Pros and Cons of LLC Formation

Jul 2, 2024

Starting a business involves many decisions, one of the most important being how to set it up.

One popular choice is forming a Limited Liability Company (LLC). An LLC is a flexible business structure that offers several benefits, including personal liability protection and favorable tax treatment. However, an LLC also has some disadvantages.

Let’s get into:

  • The advantages and disadvantages of an LLC
  • An example of how operating as an LLC can affect one your company
  • A high-level process for forming an LLC business on your own

Having the facts about all the pros and cons will help you make a better choice about forming an LLC and whether it is the right choice for you and your business.

Advantages of Forming an LLC

Forming a Limited Liability Company (LLC) comes with many benefits for business owners like you.

One of the most significant advantages is limited liability protection. If you incur business debts or get sued, your personal assets are protected, e.g. house, car, bank accounts, etc.. This protection helps reduce the fear of losing personal property because of business-related issues.

Another major benefit of owning an LLC is pass-through taxation. In some types of business structures (like corporations), the company itself pays taxes on its profits, and then the owners also pay taxes on the same money given to them–double taxation. With an LLC, your company’s profits pass directly to its owners, who then report this income on their personal tax returns.

LLCs also offer flexibility in management and profit distribution. Unlike corporations, which have strict rules about how they must be managed, you can decide how you want to run the business with less paperwork.

For example, all members can share management duties or hire a manager. LLCs can distribute profits in any way the members agree, not necessarily based on ownership percentages. This flexibility makes it easier to tailor your business operations to suit your needs and goals.

Tax Advantages

Holding companies can also provide tax benefits; by efficiently organizing their business operations, companies can reduce their overall tax obligations. For example, a holding company may offset profits in one subsidiary with losses in another, resulting in reduced tax payments.

LLC Tax Advantages and Benefits

Another significant advantage of owning an LLC is its tax advantages. When you own an LLC, you choose how you want to be taxed, which can help reduce your overall tax bill. Let's get more specific on some of these advantages:

  1. Avoid Double Taxation. An LLC is a ‘pass-through entity,’ meaning the business does not pay profit taxes itself. Instead, profits are passed through to the members, who report this income on their personal income tax returns. This avoids the double taxation issue that C-corporations face, where the company and the owners are taxed on the same income.
  2. Choice of Tax Treatment. For tax purposes, a single-member LLC is treated as a sole proprietorship, and a multi-member LLC is treated as a partnership by default. However, you can elect for your LLC to be taxed as an S-corporation or a C-corporation by filing the appropriate forms with the IRS.
    • S-Corporation. By electing to be taxed as an S-corporation, you can reduce the self-employment taxes you pay. In an S-corp, only owner salaries are subject to payroll taxes, while the remaining profits are distributed as dividends. Dividends are not subject to self-employment taxes.
    • C-Corporation. Although it's less common, you can be taxed as a C-corporation. This can be beneficial if the LLC's earnings are used to expand and grow the business. Corporate tax rates can sometimes be lower than individual tax rates. C-corps can offer other tax-deductible benefits to their employees, including the owners.
  3. Deductible Business Expenses. When you own an LLC, you can deduct a wide range of business expenses to reduce your taxable income. This includes business-related costs like rent, utilities, office supplies, travel, and marketing expenses. By lowering your taxable income, you and other LLC members can reduce what they pay in taxes.
  4. Qualified Business Income Deduction. You may also be eligible for the Qualified Business Income (QBI) deduction when you own an LLC. This allows you to deduct up to 20% of your business income from your taxable income. This deduction can provide significant tax savings for you.

Operational Flexibility and Profit Distribution

If you own an LLC, you enjoy operational flexibility (especially compared to a corporation). This flexibility allows you to structure your LLC's management and profit distribution in the best way for you. This flexibility is one of the reasons why many business owners prefer the LLC structure.

