Deciding whether to scramble aboard the LLC bandwagon is one of the most important decisions you'll make in forming your start-up, so it shouldn't be taken lightly-no matter what the headlines say. An LLC structure gives you the flexibility and tax benefits of a partnership plus the personal liability protection of a corporation. In 1977, Wyoming became the first state to adopt the LLC format, rooted in European and Latin Americans laws, and the 49 other states have since signed on. But should you?
Not without thinking about what your personal and business needs are. As Marc-David Seidel, assistant professor of management at the McCombs School of Business at the University of Texas, Austin, puts it: "Ask yourself if you really need the additional liability protection offered by the LLC structure. If not, it's less expensive and much easier on the paperwork to simply operate as a sole proprietorship."
And Seidel isn't lecturing from an ivory tower, either. He started two LLCs, both operating through a system of contracts with third-party providers. Let's look at the advantages an LLC offers.
Limited liability. Your only risk is capital paid into the business. Business debts and other liabilities can't be squeezed out of your personal assets. Caution: If you personally guarantee a debt, you've forfeited your "limited liability."
Tax simplicity. Profits and losses are reported and taxed on owners' individual returns. There's no separate business tax return, unless you have more than one member and choose to be taxed as a partnership (Form 1065). And there's no corporate "double taxation," in which both the business and the shareholders are taxed.
Flexible management. A "member" (shareholder equivalent) can be a person, partnership or corporation. Members get a percentage of ownership. If your idea people can't manage their way out of a paper bag, you can hire management help. Smaller LLCs are usually member-managed, but not always.
Flexible distribution. Profits and losses don't have to be distributed in proportion to the money each person puts in. A regular C corporation can't allocate profits and losses. And in a subchapter S corporation (taxed as a partnership), profits and losses are in proportion to shares held.
And now for the downsides:
No stock. LLCs are tough if you have several investors or raise public money, since you don't have shares or stock certificates to offer. If you give a percentage of ownership to outside investors, you must decide whether they're managing members. Seidel cautions entrepreneurs: "Ask yourself if you need more flexibility in terms of corporate stock ownership, financing options, etc. If so, the LLC is probably not a good idea--try a C corporation."
Two's a crowd. LLCs in most states require only one member: you. But if you live in Massachusetts or the District of Columbia, you must have two members, and that could be a deal-buster.
Fewer incentives. LLCs aren't ideal if you want to give fringe benefits to yourself or employees. Unlike with a C corporation, you can't deduct the cost of benefits with an LLC. And since there's no stock, you can't use stock options as incentives for your employees.
Paperwork. LLCs file articles of organization with the State Corporation Commission or Secretary of State and draft an operating agreement listing members' rights and responsibilities. Some, like an application for employer ID number (IRS Form SS-4) and choice of tax status (IRS Form 8832), are one-shot; others (annual report, quarterly withholding and tax deposit coupons, and business bank account) are ongoing. While it's not an impossible burden, there's more paperwork than if you're a sole proprietor.
Taxes. LLC members pay self-employment taxes, the Medicare/Social Security tax paid by entrepreneurs; it's calculated on 15.3 percent of profits. Contrast this with an S corporation: Self-employment tax is due on salary only, not your entire profits. You're caught in the self-employment tax net if: 1) you participate in the business for more than 500 hours during the LLC tax year; 2) you work in a professional services LLC (health, law, engineering); or 3) if you can sign contracts on behalf of the LLC.
Ultimately, the LLC decision is one you won't want to make alone. "Get advice from a specialist about the ideal corporate form to take," advises Seidel. "It can make a huge difference later on." In business, as in life, one size rarely fits all.
Joan E. Lisante is an attorney and freelance writer who frequently writes about business issues.