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LLC disadvantages: everything you need to know about the downsides of LLCs

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Updated on:
December 11, 2022
December 11, 2022
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When you are starting a business, one of the first decisions you need to make is what type of entity to form. There are many different types of business structures, but one of the most popular is the Limited Liability Company or LLC.

In this blog post, we will discuss some of the LLC disadvantages and advantages – and explain how to start an LLC – so that you can decide if it is the right structure for your business.

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What is a Limited Liability Company (LLC)?

A Limited Liability Company (LLC) is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation, creating what’s known as a hybrid entity.

Owners of an LLC are called members and they typically have equal rights in managing the company, unless otherwise agreed upon in the Operating Agreement.

The primary benefit of forming an LLC is that it protects your personal assets from being seized to pay off business debts if something goes wrong. This allows members to stay in control of their company without having to worry about being held personally liable for any lawsuits or financial problems that may occur.

Also, LLCs are taxed as a pass-through entity, which means that all profits and losses pass through directly to its members. The LLC does not pay taxes itself; instead, the owners report income on their personal tax returns and are then taxed at their individual tax rates.

LLC formation costs, fees, and taxes

The cost of forming an LLC depends on which state you choose to form your business in. For example, if you want to start a company in California then it will cost anywhere from $70-$800 depending on what type of services are provided by the registered agent service provider (more on this later).

There are also several annual fees and taxes that you will need to pay to keep your LLC in good standing. These include things like the state’s annual franchise tax, which is usually based on the total revenue of the company, and fees charged by the Secretary of State or Department of Corporations for filing documents online or via mail.

The Disadvantages Of An LLC

The LLC is a popular business entity for many reasons, but there are some drawbacks to consider. Let's review some of the disadvantages of an LLC.

Members must immediately recognize profits

Unlike corporations, LLCs must recognize profits as soon as they are earned. This can be a disadvantage for businesses that are seasonal or have irregular income streams, as it can cause them to pay taxes on profits that have not yet been realized.

Harder to transfer ownership

Because of the LLC's structure, transferring ownership in an Limited Liability Company is more difficult than it is with a corporation. Unless there's a shareholder agreement to the contrary, corporations can sell shares of stock to enhance ownership, and shareholders may sell their shares to anybody they choose.

With LLCs, on the other hand, all members must approve the addition of new members or changes in ownership percentages, unless the members agree otherwise.

Because of the lack of flexibility in changing ownership, some LLCs may find it difficult to get the funding necessary to run their operations.

Relatively high costs

Forming an LLC can be relatively expensive, especially if you need to hire a lawyer or other professional to help with the process. While there are some advantages to working with an attorney (such as getting advice on how best to structure your business), many people choose to form their LLCs by themselves in order to save money.

State fees and taxes

LLCs must pay various annual or semiannual fees or taxes in certain states if they operate there. These taxes are usually a flat fee or levied according to the company's turnover or earnings in some jurisdictions.

Record Tracking

Owners of a limited liability company must maintain their personal businesses separate from the LLC's operations. An LLC must keep its own records and should keep meeting minutes (note that this is only required by law for corporations).

You should also keep your personal and corporate funds separate, and separate the LLC's financial records from your own. This entails opening a company account for all LLC-related transactions and deposits.

LLC advantages

Despite some of the disadvantages listed above, there are many advantages to creating an LLC. Some key benefits include:

Minimal paperwork

Compared to forming a corporation, setting up an LLC typically involves much less paperwork. This is because the state usually has pre-drafted articles of organization form that you can simply fill out and file.

Tax benefits

Depending on how your LLC is structured, it may be able to take advantage of certain tax benefits not available to corporations. For example, if you are the sole owner of an LLC, you will be taxed as a single-member LLC. With this type of tax structure, your business assets and liabilities do not have to be reported on a separate tax return; instead, your income or losses from the business are simply transferred over to your personal tax return (Form Schedule C).

In addition, if you are in a high tax bracket, owning your business through an LLC may be more beneficial than forming it as a corporation. This is because there is no double taxation under the LLC structure; instead, all profits are passed directly to its owners and taxed at their individual tax rates.

Heightened credibility

Many companies choose to form an LLC because it offers them a sense of legitimacy that they do not have as sole proprietorships (many sole-proprietors change to an LLC for this reason) For example, if you own an LLC, your business may seem more professional in the eyes of customers, and people may be more likely to trust you and want to work with you.

