When forming a business the soon-to-be owner can choose his business’s formation from four main structures: a limited liability company (LLC), corporation, general partnership or sole proprietor. LLCs are the simplest, and most common, way of structuring a business and offer numerous benefits, whereas corporations can be complicated and costly. Despite this, businesses can reach a point past which it is in their interest to begin classifying as a corporation despite the cost of doing so.
Benefits of LLCs
An LLC is a US business structure that offers the personal liability protection available to corporations alongside the pass-through taxation of a sole proprietorship or partnership. It is the simplest method of structuring a business in a way that protects the personal assets of the owner in the event that the company is sued. Additionally, it is often the right choice for small businesses because LLCs offer the right balance of personal asset protection and simplicity.
Assuming there has been no foul play (i.e. fraud or criminal action) by any members, LLC owners are not held personally liable for the debts or lawsuits that their LLC incurs. This personal asset protection cannot be found in sole proprietorships and partnerships.
LLCs benefit from pass-through taxation. This means that LLC profits go directly (i.e. pass through) to the owners of the business, and each member’s individual share is only exposed to tax once on each of their individual tax returns. Contrastingly, profits in corporations are double taxed: once as the full profit before it’s distributed to the owners and again when the owners pay income tax on their share of profits.
Another benefit of LLCs is their pure simplicity. They are easy to form and require very little paperwork to maintain; contrast this with a corporation, which requires for formal officer roles to be assied, annual meetings to be held and company minutes and resolutions to be recorded.
Becoming an LLC also illustrates that the business can be regarded with increased credibility. It is recognised as far more trustworthy – this isn’t only important for instilling trust in customers, it also allows businesses to begin building a credit history and work towards securing a business loan.
Disadvantages of LLCs
LLCs don’t tend to attract investors, at least not to the same extent that corporations do. This is because its passthrough taxation makes LLC owners (i.e. people who invested) responsible for paying taxes on their share of LLC income, regardless of whether they are given a disbursement or not. What this means is that investors might never see a return on investment, but must simultaneously pay taxes every year nonetheless.
Some states, such as California, charge extra fees for operating an LLC in their state. On top of this, professional groups (i.e. doctors, dentists, lawyers etc.) are not allowed to operate through an LLC. Furthermore, single member LLCs face reduced asset protection in many states which fail to honour this protection where an LLC only has one owner. This renders the benefits of LLCs geographically locked.
Advantages of Corporations
For the majority of small businesses it is recommended that they start as an LLC. However, this advice can change when they reach a point past which they could benefit from the corporate structure.
The corporate structure starts to make sense for businesses when they are making such large profits that they need to consistently carry it over from one tax year to the next. Furthermore, if a small business is unable to spend a large amount of its profit during a tax year on expenses to grow, it’s preferential to switch to a corporation structure as they are taxed 15% for all profits that carry over, which is far less than the FICA, federal and state income taxes LLCs are liable for.
Investors are attracted to corporations for the exact inverse of the reason they are repelled from LLCs: they will only have to pay taxes on dividends when they receive them.
Deciding between an LLC and corporation should be quite a simple decision in most scenarios. The nature of the benefits of an LLC certainly favour themselves towards a smaller business more on balance, but business can reach a point where the benefits of managing the complex business structure that is the corporation will outweigh its disadvantages. It is at this point that the advice should shift towards corporation construction.