The idea of ”being your own boss” is certainly exciting. If you plan to achieve this goal by establishing your own business and prepare a business plan, then the next critical step is to decide on the right business structure. This decision has a profound impact on the company, so it needs to be carefully chosen. Factors such as personal liability, regulations, and tax treatments are governed by the form of your business entity, which can be a sole proprietorship, company, partnership, or limited liability company (LLC).
A simple, efficient and fast way to start a company is to set up a limited liability company (LLC). Let us explore what an LLC is, its applicability, advantages and disadvantages, and other basic factors that can help you determine whether an LLC is suitable for you and your business.
What is a limited liability company?
In the United States, a limited liability company is a relatively new form of business entity. Wyoming promulgated its first formal limited liability company statute in 1977. The Act combines the advantageous characteristics of partnerships and companies, and is based on the German Code of 1982 and Panamanian limited liability companies. Over the years, all states have passed legislation and even amended the bill to provide the current form of a limited liability company.
A limited liability company is a mixed form of business entity, which has the characteristics of a company and a partnership. It is structured in a way that can benefit from the transfer of tax characteristics of partnerships, while allowing flexibility in operation and management, but with limited responsibilities like a company.
In the United States, the laws of limited liability companies are governed by individual states, but they are recognized in all states. The laws of different countries are further different. In the case of a limited liability company, the “owner” of the company is called a “member”. Generally, one person can start a limited liability company, and there is no upper limit on the number of members.
Many well-known mature companies are limited liability companies. Some names are Chrysler Group LLC, Westinghouse Electric LLC, Dougherty & Company LLC, Blockbuster LLC. Due to the “liability” protection of limited liability companies, some companies such as banks, insurance, and medical services are not eligible to apply as limited liability companies.
There are many benefits to registering your company as a limited liability company. Let’s take a look at some of the biggest advantages below.
This is one of the characteristics of a company-like limited liability company. LLC provides its owners with a protective barrier against corporate debt and liability.
Let’s take an example. Jimmy owns a shoe store “boot & boot”, and its customers are lost to a more upscale store around the corner. Business is not good. The company has not paid rent for the past eight months, nor has it paid the bills for three batches of shoes. Therefore, “boot & boot” owes approximately US$75,000 to creditors, who have filed a lawsuit against the company.
In this case, the creditor is fully entitled to claim the money owed by the company, but not to claim Jimmy’s personal assets (bank deposits or gold or real estate). In a limited liability company, only the assets of the company can be liquidated to repay debts, not the owner. This is a major advantage that a sole proprietorship or partnership does not have. Legally, the owner and the enterprise are considered the same legally, which increases the vulnerability of personal assets.
The company is not directly taxed by the IRS because LLC is not considered a separate tax entity. Instead, the tax liability is borne by members who pay through personal income tax. Let’s look at an example.
Assuming that “boot & boot” has two members, the net profit for a year is as high as $60,000. The net profit will be divided into two parts (number of members), and this amount will be taxed as personal income, depending on their overall tax liability. Since a limited liability company is not recognized as a business entity for tax purposes, it must file a tax return as a company, partnership or sole proprietorship.
Please keep in mind that certain limited liability companies are automatically classified as companies by the IRS for tax purposes, so be sure to understand whether your business falls into this category. Those limited liability companies that are not automatically classified as companies can choose the business entity of their choice by submitting Form 8832. If the LLC wants to change the classification status, use the same form.
Among all forms of companies, it is easier to set up a limited liability company, with lower complexity, paperwork, and cost. This type of company is very easy to operate, with fewer record keeping and compliance issues. LLC also provides a lot of management freedom because there are no board of directors, annual meetings, or strict record book requirements. These functions reduce unnecessary troubles and help save a lot of time and energy.
The establishment of a limited liability company generally requires the submission of the “Articles of Association”, which is a document that includes basic information such as company name, address, and members. Most state applications are completed by the Secretary of State, and related application fees are charged.
The next step is to create an operating agreement. Although it is not mandatory in most states, it is particularly recommended for multi-member limited liability companies. When registering a business, other licenses and permits must be obtained.
In addition, some states such as Arizona and New York require that the formation of LLCs be published in local newspapers.
LLC provides great flexibility in investment and profit sharing.
In a limited liability company, members can choose to invest in a proportion different from their ownership percentage, that is, those who own 25% of the limited liability company do not need to contribute funds in the same proportion to the initial investment. This can be achieved by creating an operating agreement that specifies the percentage of profit (and loss) for each member of the company, regardless of their initial investment amount. Therefore, it is possible for outside investors to invest funds into the business without ownership.
The same applies to profit distribution, and LLC members can flexibly decide on profit distribution. The distribution of profits can be different from the proportion of ownership. A member may gain a greater profit from the extra time or effort they spend in conducting business by consensus.
Although a limited liability company (LLC) has advantages over certain other forms of business entities, there are some disadvantages that need to be considered before choosing a limited liability company as a business structure.
The life of a limited liability company is limited by the tenure of its members. Although it may vary from state to state, in most cases, when a member leaves the limited liability company, the business will be dissolved or ceased to exist, further requiring other members to complete the remaining business or to close the business required legal obligations. The remaining members can choose to set up a new limited liability company or part ways. This weakness of limited liability companies can be overcome by including appropriate clauses in the operating agreement.
The members of a limited liability company must pay self-employment taxes to medical insurance and social security because they are considered self-employed. Therefore, the net income of the enterprise is subject to this tax. To avoid this situation, depending on the turnover and tax burden, if the result is more favorable, the entity can choose to tax like a company. Please consult an accountant before making this choice.
A limited liability company usually pays as an initial cost or an ongoing expense higher than the expenses of a business entity such as a sole proprietorship or general partnership, but lower than the expenses that a C company must pay. The various types of fees include applicable state application fees, ongoing fees, and annual reporting fees.
Limited liability companies are a relatively new business structure, so there are not many legal cases related to them. For this reason, there are not as many legal precedents or case law for limited liability companies as in the old form. Having a certain legal priority helps to take corresponding actions in the same given case scenario. Since there are few established laws, there are more vulnerabilities.
A limited liability company is a perfect combination of protection, flexibility and tax incentives. It provides a series of tax alternatives while protecting individual members from personal liability. Limited liability companies are considered suitable for small businesses because they have less trouble and complexity in their operations. However, it is recommended to consult an accountant or lawyer for expert advice before making the final call.