Limited Liability Company: Advantages & Disadvantages
What is a Limited Liability Company (LLC)?
An LLC is a hybrid business structure that takes the best characteristics of a corporation and partnership and combines them together. In particular, an LLC allows your business to have the limited liability protection of being a corporation with the ability to be taxed as a partnership. It is generally more beneficial for your business to be taxed as a partnership because partnerships are not subject to the double taxation that corporations are subject to.
One of the best aspects of forming your business as an LLC is your ability to decide whether you want your business to be taxed as a partnership or as a corporation. If you choose to be taxed as a partnership, your business will be taxed on an individual level where each member/manager pays taxes on their own personal income tax forms for any profits they received from the LLC, but the LLC as an entity will not have to pay taxes. If you choose for the LLC to be taxed as a corporation, then the business itself will owe taxes in addition to each member/manager owing taxes on their personal income for any profit they made. Keep in mind, though, that for California tax purposes, if you are the only one forming the LLC, then you will be treated as a sole proprietorship and if there are two or more persons forming the LLC, then the LLC will be treated as a partnership. This is just for tax purposes in California though.
The Two Types of LLCs
You can form an LLC with one or more persons. There are two types of LLCs you can choose from - (1) Manager-Managed and (2) Member-Managed. A manager-managed LLC is where the day-to-day business operations will be managed by "managers." Managers are essentially like general partners in a partnership where the manager manages the daily business operations. "Members" of the LLC are not allowed to have much of a say in how the business operates, but are still entitled to any profits and are liable for any business losses. A member is a co-business owner, like a partner in a partnership.
A member-managed LLC is where "members" are allowed to manage the day-to-day operations of the business and still be entitled to receive all profits. Like a corporation, all members or managers of an LLC enjoy limited liability, meaning that they are not personally liable for the debts of the LLC. Instead, they will generally only be liable by the amount they invested in the business. For example, if you as a member/manager invested $5,000 in the LLC to get it started and later another member/manager took out a $20,000 bank loan and now the business cannot pay it off, you would be liable up to the $5,000 you invested and not for the remaining $15,000. This also means that your personal assets (e.g. your car, house, etc.) will be protected as they will not be liable for paying off any business debts. The bank can only come after you for the $5,000 you invested.
The Need for a Written Operating Agreement
Every LLC (including single member LLCs), should have an operating agreement, which is an agreement among all the members of the LLC on how the business will be operated and what rights each member has. For example, the operating agreement will clearly state the ownership percentage each member has in the LLC and how much profit each member is entitled to. An operating agreement is a private contract among all the members that is binding on both current and future members of your LLC. The agreement is a private contract among the members and it does not need to be filed with the Secretary of State unlike your LLC's Articles of Organization.
The operating agreement does not need to be in writing, but agreeing to conduct business with your fellow members orally without writing anything down can later cause problems when disagreements arise, such as how much profit each member is entitled to or what responsibilities each member has. To avoid disagreements that can destroy the business and also any friendly relationship you may have with the other members, I highly recommend creating a written operating agreement. If you can afford to, hire an attorney to draft the operating agreement to ensure that each member is treated fairly and the agreement is tailored to the LLC's business needs.
Also, keep in mind that any issue that is not covered in the operating agreement will be governed by the California Revised Uniform Limited Liability Company Act found here.
Do I Need an Operating Agreement If I am a Single Member LLC?
Yes! There are two main reasons to have an operating agreement even though you are the only member of your LLC.
Customization. If you do not have an operating agreement, the California default LLC laws will apply (California Revised Uniform Limited Liability Company Act) and they will dictate how your LLC will be managed and operated. Having an operating agreement allows you to customize how you would like your LLC managed, such as deciding when you would like profits to be distributed.
Uphold the Limited Liability Protection. Under the law, an LLC is a separate entity from yourself and you must treat it as such or else seriously risk losing the LLC’s limited liability protection, which will result in you being personally liable for the debts of the business. One of the many ways to show that you are treating the LLC as separate from yourself is to have a formal written operating agreement. This does not mean that if you do not have an operating agreement, you will automatically lose the LLC’s limited liability protection as courts will look at your entire situation to determine whether you treat the LLC as an “alter-ego” of yourself. Contact me to learn more on how to avoid the legal pitfalls of operating your LLC to not lose its limited liability protection.
Advantages of an LLC
Limited liability for all members/managers – All members/managers are not personally liable to the actions of every other member/manager or to any debts the LLC takes on
No double taxation (flow through taxation) – The LLC can choose to be taxed as a partnership, meaning the LLC itself is not taxed and instead, each member/manager is taxed individually with the profits/losses being reported on each member/manager’s own income tax forms
Increased financial resources – Can pool funds with other members/managers, which can double or triple the amount of funds your business has to operate from
Disadvantages of an LLC
Not available to providers of “professional services” – If your business provides a professional service (law, accountancy, medical, engineers, etc.), then you business is not allowed to form an LLC
Franchise Tax Board tax – An LLC will have to pay the California Franchise Tax Board a tax just for the privilege of doing business in California
Keep in mind that this tax is imposed on the LLC as a business entity and each member/manager will still have to pay additional taxes on their own personal income tax forms
Costs of Starting a LLC in California
Business License/Permits – check out http://www.calgold.ca.gov/ to know exactly what licenses and permits you need to obtain to conduct business in your particular city and county
Filing Articles of Organization
Creating an Operating Agreement
Filing Statement of Information
Franchise Tax of at least $800/year
Obtaining an Employer Identification Number (EIN)
Intellectual property protection, such as registering the business name as a trademark or registering any copyrights or patents your business may have
*The above article is for general informational purposes only and should not be taken as legal advice. Please contact a business lawyer to find out how any information here applies to your particular circumstances.