What are the Advantages and Disadvantages of Having a Limited Liability Company?

Excerpted from Complete Limited Liability Company Kit by Mark Warda ©2005

Before forming a limited liability company, the business owner or prospective business owner should become familiar with the advantages and disadvantages of the LLC and how they compare to those of other business entities.

Compared to Proprietorships and Partnerships The limited liability company offers the greatest benefits when compared to partnerships and sole proprietorships. Now that the LLC structure is available, it is advisable for most partnerships and sole proprietorships to switch.

Advantages There are several advantages to having your business be an LLC. This section describes some of those advantages and how to apply them to certain situations.

Limited Liability The main reason for forming a limited liability company or corporation is to limit the liability of the owners. In a sole proprietorship or partnership, the owners are personally liable for the debts and liabilities of the business, and creditors can go after nearly all of their assets to collect. If an LLC is formed and operated properly, the owners can be protected from all such liability.

Example 1: If several people are in a partnership and one of them makes many large, extravagant purchases in the name of the partnership, the other partners can be liable for the full amount of all such purchases. The creditors can take the bank accounts, cars, real estate, and other property of any partner to pay the debts of the partnership. If only one partner has money, he or she may have to pay all of the debts accumulated by the other partners. When doing business in the LLC or corporate form, the business may go bankrupt and the shareholders may lose their initial investment, but the creditors cannot touch the personal assets of the owners.

Example 2: If an employee of a partnership causes a terrible accident, the partnership and all the partners can be held personally liable for millions of dollars in damages. With a corporation or LLC, only the business would be liable whether or not there was enough money to cover the damages. One true story involves a business owner who owned hundreds of taxis. He put one or two in each of hundreds of different corporations that he owned. Each corporation only had minimum insurance and when one taxi was involved in an accident, the owner only lost the assets of that corporation. The injured party tried to reach the owner's other assets, but the court ruled that this was a valid use of the corporate structure.

Note: If a member of a limited liability company does something negligent, signs a debt personally,or guarantees a company debt, the limited liability company will not protect him or her from the consequences of his or her own act or from the debt. Also, if a limited liability company fails to follow proper formalities, a court may use that as an excuse to hold the members liable. The formalities include having separate bank accounts, filing annual reports, and following other requirements of state law.

Since the limited liability company is relatively new, there have been few cases interpreting the law. Courts will most likely look to both corporation and partnership law when ruling in a limited liability company case. When a court ignores a corporate structure and holds the owners or officers liable, it is called piercing the corporate veil. (It is not yet clear how or when the courts would allow a party to pierce the LLC structure.)

Continuous Existence A limited liability company may have a perpetual existence. When a sole proprietor dies, the assets of his or her business may pass to the heirs but the business no longer exists. (This may also happen with a partnership if it is not set up right.) If the surviving spouse or other heirs of a business owner want to continue the business in their own names, they will be considered a new business-even if they are using the assets of the old business. With a partnership, the death of one partner can cause a dissolution of the business if there is no provision in the partnership agreement for it to continue.

Example: If the owner of a sole proprietorship dies, his or her spouse may want to continue the business. That person may inherit all of the assets, but would have to start a new business. This means getting new licenses and tax numbers, registering the name, and establishing credit from scratch. With an LLC, the business continues with all of the same licenses, bank accounts, and so on.

Ease of Transferability A limited liability company and all of its assets and accounts may be transferred by the simple transfer of interest in the company. With a sole proprietorship, each of the individual assets must be transferred and the accounts, licenses, and permits must be individually transferred.

Example: If a sole proprietorship is sold, the new owner will have to get a new occupational license, set up his or her own bank account, and apply for a new taxpayer identification number. The title to any vehicles or real estate will have to be put in his or her name, and all open accounts will have to be changed to his or her name. He or she will probably have to submit new credit applications. With an LLC or corporation, all of these items remain in the same business name and are under control of the new manager or officer.

Note: In some cases, the new owners will have to submit personal applications for such things as credit lines or liquor licenses.

Sharing Ownership With a limited liability company, the owner of a business can share the profits of a business without giving up control. This is done by setting up the share of profits separate from the share of ownership.

Example: John wants to give his children some of the profits of his business. He can make them members of the company entitled to a share of the profits without giving them any control over the management. This would not be practical with a partnership or sole proprietorship.

Ease of Raising Capital A limited liability company may raise capital by admitting new members or borrowing money. In most cases, a business does not pay taxes on money it raises through the sale of its shares.

Example: If an LLC or corporation wants to expand, the owners can sell ten percent, fifty percent, or ninety percent of the ownership and still remain in control of the business. The people putting up the money may be more willing to invest if they know they will have a piece of the action than if they were making a loan with a limited return. They may not want to become partners in a partnership.

Note: There are strict rules about selling interests in businesses with criminal penalties and triple damages for violators.

Separate Record Keeping An LLC has all its own bank accounts and records. A sole proprietor may have trouble differentiating which expenses were for business and which were for personal items.

