Lately, numerous services have been pushing limited liability companies (“LLCs”) as an ideal entity structure for small businesses, with some even backed by celebrity endorsements. To level-set, an LLC is a type of business entity that offers personal liability protection for its owners – which are referred to as “members” of the LLC. An LLC might be a good fit for many businesses, but it is not a universal solution. Sometimes, a corporate setup may align better with a business’s goals. Before rushing to create an LLC for your business, it is important to evaluate multiple factors, as highlighted in this article.
Potential Risks to Personal Assets
While businesses often opt for LLCs to protect members’ personal assets, there can be circumstances under which this protection is not as robust as expected.
Although LLCs have been around for decades, they still are relatively new when compared to corporations, which have been recognized for hundreds of years. It is true that both corporations and LLCs can be at risk of “veil piercing” (where courts will allow creditors to reach owners’/members’ personal assets). However, the long history of established case law for corporations better clarifies when “veil piercing” is appropriate and what corporations need to do to avoid it from happening. Further, corporations are required to follow a list of formalities, including holding regular board meetings and having formalized corporate structures. These formalities help strengthen the separation between the corporation and its owners. On the other hand, LLCs have fewer statutory formalities, which can sometimes blur the lines between the business and personal affairs of its members. When these lines get blurred (e.g., mixing LLC income with personal income in the same bank account), courts are more inclined to allow creditors to reach the personal assets of members. In line with this, if your company happens to be a single-member LLC (i.e., just one owner) and you have not prepared an operating agreement for the LLC, it may be more difficult to prove that the LLC is a separate entity from the owner. This could lead to the LLC being treated instead as a sole proprietorship, which means the personal assets of the single-member could be at risk of exposure if the LLC is sued or cannot pay its debts.
Taxation Concerns of LLCs
LLCs typically are structured as pass-through entities for taxation purposes. This means that all profits and losses from the LLC hit each member’s personal tax returns. A highly profitable LLC can push its members into a higher tax bracket. Additionally, the distributed share of an LLC’s income typically is subject to self-employment tax, which includes Social Security and Medicare (unless you are a passive member, which means you have invested in the LLC but are not involved in the day-to-day operations and have no rights over management or operations of the LLC). Alternatively, using a corporate entity structure may help reduce your tax bill. First, C-corporations can deduct salaries, bonuses, and the cost of employee benefits as a business expense, which can help reduce the overall taxable income of the corporations. As an S-corporation (though not all businesses qualify), profits and losses still flow through to owners, but owners have the option to split their income into distributions and into reasonable salaries. This potentially can help reduce the self-employment tax burden.
There are taxation drawbacks with electing a corporate entity structure (or electing to have your LLC taxed like one) which also are important to consider, including the potential for double taxation of profits. However, rushing into an LLC structure without carefully considering potential taxation concerns could cost you a lot more money on your tax bill.
Funding Your Company
How you will fund your business is a key factor to consider when determining whether or not to create an LLC. If you are self-funding or raising capital from close contacts, an LLC might suffice. However, if you are planning to fund your business by seeking outside investment, choosing an LLC could be problematic. There are multiple reasons why venture capital, angel investors, and other outside investors avoid investing in LLCs. A short list includes:
- As mentioned above, many LLCs are pass-through entities, potentially complicating taxation for venture capitalists and other investors.
- Some investment funds might have tax-exempt partners who cannot receive active trade or business income due to their tax-exempt status.
- LLCs that have business activities in multiple states could result in investors being subject to various state income taxes.
- Venture capitalists often want to acquire preferred stock in an organization. However, LLCs offer membership interests, and it can be somewhat complicated to create different rights for the venture capitalist interests.
Given these challenges, businesses seeking outside investment must carefully consider their choice of business structure. An LLC, despite its other advantages, may hinder the attraction of venture capital and angel investors, potentially limiting opportunities for growth and success.
Conclusion and Key Takeaways
This article is not intended to discourage businesses from choosing the LLC structure – after thorough consideration, an LLC might very well be the best fit. Nonetheless, a business’s entity structure plays a crucial role in charting its path to long-term success. Therefore, it is important to invest time and thought into selecting the one that aligns best with its vision and objectives. For personalized advice on business structures, it is helpful to walk through your potential entity structure options with legal counsel. They can help you dig further into the issues discussed above and other considerations.