing the pros and cons of LLCs, it’s important to understand what an LLC is—and isn’t. An LLC is a a flexible form of business entity that provides its owners with limited liability. Say that a customer slips and falls in your restaurant. While they may be able to sue the business, they would not be able to sue for the business owner’s car, home, or personal savings accounts.
An LLC is an option for small businesses and self-employed people who may be operating as sole proprietors and who want liability protection, but may not want to register as a corporation. Keep in mind that LLC status does not imply any form of liability insurance, only protection of the member’s personal assets in the event the LLC experiences a liability. So, if the LLC is engaging in a business activity that carries a risk of liability, it should carry an appropriate amount of insurance to mitigate that risk
An LLC is not itself a tax designation but can designate how to be taxed. Therefore, an LLC can be regarded as a sole proprietorship, partnership, or corporation, such as an S-Corp.
If no designation is made, then by default an LLC will be regarded as a sole proprietorship (a “disregarded entity”) for a person operating alone and as a partnership for a business run by two or more people.
Filing As an LLC
Though each state has its own rules governing an LLC within its jurisdiction, LLCs are largely similar across the board with regards to taxation, formation, limited liability, and operation.
LLCs with more than one member might want to draft an operating agreement. According to TurboTax , items in this document could include “The rights and responsibilities of the LLC members; what percentage of the business each member owns; how the business will be managed; how members will make decisions on major issues; what the procedures are for adding new members; and what tax treatment the LLC chooses.”
When filing articles of organization, members need to decide on a name that is unique from any other LLCs filed in that same state. Most states provide an online database or search function for LLCs currently registered in the state. LLCs will also need to include a primary business address, and the names of the members. There is no limit to the number of members an LLC can have.
Now that we have the basics of an LLC down, we can ask the question, “Should my business file as an LLC?” Let’s take a look at the LLC advantages and disadvantages.
Pros and Cons of LLC Formation
The primary LLC advantage is to have limited liability—the liability of a member is limited to their stake in the business. For example, if a creditor were to sue an LLC , they could usually do so only for an amount up to the total that the member has invested in the business.
The protection of an LLC also generally extends to an LLC filing for bankruptcy . Another key advantage is that the members of an LLC are not generally held personally liable for any of the company’s debts, so long as they have not personally guaranteed them.
The paperwork to file an LLC is generally simple, and the rules of formation and operation are relatively relaxed. For example, an LLC can have as many or as few members as they please, including just one.
If an LLC has one member (SMLLC), it will default to being taxed as a sole proprietorship. In this way, it is not so different from simply operating a sole proprietorship, except for the liability protection.
According to the IRS’ website , “Most states do not restrict ownership, and so members may include individuals, corporations, other LLCs, and foreign entities.”
Unlike with corporations, an LLC is not required to have a board of directors and other business formalities. Corporations usually also require substantial record-keeping and paperwork, in addition to specific requirements regarding the structure of management and ownership, and how profits are paid out.
Unless specifically designated otherwise, an LLC will be considered what is called a “pass-through organization” for tax purposes . Profits “pass through” directly to members, avoiding any potential corporate taxation. Business income is only taxed once, according to the owner’s personal tax return.
Ease of Transfer:
There may come a time in a business’s lifespan where ownership interests may need to be sold or transferred to a third party. A member can sell, gift, or leave their interest in the LLC to an heir with relatively little paperwork and administration.
Limits to Liability Protection:
Though registering as an LLC does offer liability protection, it does not apply in all cases. In a dispute involving an LLC, a judge ruling over a court proceeding could determine that there has been a “piercing of the corporate veil,” wherein a member of an LLC is personally liable for illegal acts such as fraud. When a member is found to be personally liable, the corporate veil has been pierced.
An example of one such exception to the limited liability protection is when a member personally guarantees a loan to a creditor.
It might be a good rule of thumb to avoid participating in an activity that will result in a loss for others and to keep business transactions and conversations segregated from personal ones.
An LLC is treated by the IRS as a sole proprietorship or partnership for tax purposes as a default, “unless it files Form 8832 and affirmatively elects to be treated as a corporation.” If an LLC is taxed as a sole proprietorship or a partnership, the IRS assumes members to be self-employed.
Those who have ever been self-employed may be aware of the “self-employment tax” —self-employed persons must not only pay their share of Medicare and Social Security tax, but the employer’s share as well.
When filing as a self-employed person, the self-employment tax is based on the business’s net earnings.
Compare this to filing as an S-corp, where members can divide income between both a salary and a business distribution—self-employment taxes are only owed on the salary portion and ordinary income tax on the distribution portion.
An LLC allows for flexible disbursement of profits, which may be ideal for a small or new company. But as a company grows larger, they may want the opportunity to raise capital in ways that are not appropriate without having filed as a corporation.
For example, if a company would like to raise cash by offering shares of stock for sale to the public, articles of incorporation would provide necessary guidance.
After weighing the pros and cons of LLC formation, it could be smart to speak with a tax advisor and lawyer before making a decision about whether to create an LLC for your small business.
Setting Up Your Money
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