Operating flexibility

Unlike corporations, which must adhere to certain formalities when running their businesses, LLCs have far more flexibility. For example, LLC members can adapt the company’s operating agreement as needed; this is particularly beneficial for new companies that are still figuring out how best to operate.

Limited liability protection

As mentioned earlier, the personal assets of LLC members are protected from being seized to pay off business debts if things go awry. This protection extends to both domestic and foreign judgments, making it a particularly attractive option for businesses with international operations.

Flexible management structure

LLCs offer a high degree of flexibility when it comes to their management structure. Members can choose to manage the company themselves or appoint managers to do so on their behalf. This gives businesses a great deal of control over how they are run and who makes decisions regarding important matters such as business strategy, financial planning, and personnel decisions.

Ease of formation

Compared to other business structures, LLCs are fairly easy and inexpensive to set up. In most states, you can form an LLC online in just a few minutes by filling out the articles of organization form that is typically provided on each state's website.

Once you have filled out and submitted this form, your LLC will be up and running. Read more about the easiest states to form an LLC.

How to form an LLC

Now that we've covered the advantages and disadvantages of forming an LLC, let's take a look at how you can set one up for yourself.

Choose a state to incorporate your business

The state in which you choose to form your LLC can have a big impact on how the business is taxed and what regulations apply. For example, if you are starting an online store or service-based company then forming an entity in Delaware may be beneficial because there are no sales taxes charged within its borders (which means lower operating costs).

Each state has its own specific requirements for forming an LLC, so it's important to do your homework and make sure you are aware of all the rules and regulations that apply in the jurisdiction where you plan to operate.

You can find a list of all the states that offer LLCs and their corresponding requirements on the website of the National Association of Secretaries of State.

Choose a business name

Once you have determined what state to incorporate your LLC in, the next step is choosing a name for it.

This may sound like an easy task at first, but the process can quickly become complicated if you don't know what rules apply when it comes to naming an LLC. For example, some states require that names must include words like "limited," "company," or "incorporated."

In addition, you will need to make sure that the name is not already taken by another business entity in your state. You can search for registered businesses in your state using the Secretary of State's online database.

Also, keep in mind that some states require you to reserve your LLC's business name before filing the articles of organization. This can be done by submitting a Name Reservation form to your state's secretary of state office. Once the name has been reserved, it cannot be used by another company for up to 120 days.

Designate a registered agent

Once you have chosen a business name, you will need to designate a registered agent for your LLC. This is an individual that is authorized to receive legal and tax notices on behalf of your LLC. The registered agent can be either a resident of the state where your LLC is formed or a professional service provider such as an attorney or CPA.

In some states, you must also submit a Registered Agent Consent Form with your articles of organization to show that the registered agent has agreed to serve in this capacity.

Decide on member vs. manager management

If you are forming a single-member LLC, or one that has only one owner, then your default management structure will be member-managed. However, if you plan to operate as a multi-member LLC with two or more owners, you can choose either the manager-managed option or the member-managed option.

The type of management structure you choose will have important implications for the day-to-day operations of your LLC. With manager management, all business decisions are made by one or more managers who are appointed by the members. This type of structure can be helpful if you don't want to give up too much control over your business to the other members.

Member management, on the other hand, puts more of the day-to-day decision-making in the hands of the members. This can be a good option if you want all LLC owners to have a say in how the business is run.

In some states, you must make your management structure selection when you file your articles of organization. In others, you may have the option to change your management structure later on by amending your articles of organization.

Draft and file the articles of organization

Once you have decided on all the important details related to your LLC—name, registered agent, management structure, etc.—you will need to file a set of articles of organization with your state's secretary of state office. This document officially creates your LLC, and you will need to pay a filing fee when you submit it.

The exact requirements for filing these papers vary by state, but they should include:

  • the name and address of each member (i.e., the owner)
  • the name and address of your LLC's registered agent
  • the name, address, and title of each member (i.e., owner) or manager of the company—if it is to be managed by a person other than its members
  • a statement indicating whether the LLC will have perpetual existence or will expire at a specified date

In most states, the articles of organization must be submitted either in-person or by mail. However, some states allow for online filing instead. Check with your state's secretary of state office to see what options are available.

You can find a sample of articles of organization form and more information on the specific requirements for your state by visiting your state's secretary of state website.

Create an operating agreement

Although not required in all states, it's generally a good idea to have an operating agreement specifying the rights and responsibilities of the LLC members.

