Disadvantages of a Limited Liability Company (LLC)

A Limited Liability Company (LLC) shares the features of a partnership, as well as those of a corporation. Just like an S-Corp or a C-Corp, shareholders are not personally liable for the debts and the actions of the entity; however, unlike a C-Corp no tax is levied at the entity level. Income is directly passed to the members, pretty much like an S-Corp.

The main difference between an S-Corp and a Limited Liability Company is that the latter can choose to be taxed as a partnership while the former may have the benefit of being taxed as a partnership provided the entity complies with certain restrictions.

A Limited Liability Company has a business structure that combines the limited personal liability feature of the corporation with the single taxation feature of a partnership and a sole proprietorship, thus allowing income to flow directly to the members. It would behoove the readers to note that the owners are called members, and their interest in the company is expressed in percentage.

These members may be individuals, corporations, other LLCs and foreign entities. For instance, in case of a Company with 4 members, each member will have an interest of 25 percent. All members are expected to file tax returns separately, and the LLC files tax returns with the Internal Revenue Service only for the purpose of providing information.

To start a sole proprietorship, one does not have to file any formation document or pay filing fees. The formation cost of a Limited Liability Company is around USD 700, which is the same as the cost required to form an S-Corp. Hence, for an individual, sole proprietorship may be preferable to an S-Corp.

A C-Corp and an S-Corp can raise capital by issuing shares. However, the members of the LLC can only sell interest in the company subject to the operating agreement that defines the financial and the management structure.

Although most states do not require the LLC to have an operating agreement, it's not prudent to run a company without having a proper operating agreement in place. This is because the agreement not only helps the members overrun unfavorable state default laws, but also ensures that the LLC is easily distinguishable from a sole proprietorship.

The Federal Government does not recognize LLCs for the purpose of taxation. The LLC is either classified as a corporation, a partnership, or a sole proprietorship for the purpose of taxation. IRS Form 8832 is used to classify the LLC.

If the LLC is classified as a sole proprietorship with one member, IRS Form 1040―Schedule C has to be used for tax purposes. In case of a partnership, IRS Form 1065 is used, while both C-Corp and S-Corp use IRS Form 1120. Shareholders in an S-Corp, and members in case of a partnership, use Form K-1 for personal tax returns.

Despite the aforementioned disadvantages, there are significant benefits to incorporating a company as an LLC. The biggest advantage is that there is no question of double taxation since there is no tax at the entity level. Income is passed directly to members just like in case of a sole proprietorship or a partnership.

However, unlike sole proprietorship and partnership, members of a Limited Liability Company have limited liability. The limited liability feature of the S-Corp thus becomes available despite the entity having to comply with very few legal and administrative requirements. Finally, a Limited Liability Company can be formed with just one member, whereas an S-Corp can be owned by 100 or fewer shareholders.