What are the Disadvantages of an LLC?
By Isidora Alimpic
June 17, 2023
Combining the benefits of partnerships, corporations, and even sole proprietorships, LLCs have become a prevalent choice among entrepreneurs. However, focusing only on the upsides of any business type is a sure-fire way to get yourself in trouble. That’s why our guide will tell you all about the disadvantages of an LLC, along with many other pieces of information that will help you make a decision that’s best for you.
Background
It may come as a surprise to some, but LLCs haven’t been around for that long. In fact, it wasn’t until 1977 that Wyoming enacted a law authorizing the creation of limited liability companies.
At first, LLCs weren’t as favored as they are today. As the IRS went back and forth on how to tax them, other states were hesitant to adopt this new kind of business entity. After 11 years, the IRS finally ruled that LLCs would be taxed as partnerships, and by 1996 all 50 states had LLC statutes.
What is an LLC?
To understand the advantages and disadvantages of an LLC, you must first know what exactly an LLC is. A limited liability company, or LLC, is a US business structure whereby the owners aren’t legally accountable for the company’s debts or liabilities. As mentioned, it’s a hybrid legal entity that integrates characteristics of a corporation and a partnership (or sole proprietorship).
An LLC shares the limited liability traits with corporations and the pass-through taxation with partnerships. However, in certain situations, an LLC may choose to use corporate tax rules and act as a nonprofit.
Disadvantages of an LLC
Although forming an LLC brings many perks, the disadvantages are not to be overlooked, as they aren’t as minor as some might think.
LLC Costs
Depending on the state, fees for starting an LLC can range from $50 to $500. That means that, in some cases, a corporation is the cheaper option. Also, compared to a partnership or sole proprietorship, operating an LLC is slightly more expensive because you have to take care of both filing and annual state fees.
LLC Taxation
We should mention two quite significant LLC disadvantages pertaining to taxation that are often passed over. First, if you’re an LLC member, you have to pay income taxes on your share of the company’s profits even if you are not included in their distribution. On top of that, most LLC owners must pay self-employment taxes, which currently amount to 15.3% – 12.4% for Social Security and 2.9% for Medicare.
LLC Banking
Checks made out to an LLC have to be deposited into a business account, meaning it can be difficult or even impossible to cash them. This may not seem like a significant issue to some, but it’s an LLC disadvantage nevertheless.
LLC Member Turnover
You must make sure to include a withdrawal provision in your LLC’s operating agreement. If you neglect to do so, your company might end up being dissolved in the event that a member leaves, goes bankrupt, or dies.
LLC Paperwork
As an LLC owner, you’ll have to deal with quite a bit of additional paperwork since your personal finances must be kept separate from the company’s activities. The business will require a separate accounting ledger and bank accounts.
LLC Funding
One of the main disadvantages of an LLC is funding. Although you may find this business entity’s flexibility to be a huge plus, your potential investors will probably not share your opinion. They will often see LLCs as far too complicated and not worth the likely additional taxes. This a hurdle that many new business owners face and have difficulties overcoming without at least some professional legal assistance.
Disadvantages of an LLC
Although forming an LLC brings many perks, the disadvantages are not to be overlooked, as they aren’t as minor as some might think.
Costs
Depending on the state, fees for starting an LLC can range from $50 to $500. That means that, in some cases, a corporation is the cheaper option. Also, compared to a partnership or sole proprietorship, operating an LLC is slightly more expensive because you have to take care of both filing and annual state fees.
Taxation
We should mention two quite significant LLC disadvantages pertaining to taxation that are often passed over. First, if you’re an LLC member, you have to pay income taxes on your share of the company’s profits even if you are not included in their distribution. On top of that, most LLC owners must pay self-employment taxes, which currently amount to 15.3% – 12.4% for Social Security and 2.9% for Medicare.
Banking
Checks made out to an LLC have to be deposited into a business account, meaning it can be difficult or even impossible to cash them. This may not seem like a significant issue to some, but it’s an LLC disadvantage nevertheless.
Member Turnover
You must make sure to include a withdrawal provision in your LLC’s operating agreement. If you neglect to do so, your company might end up being dissolved in the event that a member leaves, goes bankrupt, or dies.
Paperwork
As an LLC owner, you’ll have to deal with quite a bit of additional paperwork since your personal finances must be kept separate from the company’s activities. The business will require a separate accounting ledger and bank accounts.
Funding
One of the main disadvantages of an LLC is funding. Although you may find this business entity’s flexibility to be a huge plus, your potential investors will probably not share your opinion. They will often see LLCs as far too complicated and not worth the likely additional taxes. This a hurdle that many new business owners face and have difficulties overcoming without at least some professional legal assistance.
Should You Create an LLC?
It isn’t our intention to deter you from forming an LLC. Despite our list of LLC pitfalls, they can be a perfect fit for some entrepreneurs. To give you a better idea of what might be your best course of action, we’ll quickly compare your other options with LLCs.
Sole Proprietorship vs. LLC
A sole proprietorship is the simplest business structure of all. It costs nothing to form one, and you’re entitled to all the profits. However, you’re responsible for all the losses as well, and that’s not the only issue. The biggest drawback of being a sole proprietor is that you have no liability protection whatsoever. Unsatisfied customers can sue you directly, and if they win, they’ll have access to your personal assets.
The most substantial LLC benefit is that, as an LLC member, you would be sheltered from such lawsuits. Any potential plaintiff would only be able to go after the LLC and its assets. On the other hand, creating an LLC does entail a bit more filling, so you might want to consider hiring an LLC formation service.
Corporations vs. LLC
Large investors prefer corporations because they are predictable, often have a long lifespan, and, most significantly, because it’s very simple to transfer shares. Almost the exact opposite can be said for LLCs – they are unpredictable, often short-breathed, and there is no such thing as LLC shares. Interestingly, these aspects are by many considered to be the main LLC advantages.
LLCs allow you to choose who your business partners are. Also, they don’t have a rigid management structure, which gives you the freedom to organize your company however you like. Lastly, many people find LLCs to be the ideal choice for side businesses or short-term ventures.