Choice of Entity: A Primer for the New Business Owner Part 2: Doing Business as a Limited Liability Company

Welcome to post number 2 in my primer for the new business owner series. In my last post we discussed doing business as a sole proprietor.  In today’s installment we turn to the limited liability company or LLC.  By a wide margin, LLC’s are the preferred choice of entity for most small business owners.  The benefits of operating as an LLC are numerous and include the following:

1. Limited Liability.  LLC’s provide their owners with the same personal asset protection available to corporate shareholders.
2. No entity level tax.  LLC’s are not taxed as separate entities.  Instead, the income or loss of the LLC’s business is passed through to the owners of the LLC who report it on their tax returns.
3. Flexibility.  Like partnerships, LLCs are contractual in nature.  This provides LLC owners with much greater flexibility when it comes to choosing how to manage the business and share in its profits and losses.
4. Simplicity.  LLCs are not bound by many of the technical requirements associated with operating as a corporation (think organizational minutes, stock certificates, by laws, documenting annual meetings and the like).  Forming an LLC is very simple and requires only the filing of a one page organizational document.

There are of course some potential disadvantages to doing business as an LLC.

1. Employment Taxes.  Employment taxes paid by the active members of an LLC can be higher than those paid by owners of an S corporation.  For this reason, many LLCs make an election to be taxed as an S corporation.
2. Phantom Income.  Owners of an LLC will be taxed on the profits of the LLC even if those profits are not distributed.  This is generally not a problem for the majority owners since they will likely control the timing of distributions of available cash.  Minority owners however should be aware of the possibility that they may be taxed on their share income even if they don’t receive a corresponding distribution of cash.
3. Flexibility.  While the flexibility to structure the management and economics of the business in pretty much any way the owners see fit is a significant benefit of the LLC form of doing business, that flexibility can also get LLC owners into trouble.  Particularly when it comes to their economic deal, complex partnership tax laws could be implicated depending on the specifics of the business deal.

Generally speaking, for the small business owner the advantages of operating as a limited liability company will outweigh the disadvantages, especially for the single owner business.  However, each case is unique and determining whether there are benefits to be gained from operating as an LLC requires a careful review of all of the specific and unique circumstances applicable to the  particular business and its owners.