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What to consider before you form an LLC

Posted by Tasnim Ahmed

March 21, 2022

Close-up of a man reading a business newspaper.

When launching your own business, one of the earliest decisions you’ll need to make is deciding on its legal structure. Among entrepreneurs and business owners in the U.S., the limited liability company is one of the most popular types of business entities.

By definition, an LLC is a legally registered business entity that offers owners personal liability protection from its debts and obligations. An LLC is a hybrid of a corporation and a partnership or sole proprietorship, combining characteristics of both.

That said, the LLC is not the perfect form for every business owner. It has many inherent benefits but also some disadvantages that entrepreneurs should be aware of when setting up a business.

Positives

Setting up an LLC is a relatively easy process compared to forming a corporation. Further, the LLC protects its owners and members from personal liability for the business’s debts.

Any number of people can be a part of an LLC, and it necessitates less paperwork than a corporation as there is no requirement for its meetings to be documented. LLC owners report business income and losses on their personal tax returns, avoiding double taxation to which some corporations are subject.

Drawbacks

In general, it is more costly to form and run an LLC than to be a sole proprietor or have a partnership. The filing fee to form an LLC varies by state, as do recurring annual fees.

While you will incur many expenses to get your business going, by federal law an LLC is only allowed to deduct up to $5,000 on startup and organization costs in its first year of operation. Startup costs over this deduction limit are amortized for 180 months. So, no matter what your investment is, you can only write it off very slowly.

For example, perhaps you plan to research a certain market sector for your venture. You form an LLC and name your firm, although it’s not yet operational or making a profit. But in the eyes of the IRS and secretary of the state, you own a functioning business that must pay taxes. Preparing an LLC’s tax returns is more costly than your individual tax returns. In hindsight you may feel you’re taking on additional expenses despite not having earned anything yet.

Further, an LLC may not be the best entity for business owners who want to avoid pressure from investors to create returns on their investments and a solid exit strategy. Businesses that pursue equity compensation or stock options, multiple financing rounds and profit reinvestment with the goal of a big-ticket buyout, for example, should stay away from an LLC.

While equity compensation is a powerful tool for attracting talent and financing for your fledgling company, with an LLC this is a very complex undertaking as opposed to a C corporation. They are expensive to draft and a pain to distribute.

The nature of an LLC also complicates the tax situation of potential investors. Some investors, such as hedge funds and the like, cannot put money into an LLC for legal or other reasons. In the end, most investors prefer the familiarity of a C corp and the simple stock ownership options they provide.

Seek professional guidance for your situation

It is important for prospective LLC owners to speak to a tax expert or CPA before making a formal decision on business structure. You may find out that forming an S corporation, for example, could provide better tax savings. Also, you need to be informed as to your particular state’s regulations as they pertain to LLCs. Ask the appropriate questions, gather the facts and analyze the nature of your business to determine which structure is best for you.

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What to consider before you form an LLC

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