To understand the advantages and disadvantages of a limited liability company, let’s take the example of three individuals: Sam, Paul, and Harry. They want to start a business together, but they are quite uncomfortable with forming a partnership since, in that case, they will be personally liable for the debts of the business. They know that a corporation enjoys limited liability, but they are unhappy with the clauses in a corporation too. A corporation would not let them manage it by themselves. Also, they will have to pay a double tax on their earnings. They found a solution in forming a Limited Liability company, which will combine the benefits of both the Partnership and the Corporation forms of business organization.
Limited Liability Company as a business organization is allowed and governed under state laws. The owners of a limited liability company are referred to as its members. Unlike a corporation, the members of this organization can manage the company themselves. They can be fully involved in the everyday operations of the company (without having to appoint a Board of Directors, who then appoint managers) while still enjoying limited liability. A single person/member can form a Limited Liability Company. At the same time, there is no limit on the maximum number of members a limited liability company can have. Let us understand the advantages and disadvantages of a limited liability company in more depth.
Advantages of a Limited Liability Company
A limited liability company borrows this advantage from corporations. The company exists as a separate legal entity that protects its members from being personally liable for business obligations.
A simple example would be if the company was started by Paul, Sam, and Harry. It takes a huge amount of loan to invest in some risky projects. And the project unfortunately fails, resulting in massive losses. Now, the company does not have enough money or capital to pay back the bank loan. So, if the bank goes to court, the court can mandate Paul, Sam, and Harry to sell off the assets of the business and pay back the loan. The court, however, cannot pursue their personal assets. Hence, courts cannot ask the owners to personally pay for the damage and debts of the business. Their personal assets are safe (which is not the case in partnership and sole proprietorship forms of businesses).
By default, LLCs are pass-through entities for tax purposes. This means that the profits and losses of the LLC are passed through to the individual members’ personal tax returns, avoiding double taxation at both the corporate and individual levels. However, members have the option to elect corporate taxation if it is more advantageous for their situation.
So, if the company started by Sam, Paul, and Harry makes a profit of $60,000, it won’t have to pay any corporate tax on this income. Instead, assuming that the three members share this profit equally, Sam, Paul, and Harry will each pay tax on $20,000 (according to the tax rate) as personal income tax.
Flexibility of Income Distribution
LLCs have flexibility in how they distribute profits among members. Unlike corporations, which are required to distribute profits based on the number of shares owned, LLCs can distribute profits according to the terms outlined in their operating agreement. This allows for a customized approach to profit sharing.
Suppose that the capital contribution of the three members, Paul, Sam, and Harry, is $20,000 each. However, Harry puts more effort and time into the business than the other two. Naturally, Harry will want a greater share of the profits since he contributes more time and effort to the business. Under limited liability companies, they are free to divide their business profits according to the ratio they think is appropriate. This ratio, however, should comply with the Internal Revenue Service’s rules on partnership income distribution.
Another good advantage of limited liability companies is that they are relatively easier to set up and run than corporations. Whereas incorporation of a corporation is a hectic and costly process, all that law requires to form a limited liability company is the filing of an Articles of Association and the drafting of an Operating Agreement (operating agreement defines the company’s policies and procedures such as accounting methods to be used, rights and responsibilities of the members, etc. ). Also, whereas a corporation requires regular shareholders’ meetings, etc., a limited liability company does not require such formalities.
Lastly, the owners of a limited liability company have the advantage of controlling the business directly. Unlike in corporations, where the company must have officers (CEO, CFO, etc.) and a Board of Directors, all members of a limited liability company are free to manage the company directly and take the business in whatever direction they want to go.
Disadvantages of a Limited Liability Company
Difficult to Raise Capital
A limited liability company generally has the same two sources of raising funds as a corporation: equity and debt. Raising funds through the equity route means selling ownership stakes of the business. This will also mean adding one more member (or more) to the list of members. Hence, you will have one more member (or more) to share your profits. Existing members may have to share decision-making power with the new member.
Avoiding this route will require the members to go and search for an investor, which is also difficult. Limited liability companies are not very popular. So, convincing potential investors that investing in your business will be a good decision can be a challenge.
The alternative to this is debt financing (through bank loans). But, bank loans also have a limit on the amount of debt you can take. Suppose that you want to open 50 more stores of your brand or any other project which requires massive investment. In these cases, debt financing can not provide you with such an amount of money, especially if your business is new and doesn’t have a good track record. Debt financing also commits your business to pay regular interest rates out of the profits, along with the principal amount. Hence, raising capital for a limited liability company is a very uneasy task.
Confusion Across States
Since limited liability companies are registered with states and not Federal agencies, different states may have different regulations governing such companies. So, if you decide to do business in multiple states, it may become a little complex to understand and abide by the different requirements of different states. Hence, an interstate business may not go well with this form of business organization.
No Perpetual Existence
Most of the states in the US require the founders to set a limit for the company’s existence. Even in the absence of such a clause, a limited liability company will cease to exist in the event of death or withdrawal of a member from the company. There is a way out of this by transferring the ownership stake of the outgoing partner, but it comes with heavy restrictions, especially for this kind of business organization.
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