Let's explore this flexibility in more detail:

  1. Management Structure:
    • Member-Managed. In a member-managed LLC, members are actively involved in running the business. This is common in smaller LLCs where the owners want to have hands-on control over the daily operations. Decisions are made by the members, making it a collaborative setup.
    • Manager-Managed. In a manager-managed LLC, members appoint a manager to handle day-to-day operations. These managers can be members of the LLC or hired. Larger LLCs often choose this option when the members prefer to take a more passive role in the business. The managers make operational decisions, allowing the members to focus elsewhere.
  2. Profit Distribution:
    • Flexible Profit Sharing. Unlike corporations, where profit distribution is usually based on the number of shares owned, LLCs let members choose how to distribute profits. The profit-sharing agreement is typically outlined in the LLC's Operating Agreement. For example, members who perform services in their capacity as members can be allocated a share of LLC income in addition to the share of income allocated based on their percentage ownership in the LLC. This “preferential allocation” would reduce the income to be divided among all members. There are other income distribution methods available that offer significant flexibility.
    • Adjustable Profit Shares. Profit-sharing percentages can change over time as the business grows and evolves. For example, if new members are brought into the LLC or members change their responsibilities, ordinary and preferential allocations can be changed to reflect it.

Disadvantages of LLCs

Although there are many advantages to operating your business as an LLC, there are some drawbacks to consider before deciding if an LLC is the best fit for you.

One of the main disadvantages of an LLC is the self-employment taxes. When you own an LLC, you are considered self-employed. This means you are responsible for paying the employer and employee portions of Social Security and Medicare taxes.

Another potential drawback of forming an LLC is the initial business formation process and the ongoing compliance costs. If you want to set your LLC up correctly, you must follow several necessary steps (which we will share below).

Plus, setting up an LLC comes with a cost. The fees vary by state, but they range from $35 in Montana to $500 in Massachusetts.

In addition to the cost of filing your Articles of Incorporation with your Secretary of State, consider the cost of the following:

  • Getting and maintaining the right business licensing
  • Ongoing expenses such as annual report fees

Both are required to keep your LLC in good standing with the state.

Another potential drawback to owning an LLC is attracting investors. LLCs can't issue stock, which means investors can't easily buy and sell ownership shares in the company. Compared to a corporation, this can make raising capital and growing your business more difficult.

Compliance and Paperwork

LLCs are well-known for being more straightforward to operate than a corporation. Still, if you own an LLC, you have responsibilities and compliance obligations to meet. Your requirements will vary by state and generally involve filing annual or biennial (every other year) reports.

When you file your report, you'll likely need to share:

  • Basic information about the LLC. This could include when it was formed, the business address, and the registered agent's name and address.
  • Financial details. You may need to provide income statements and other financial records.
  • Other legal documentation. States may request different documentation, but you must be prepared to provide what they ask. We can help.

You may also need to pay a filing fee when you submit your report. This fee varies by state and can range from $0 in a handful of states to $800 in California.

An important note: you must still file your report and pay the fee even if your LLC is not making income.

Some states may also require you to publish a notice in local newspapers when your LLC is formed.

It's essential to stay on top of these compliance requirements to avoid penalties from the state. You could face fines if you miss these deadlines or fail to file your reports. You could even jeopardize your limited liability protection.

Considerations for Specific Use Cases

When you think about forming an LLC, it's important to consider how this business entity will affect your specific business.

We see many real estate investment businesses operate as LLCs, so we'd like to use it as an example and show:

  • How an LLC's benefits apply (ease of making membership changes, protecting personal assets, and one type of tax advantage)
  • How an LLC can bring up some complexities and challenges for this type of business (transfer taxes and due on sale clauses)

LLC Advantage Applications:

  1. Make Member Changes Easily. If you start investing in real estate with friends or family, you can create an LLC, and all of them can of them can be members. Your roles must be indicated in your LLC's Operating Agreement (not required in all states, but we highly recommend creating one).
    Real-world example: Down the line, you may want to add members to or remove members from the business. You can make these changes by updating the LLC's Operating Agreement. Similarly, you can update the agreement if responsibilities or profit distributions need to change.
    This flexibility makes it easy to have a business that grows with your business needs.
  2. Protecting Personal Assets. Using an LLC for a real estate business can help protect personal assets. It's one of the main reasons small businesses elect to create an LLC, and real estate investment businesses are no different.Real-world example: If a client decides to sue you because something went wrong with a property you sell, only the LLC's assets are at risk. This could happen if someone gets hurt or suffers a major financial loss.
  3. Depreciation. When you own real estate through an LLC, you can also take advantage of depreciation at tax time. Depreciation allows you to deduct a portion of the property's value each year, reducing your taxable income. This can provide significant tax savings with the IRS over time.
    However, it's important to understand the limitations of depreciation to ensure you're making the most of it.

