Forming an LLC
What are the advantages of forming an LLC (limited liability company)? We discuss LLC advantages in-depth in this article. The bottomline? LLC benefits are compelling. It's worth taking a serious look at choosing an LLC over a corporation or other business structure. But we also discuss a few LLC disadvantages that might make you steer clear of LLC formation.
The LLC, a relatively new form of business organization, is growing in popularity. So what are the LLC advantages that are making it so popular?
The advantages of forming an LLC are that the members are afforded limited liability and have pass-through taxes similar to a partnership.
By forming an LLC instead of a corporation, you get all the benefits of forming a corporation but you avoid a few drawbacks that you would run into if you formed a corporation. Specifically, when you form a corporation, you subject yourself to double taxation and excessive paperwork. Both of those annoyances can be avoided if you form an LLC.
How do LLCs work? The LLC allows for multiple owners, or members. Additionally, there is a managing member, who also enjoys the rewards of limited liability and is typically the person responsible for managing the business. (However, if the LLC has just one owner, it will be taxed as a sole proprietorship.)
The profits or losses of the business pass directly through to the owners' personal income tax returns, on their Form 1040. The LLC files a Form 1065, and then lists each member's taxable profit on Form K-1. In other words, the LLC itself does not file taxes.
This is what we mean when we say you avoid double taxation with an LLC. In a corporation, it works differently. The corporation is taxed and, accordingly, must file taxes. Then, distributions to the owners are taxed. In essence, the government takes two bites out of your revenues instead of the one bite they'll take if you've form an LLC instead of a corporation.
With an LLC, the bottom-line profit of the business is not considered to be earned income to the members, and therefore is not subject to self-employment tax. But keep in mind that the managing member's share of the bottom-line profit of the LLC is considered earned income, and therefore is subject to self-employment tax.
Members are compensated using either distributions of profit or guaranteed payments. A distribution of profit allows each member to pay themselves by merely writing checks--whenever they need the money (provided the business has the available cash). However, as a member of an LLC, you are not allowed to pay yourself wages.
Guaranteed payments represent earned income to the members, thereby qualifying them to enjoy the benefits of tax-favored fringe benefits. The members' share of bottom-line profit is not considered earned income because the members are considered to be inactive owners; therefore, the members do not qualify for special tax-favored "fringe benefit" treatment.
A corporation can be a member of an LLC. This allows you to create an additional level of ownership, which is designed to create an entity that can offer such traditional fringe benefits as retirement plans and an additional level of protection from liability.
The managing member of an LLC can deduct 100 percent of the health insurance premiums he or she pays--up to the extent of their pro-rata share of the LLC's net profit, because the profit is considered earned income. Note: If a member has earned income, he or she will also qualify.
So are there any disadvantages to an LLC? Why isn't every corporation in the world switching to LLC status? Why are traditional C corporations and S corporations still being formed? There are a few answers to that question.
In fact, we recently chose a C corporation structure over an LLC structure, and here's why. The entity we were forming will be seeking outside investment and will be offering stock options to employees. Many angel investors and venture capital firms are still gun-shy about investing in LLCs because it's a new business formation that is not well understood.
When you're raising capital, it helps to keep things simple and avoid anything that makes an investor think twice; hence, despite our having used LLCs successfully in the past, we went with the C corporation formation.
Another advantage of the C corporation over the LLC is that law firms tend to have many more boilerplate agreements for C corporations than they do for an LLC. Hence, your legal bills may be higher if you go with an LLC because more lawyer time is involved in drafting agreements. Of course, that will change over time as more and more business entities adopt LLC status.
The bottomline? LLCs are an excellent form of organization that is growing in popularity. If the state where you intend to operate allows the creation of LLCs and you could use the features it offers, yet you don't want all of the paperwork and costs associated with incorporating, it's worth learning about LLC benefits and LLC drawbacks.
Consult an attorney and ask him about the pros and cons of creating a LLC. Alternatively, there are many excellent online incorporation firms that are equipped to answer your questions about LLCs and help you with forming an LLC at a very reasonable cost.
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