When an LLC Is Not the Best Fit

Business owners who are interested in forming a new limited liability company (LLC) or converting their existing business to an LLC are probably familiar with the benefits of this entity type. While the LLC is a great fit for many companies, there are situations in which its disadvantages may outweigh its advantages.

Depending on the business and its goals, incorporation may be a better fit. There are also situations in which neither an LLC or incorporation would be necessary or worthwhile. Understanding the nuances of the LLC structure and how it can affect your business will help you determine the right legal entity type for your company.

The Plus Side of LLCs

An LLC is a legal entity that is separate from its owners or members. LLC members are generally not personally liable for the business’s debts. At the same time, LLC earnings are taxed at the individual level on LLC members’ tax returns. This avoids the double taxation of corporations (corporations pay the taxes on annual profits, and the shareholders pay tax on the dividends they receive). That is, unless the LLC elects to be taxed as a corporation.

Limited liability and pass-through taxation are not the only benefits of an LLC. LLCs also provide considerable flexibility:

• Setup. LLCs are relatively simple to set up. Typically, formation requires only that the individuals who are forming the entity choose a company name, file formation documents with the state, and select a registered agent.
• Membership. LLCs can have either a single member or an unlimited number of members.
• Profit sharing. Profits can be shared equally among the members, but they do not have to be.
• Management structure. LLCs can be run by members (member-managed) or managers (manager-managed). LLC managers can be members or nonmembers.
• Taxation. LLCs can be taxed as a sole proprietorship, a partnership, an S corporation, or a C corporation.

The operating agreement is at the heart of an LLC’s flexibility. The terms included in an operating agreement can often override the default rules set forth in each state’s LLC law. Voting rights and duties, member and manager responsibilities, profit and loss distributions, meeting schedules, and buyout and sellout rules are among the terms that can be stipulated in the operating agreement.

What Types of Businesses Benefit Most from an LLC Structure?

The flexibility of an LLC makes it appropriate for a wide range of businesses. Not only are many small businesses formed as LLCs—many large, international companies also operate as LLCs, including Pepsi-Cola, Nike, and eBay. In addition, some solo business practitioners form their businesses as single-member LLCs.

In short, an LLC can be a good fit for many types of business. However, that does not necessarily mean it is the best entity choice for every business. Businesses that benefit the most from an LLC structure include those with the following characteristics:

• Co-owners or employees. Although single-member businesses can form an LLC, the liability shield an LLC provides is often more important when an owner may be potentially liable for the actions of co-owners or employees.
• Significant risks. Owners of businesses that have high financial or litigation risks might benefit more from an LLC’s liability shield than businesses that do not face such risks. A way to gauge risk is to consider the number of contracts, creditors, and customers the business has. These outside parties could bring lawsuits or have financial problems that jeopardize an LLC, making its liability shield more important for its owners.
• Professionally licensed members. The professional limited liability company (PLLC), a specialized type of LLC, is popular with licensed professionals, such as doctors and lawyers, who face a greater risk of being sued than many other types of businesses.

A small business owner who is primarily interested in the liability shield offered by an LLC might also consider forming a C corporation, limited partnership, or limited liability partnership. A business owner who does not face significant risks from internal or external parties but still wants to limit personal liability can look into business insurance, including general liability insurance, commercial property insurance, professional liability insurance, and business income insurance.

Startups and Other Businesses That Should Not Form an LLC

LLCs are less attractive to startups seeking investors. Outside investors often prefer to put their money into startups formed as corporations. If a company formed as an LLC wants to raise capital, it may be at a disadvantage with investors for the following reasons:

• LLCs cannot issue stock. Many investors simply want to own stock in an early-stage business and cash out later. But LLCs cannot issue stock. Investors in an LLC must become an LLC member, which introduces complications they may wish to avoid.
• Taxation. Investors may also want to avoid becoming an LLC member because of the tax implications. If the LLC is taxed as a partnership, investors could be liable for taxes on LLC income even in years when they receive no distributions. In addition, investors could be taxed in every state where the LLC does business.
• Inability to invest. Certain investor classes, such as venture capitalist funds, may not want to invest in LLCs and other pass-through entities because their partners have tax-exempt status.
• Ownership interest transfer. It can be far easier to transfer shares of a corporation than to transfer LLC ownership interests. State LLC laws and operating agreements can significantly impair the transferability of membership interests.
• Valuation. The value of an LLC membership interest may be more difficult to determine than the value of corporate stock.

Investors generally prefer to put their money in C corporations. Companies that want to eventually sell their shares to the public through an initial public offering (IPO) and are seeking investors may be better served by forming a C corporation.

The following additional factors can weigh against forming an LLC:

• Administrative requirements. LLCs do not involve a lot of startup costs and paperwork, but they have more formation requirements under state law than sole proprietorships and partnerships. For example, an LLC must appoint a registered agent to accept official business documents. LLCs are also subject to state filing fees and reporting requirements.
• Maintaining the liability shield. In certain situations, creditors can break through the LLC’s liability shield to hold individual members personally responsible for the company’s debts. To uphold the liability shield, LLC owners must be careful to keep the business’s assets separate from their personal assets and adhere to all of the governance formalities required by state law.
• Tax complications. LLC owners that take advantage of pass-through taxation could be subject to Social Security and Medicare taxes, also known as self-employment taxes. Sole proprietors and partners pay the same self-employment taxes. Paying self-employment taxes may ultimately be cheaper than the double taxation on corporations.
• Difficulty transferring member interest. Often, approval from other members is necessary before a member can transfer their ownership interest in an LLC, although the exact terms are dictated in the operating agreement. Without a pre-negotiated exit strategy that involves documents such as a buy-sell agreement, an LLC member who wants to leave the business could face difficulties transferring their interest. Corporate shares, on the other hand, are typically easily transferable.

Before Choosing an Entity Structure, Talk to Our Small Business Lawyers

Although the advantages of LLCs often outweigh the disadvantages, an LLC structure is not appropriate for all businesses. Once we learn more about your business and where it is headed, we can explain the pros and cons of LLCs and other business entities in greater detail to help you decide which entity type is the best fit for your business. To set up a meeting, please call or contact us.