Complexities and Challenges:

There are a few things to consider with a real estate investment business that add a little more complexity to the decisions you might make.

  1. Transfer Taxes. When you transfer property into an LLC, you may have to pay taxes. What you pay is generally based on two things:
    • The tax rate where the property is located
    • The value of the property
    These taxes can be quite high. That's why it's important to research and understand the potential costs before you transfer a property to an LLC.
  2. 'Due on Sale' Clauses. Another complexity for real estate investment businesses involves 'due on sale' clauses. Often found in mortgage agreements, it means that if the property is sold or transferred, the full loan amount becomes due immediately.
    Transferring property into an LLC may trigger this clause, meaning you must pay off the mortgage immediately.
    This can be a major financial burden, so you must check your mortgage agreement and talk to your lender before transferring property into an LLC.

Using an LLC for real estate investment businesses can offer many advantages. You can protect your personal assets, make it easier to manage the business with multiple owners, and access tax advantages.

Still, challenges and complexities exist, like potential transfer taxes and 'due on sale' clauses. Although these challenges exist, they can be overcome with careful planning and management.

We used a real estate business as an example of an LLC with upsides and points to consider, but we hope you take this away:

Before you set up an LLC, take time to understand how it will affect your business and carefully weigh the pros and cons.

When you know how operating as an LLC will affect your business and seek professional advice, you can make informed decisions and manage your LLC successfully.

That's true, no matter what industry your business falls under.

Forming an LLC

The process of forming an LLC is straightforward, but it involves several steps. At a high level, here are the steps to follow to get your LLC started:

  1. Choose Your LLC's Name. This name must comply with your state's naming rules and not already be used by another business.
  2. Appoint a Registered Agent. This person or hired service receives legal documents on behalf of your LLC. The registered agent must be 18 or older and have a physical address in the state where your LLC is formed.
  3. File Your Articles Of Organization. The specifics vary by the state you operate your LLC from, but in general, this document includes:
    • Your LLC's name and business address
    • The registered agent's name and address
    Some states request the following:
    • Signatures of all forming members
    • Whether your LLC is manager-managed or member-managed
    • The business purpose and its planned duration
    You can file your application online at your Secretary of State website or by mail online at your Secretary of State website, or mail your application. You will need to pay a filing fee (which varies by state and, and this can cost several hundred dollars). Processing times can range from immediate to several weeks.
  4. Obtain An EIN (Employer Identification Number). This 9-digit number is used for tax purposes and is necessary if your LLC has employees or multiple members. You may also need one to open a business bank account or get a business credit card.
  5. Create An Operating Agreement. Although it's not always legally required, we highly recommend an Operating Agreement for all LLC owners. It helps keep your business running smoothly and prevents disputes. This document outlines:
    • How your LLC will be managed
    • How profits and losses will be distributed
    • Roles and responsibilities of the members

Bottom Line: Consider The Pros and Cons and Create a Business That’s Right For You

An LLC can offer numerous advantages, such as liability protection, tax benefits, and operational flexibility. However, it is essential to understand both the pros and cons–and how they apply to your specific business.

We encourage you to consider all these factors carefully and seek legal advice from a professional to determine if an LLC is the best structure for your business.

Pros & Cons of Forming an LLC FAQs

The main downsides to an LLC are self-employment taxes, the setup process and costs, and the ongoing compliance requirements (reporting and expenses).

The four benefits to owning an LLC are operational and management flexibility, tax advantages, personal liability protection, and added credibility for your business.

An LLC can be a great option for your side hustle. As with any business, you need to fully understand the implications and responsibilities of owning an LLC before forming one.

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