Ease of Estate Planning With an LLC or corporation, shares of a company can be distributed more easily than with a partnership or sole proprietorship. Different heirs can be given different percentages, and control can be limited to those who are most capable.

Prestige The name of an LLC or corporation sounds more prestigious than the name of a sole proprietor to some people. John Smith d/b/a Acme Builders sounds like one lone guy. Acme Builders, L.L.C., sounds like it might be a large sophisticated operation. One female writer on the subject has suggested that a woman who is president of a corporation looks more successful than a woman doing business in her own name. This would be the same with an LLC and would apply to everyone.

Separate Credit Rating An LLC has its own credit rating, which can be better or worse than the owner's credit rating. An LLC can go bankrupt while the owner's credit remains unaffected, or an owner's credit may be bad, but the corporation may maintain a good rating.

Disadvantages The main disadvantage that most professionals see in the LLC is that the law is new and it is not yet known how the courts will interpret it. But for some lawyers this is an excuse not to learn new things. It is always more comfortable to do what you have always done. But while there is always a chance for bad interpretation of the law, most cases should turn out as the law intended, and owners of LLCs should be protected from liability.

Cost Compared to a sole proprietorship or partnership, an LLC is more expensive to operate. In some states the fees are as low as $50 or even $10, but in others they are hundreds of dollars each year. However, this cost is offset by the lesser need for liability insurance.

Separate Records The owners of a limited liability company must be careful to keep their personal business separate from the business of the limited liability company. The limited liability company must have its own records and should have minutes of meetings. Money must be kept separate. Records should be separate in every business and the structure of a company might make it easier to do so.

Taxes A limited liability company owner will have to pay unemployment compensation tax for him- or herself, which he or she would not have to pay as a sole proprietor.

Banking Checks made out to a limited liability company cannot be cashed; they must be deposited into a corporate account. Some banks have higher fees just for businesses that are incorporated. (See pages 34—35 for tips on avoiding high bank fees.)

Compared to Limited Partnerships A limited partnership is an entity in which one or more partners control the business and are liable for the debts (the general partners), and one or more partners have no say in the business nor liability for the debts (the limited partners). This is expensive to set up because the limited partnership agreement is costly. The limited liability company allows a similar structure at a lower cost with the added benefit that no one needs to be liable for the debts of the business. For most businesses that were once limited partnerships, the LLC is now the preferred form of business.

Compared to Corporations The biggest advantage of an LLC over a corporation is that in most states it provides double asset protection. A corporation provides asset protection in that a shareholder is protected from liabilities of the corporation. But a member of an LLC gets this protection, plus personal creditors cannot take his or her LLC away from him or her if set up correctly. This is explained in more detail in the next chapter.

? An LLC requires less formality than a corporation. While improper procedures in a corporation may allow a creditor to pierce the corporate veil and hold shareholders liable, the LLC is meant to be a safe harbor to protect business owners from liability.

? An LLC can make special allocations of profits and losses among members, whereas an S corporation cannot. S corporations must have one class of ownership in which profits and losses are allocated according to the percentage of ownership.

? In an LLC, money borrowed by the company can increase the tax basis of the owners
(and lower the taxes); whereas in an S corporation, it does not.

? Contributing property to set up an LLC is not taxable even for minority interest owners. In the case of a corporation, the Internal Revenue Code Section 351 only allows it to be tax free for the contributors who have control of the business.

? The owners of an LLC can be foreign persons, other corporations, or any kind of trust. This is not true for the owners of S corporations.

? An LLC may have an unlimited number of members while an S corporation is limited to one hundred.

? If an S corporation violates one of the rules, it can lose its S corporation status and not be allowed to regain it for five years.

NOTE: Another advantage may be psychological. The LLC is still a relatively new entity, and in the twenty-first century it may look more up-to-date to be an LLC rather than an ordinary corporation.

The main disadvantage of an LLC, which is taxed as a disregarded entity compared to an S corporation, is that with an S corporation, profits taken out other than salary are not subject to social security and medicare taxes (15.3% at the time of publication); whereas all profits of an LLC are subject to these taxes (up to the taxable limits). However, if this is an issue for you, you can opt to have your LLC taxed as a corporation and then choose S corporation status. (see Chapter 4.)

For a large business where the owners take out salaries of $80,000 or more plus profits, there would not be much difference since the social security tax does not apply above that level. But for a smaller business where an owner would take out, say, $30,000 salary and $20,000 profit, the extra taxes would be over $3,000.

In some states, a disadvantage of an LLC is its start-up and annual fees are higher than for an S corporation.

Converting an Existing Business While an LLC may appear to be the best type of business entity for you, if you have an existing business, you should weigh the time and expense involved in making the conversion.

A sole proprietorship would be the easiest to convert, and a corporation would be the most complicated. (The corporation has potential tax issues which should be reviewed by a tax specialist.) At a minimum, some of the things which will have to be handled in your conversion are federal employer identification number, state tax account numbers, fictitious name registration, business licenses, professional licenses (if any), bank accounts, vendor accounts, customer accounts, and utilities.