Pros and Cons: Limited Liability Companies

You’ve got a great idea for a new business and the pieces are slowly falling into place — you’re preclearing a few options for a company name, you’ve garnered interest from potential business partners, and there’s a vacant office in the nearby office park that’s the perfect distance from your house.  During a recent meander through the office park, you noticed that many of the companies there append the acronym “LLC” to their company name.  That got you thinking: what’s an LLC, and why are so many companies identifying as one?

LLC is a short form for “Limited Liability Company,” a business structure that has a straightforward format and notable flexibility that offers unique benefits to business owners.  There are as many iterations of business structures as there are businesses, and between C Corporations and sole proprietorships, it’s not difficult to personalize a company’s organizational structure to cater to that company’s particular circumstances.  Nonetheless, the particularly customizable format of the LLC has made it the business entity of choice for many fledgling companies.

LLCs are straightforward to establish and maintain: the primary formal legal step in most states is to prepare and file Articles of Organization with the state Payment of a nominal filing fee typically accompanies such registration.  Some states also require LLCs to file an annual report or a renewal to ensure that the LLC is still operational and that the information in the State LLC database remains accurate.

In addition to streamlined administrative and recordkeeping requirements, LLCs also have the advantage of providing great flexibility in ownership, internal organization, and profit sharing arrangements.  An LLC can be owned by a single individual, multiple individuals, or even multiple companies, depending on the laws of the state where the LLC is established.

The owners of an LLC are often referred to as “members.” The internal organization of an LLC can be modified to give each particular member distinct duties from the outset or, on the other hand, left undefined until the members organically determine the roles that they each best fill.  The duties of LLC members are highly customizable: the members can elect to actively participate in the daily management of the LLC, or they can elect to be passive investors; they can choose to establish distinct roles via adoption of a formal internal operating agreement, or they can assume mutable roles via an informal understanding about how to manage the company.  An LLC has the additional advantage of limiting the liability of its members, potentially shielding the members’ personal assets in the event the company runs into trouble.

LLCs also permit great flexibility in profit sharing and loss distribution.  The flexibility offered by LLCs also extends to taxation schemes.  In some states, unless an LLC’s members affirmatively elect for their LLC to be taxed as a corporation, LLCs are usually automatically subject to a “pass through” tax scheme.  This means that, unlike a traditional corporation, the company itself is not subject to separate taxation.  Instead, profits, losses, and tax reporting responsibilities are “passed through” the company to the members of the LLC.  Thus, the profits and losses each member incurs in connection with the LLC are reported on that member’s personal federal tax return, potentially simplifying the reporting requirements for the company as a separate entity.  Despite the flexibility an LLC offers in electing a taxation scheme, LLC members should be aware that they may be required to pay self-employment tax on all profits they earn from the LLC during a given year.

Indeed, LLCs are not without drawbacks, in part because of the operational simplicity that makes them so attractive.  Although LLCs are easy to establish and operate, they can also be easy to dissolve.  In certain jurisdictions, absent an agreement to guard against dissolution, the loss of a single member may cause an LLC to cease to exist.  Additionally, the organizational structure of a multi-member LLC can quickly become unclear unless the members create and abide by an operating agreement that parses out which member plays what role and establishes which members are authorized to enter into legal agreements on the LLC’s behalf.  Nonetheless, the problems posed by the flexibility of LLCs can be easily navigated with foresight and adoption of an effective operating agreement.

As you orchestrate the formation of your company, be aware that the business structure you choose can impact everything from your personal liability in troubled times to your income reporting requirements on a yearly basis.  On your next stroll through that office park, take a minute to consider the pros and cons of the flexibility that LLCs provide and whether filing to designate your company as an LLC would secure the optimal business structure for you.  With a little planning, your business can have a custom-made structure uniquely designed to help your company profit and grow.  — Mary Witzel