This document can help prevent misunderstandings among members about how the company should be run and can help avoid disputes down the road. An operating agreement can be as simple or complex as you like, but should at least include:

  • the name and address of the LLC
  • the business purpose of the LLC
  • the names and addresses of all members
  • the percentage interest each member has in the LLC
  • the rights and responsibilities of each member, including voting rights, management rights, and the right to receive profits and losses
  • the procedures for adding or removing members
  • the procedure for dissolving the LLC

Maintain an LLC membership ledger

An LLC membership ledger is a document that lists the name and contact information of each LLC member, as well as their ownership percentage. This document is important for tax purposes and should be kept up to date.

You can create your own membership ledger or use a template from an online resource like Rocket Lawyer.

Obtain business licenses and permits

Depending on the type of business you operate, you may need to obtain one or more business licenses and/or permits. Check with your state's secretary of state or department of commerce to find out what's required. You can also visit the website of the U.S. Small Business Administration for a list of federal permits, licenses, and registrations that may be required for your business.

Obtain an EIN

An Employer Identification Number (EIN) is a nine-digit number that the IRS uses to identify businesses for tax purposes. Even if your LLC has no employees and will not pay any payroll or excise taxes, it still needs to obtain an EIN in order to file business tax returns. You can apply for an EIN online or by faxing or mailing in Form SS-16, the Application for Employer Identification Number.

Other reasons why you may need to obtain an EIN to form your LLC include: opening

  • a business bank account
  • filing state or local taxes
  • applying for business licenses.

Give notice to your local tax authority

Depending on your state's laws, you may have to notify your state or local tax authority when you form an LLC. This is particularly true of businesses that must pay sales taxes, such as retail stores and restaurants. The notice usually requires information about the business's location and type, along with proof that it has obtained a federal Employer Identification Number (EIN).

Open a bank account

Once your LLC is up and running, you'll need to open a business bank account in its name. This will help keep your personal and business finances separate and make it easier to track the company's income and expenses.

You'll need your EIN, articles of organization, operating agreement (if you have one), and a photo ID to open an account. You may also need to provide proof that you've registered your business with state or local taxes authorities.

Create your business website

With so many people using the Internet to find information, your LLC needs to have a website. A website can provide potential customers with information about your business, what you sell, and how to contact you. It can also help build credibility for your company and reinforce the professionalism of your brand.

Creating your website, though, requires you to do a couple of things. They include:

Choosing a domain name

The first thing you'll need for your website is a domain name. This will be the address that people type into their browser to find your site (e.g., examplellc.com). You can buy available domains through third-party vendors, such as GoDaddy and Network Solutions, or register them for free through sites like Dotster and Hover.

Registering a web host

Once you have a domain name, you'll need to find a web host to store your website's files. This is the company that will "host" your site on its servers and makes it available to people who type in your domain name. You can compare the prices and features of various web hosts at websites like HostGator, JustHost, and Bluehost.

Designing your website

The next step is to create the actual website. You can do this yourself using free or paid software, or you can hire a professional web design company to do it for you. If you decide to DIY, be sure to read a book or find an online tutorial that can walk you through the process.

Create a company email address

A company email address is important from a marketing perspective. It provides customers with another way to contact your business while reinforcing professionalism for your brand.

There are several website providers, such as GoDaddy, that offer free or low-cost email accounts to businesses. You can also set up your company's email address through your web host. Just be sure to choose a name for the account that reflects your LLC (e.g., info@examplellc.com).

Register to do business in other states (optional)

If you plan to do business in other states, you'll need to register your LLC with the appropriate state authorities. This process is known as "foreign qualification" and can be done through the secretary of state or department of commerce in each state where you want to operate.

Typically, a lot of factors are assessed to determine whether an LLC is transacting business in a state, as well as if it needs foreign qualification. Some of the most frequently used criteria are:

  • If it accepts business orders in the state
  • If it has a few employees in the state
  • If it has a physical presence in the state

Different states have varying requirements. It's best to get legal advice from an attorney to see if your LLC needs to foreign qualify in a certain state.

File annual reports

Most states require Limited Liability Companies to submit annual reports and pay a small fee. This is generally done through the secretary of state or other designated offices within the state government.

Failure to file an annual report will typically result in your company's dissolution. If you don't want that to happen, create a reminder in your calendar at least three months before the due date to make sure the report gets filed on time.

Final thoughts

Establishing an LLC can be a great way to start your own business, but it's important to understand the pros and cons a sole proprietorship to an LLC or type of entity before you make any decisions. By doing your research and following the steps above, you'll be on your way to setting up shop in no time.

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