Pros and Cons of the LLC Model
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Q: I'm starting a business with two other individuals. We are in the process of selecting a business structure. We've heard there are some advantages to the LLC structure. Is this something we should consider?
A: A limited liability company, or LLC, is a relatively new form of business organization that is certainly worth consideration. It has several features that create favorable tax treatments, as well as protection from personal liability. Since the status of the LLC form of organization varies somewhat from state to state, be certain to find out how your state's law applies.
The LLC allows for multiple owners, or members, who enjoy limited liability, as well as a managing member, who also enjoys limited liability and typically is the person responsible for managing the business. The profits or losses of the business pass directly through to the owner's personal income tax return, Form 1040. The LLC files a Form 1065, and then lists each member's taxable profit on Form K-1. The bottom-line profit of the business is not considered to be earned income to the members, and therefore is not subject to self-employment tax.
The following are advantages of the LLC form of business organization:
- An LLC allows for an unlimited number of members; however, if the LLC has just one owner, it will be taxed as a sole proprietorship.
- The LLC allows for the "special allocation" of profits--the disproportionate splitting of member profits and losses (in different percentages than their respective percentages of ownership). This means that members can enjoy the benefits of receiving profits (and writing off losses) in excess of their individual ownership percentage.
- The members enjoy limited liability, which means they are personally protected from any liability of the LLC and successful judgments, as well as from the LLC itself.
- Managing members' share of bottom-line profit is considered earned income because the managing member is considered to be an active owner--therefore qualifying the managing member for special "fringe benefit" treatment.
- The members' share of the bottom-line profit of an LLC is not considered earned income, and therefore is not subject to self-employment tax.
- Members are compensated using either distributions of profit or guaranteed payments. A distribution of profit allows each member to pay themselves by merely writing checks--whenever they need the money (provided the business has the available cash). Guaranteed payments represent earned income to the members, thereby qualifying them to enjoy the benefits of tax-favored fringe benefits.
- The managing member of an LLC can deduct 100 percent of the health insurance premiums he or she pays--up to the extent of their pro-rata share of the LLC's net profit, because the profit is considered earned income. Note: If a member has earned income, he or she will also qualify.
- A corporation can be a member of an LLC. This allows you to create an additional level of ownership, which is designed to create an entity that can offer such traditional fringe benefits as retirement plans and an additional level of protection from liability.
- As a member, you can contribute capital or other assets to the LLC, or loan the LLC money to put dollars or value into the business. You can take dollars out by taking a repayment of your loan (plus interest), a distribution of profit or a guaranteed payment. If any of the members die, the LLC can continue to exist--subject to the unanimous positive vote on the part of all remaining members.
Some of the disadvantages of an LLC are:
- Each member's pro-rata share of profits represents taxable income--whether or not a member's share of profits is distributed to him or her.
- The managing member's share of the bottom-line profit of the LLC is considered earned income, and therefore is subject to self-employment tax.
- The members' share of bottom-line profit is not considered earned income because the members are considered to be inactive owners; therefore, the members do not qualify for special tax-favored "fringe benefit" treatment.
- As a member of an LLC, you are not allowed to pay yourself wages.
Note: The information in this column is provided by the author, not Entrepreneur.com. All answers are general in nature, not legal advice and not warranted or guaranteed. Readers are cautioned not to rely on this information. Because laws change over time and in different jurisdictions, it is imperative that you consult an attorney in your area regarding legal matters and an accountant regarding tax matters.
David Meier is the founder and COO of Business Development Coaching, a company that provides small-business owners with ongoing business coaching.