Limited Liability Companies (LLCs) have gained popularity as a preferred business structure due to their flexibility and liability protection. However, it’s essential to consider all aspects before making a decision. In this article, we explore the reasons why forming an LLC might not be the best choice for everyone. Understanding the potential downsides can help entrepreneurs make informed decisions about the most suitable business entity for their specific circumstances.
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One reason to reconsider forming an LLC is if you prefer a simplified tax structure. While LLCs offer flexibility in taxation, they can also introduce complexity. By default, an LLC is treated as a pass-through entity, meaning the profits and losses flow through to the members’ personal tax returns. For some individuals, this added complexity may not be desirable, especially if they prefer a simpler tax structure.
Taxes If you operate as a single-member LLC, you may face self-employment taxes on your business income. Unlike corporations, LLCs are subject to self-employment taxes on all their profits. Depending on your specific financial situation, this additional tax burden could be a drawback that makes you reconsider forming an LLC.
If you plan to raise capital from venture capitalists or angel investors, forming an LLC may not be the most attractive option. Investors often prefer the traditional corporate structure, such as a C Corporation, due to the ease of issuing shares and the potential for future stock offerings. If your primary goal is to attract significant investment, exploring alternative business structures might be more advantageous.
While LLCs are generally less formal than corporations, they still have certain requirements that may not align with your preferences. Depending on the state where you form your LLC, you might need to maintain detailed records, hold regular meetings, or file annual reports. If you prefer a more informal business structure without these administrative obligations, reconsidering an LLC is worth considering.
Unlike corporations that can exist in perpetuity, some states impose a limited lifespan on LLCs. This means that the LLC will dissolve after a specified period, often upon the departure or death of a member. If you envision your business having a long-term legacy or potential for generational transfer, an LLC’s limited lifespan might be a drawback that encourages you to explore other business entity options.
Certain professions, such as doctors, lawyers, and accountants, may have restrictions on forming an LLC. Regulatory bodies in these fields might limit the types of business entities professionals can use, requiring them to establish a different structure or operate as a sole proprietorship or partnership. If you belong to a profession with specific restrictions, forming an LLC might not be a viable choice.
While Limited Liability Companies offer significant advantages for many entrepreneurs, it’s crucial to evaluate both the benefits and drawbacks before deciding to form an LLC. Factors such as taxation, self-employment taxes, capital raising, formality requirements, limited lifespan, and professional restrictions should all be carefully considered. By understanding the potential downsides, you can make an informed decision about the most suitable business structure that aligns with your specific goals, preferences, and industry requirements.
Why Should You Not Form an LLC?
Well, everybody loves LLCs. They are great. They are one of the most popular business types, but there is one very important reason why you should consider not forming an LLC, and then there are some less important reasons that might matter to you.
The most important reason is because it is an S corporation who gets a tax benefit. The default rules for an LLC are you do not get the payroll tax benefit that an S Corp gets.
Let me explain how that works. Let’s say in an LLC that you are the sole owner, and the LLC generates $200,000 in income but had $100,000 in expenses. So that means you only have $100,000 in profit. But still, that is good money.
In an LLC, the default rule with the IRS is that you are not taxed at the LLC level; you are taxed at the personal level. It is called a pass-through entity. So you are going to pay two types of tax on that $100,000. Income tax, like everybody pays when they have income and payroll tax.
What Is Payroll Tax?
It is roughly 15%, and it is the payroll withholdings that apply whenever you are working for somebody. Typically, the employee has payroll withholdings and pays the payroll tax of about 7.5%. And then, the employer pays 7.5%. That adds up to roughly 15%. But think about it in this scenario; you are both the employer and the employee. So you have to pay the whole 15%. So now you are paying on that a hundred thousand dollars 15% payroll tax, plus whatever the federal income tax bracket is that you are in, plus the state income tax bracket that you are in. So that is a pretty high amount of money. That is an LLC.
But for an S corporation, there is a significant discount in many circumstances. So using the same scenario of an S corporation this time. Earning a hundred thousand dollars. Let’s say the job that you are doing for the S corporation is only worth $50,000. In other words, if the S corp were to hire an employee to do the job that you are doing, the S corp would pay a salary of $50,000 to that employee.
Well, that is how we will, for this scenario, we will treat you that way. The S corp is going to pay you wages of $50,000. That leaves the other half of the profits, $50,000, available to be paid out as a profit distribution. Wages are subject to the 15% tax. Profit distributions in an S Corp are not. So, you are saving 15% of $50,000 in this scenario. And that is every single year.
So as you can see in this scenario, 15% of $15,000, that is thousands of dollars, that is a lot of money in your pocket every year. I am not talking about an additional deduction or a credit, or an exemption. That is actually cash in your pocket. You are avoiding having to pay that payroll tax for the $50,000 that exceeds your wages.
So an S corporation has an incredible benefit. Now, if the company is only making $20,000, that benefit is not going to kick in because you have to pay your wage in an S corp or an LLC. And if you are only making $20,000, it is not going to cover your whole wage.
So if you are thinking about this, you might say, well, “Hey, why don’t I just pay myself a dollar in a wage? That way, I will pay 15% tax on a dollar, and the $999,000 or $99,000, $999, that all comes in free of the payroll tax.” Well, the IRS thought of that. And the rule is you have to pay yourself a fair market wage. So what you want to do is take a look on Indeed or Craigslist and see what is a fair wage. And then I would even recommend saving the evidence of the wage or the job postings for the kind of job that you are doing. I would also recommend running it by a CPA or tax attorney. That way, you have the protection of a licensed professional reviewing whether you made a reasonable wage when setting your wage in an S corp.
If You Have an LLC, Can You Still Get the Payroll Tax Benefits in an S Corp?
Yes, you can. An LLC can elect to be taxed as an S Corp, but you can only do that if your LLC otherwise doesn’t violate S Corp rules, and you need to then treat your LLC essentially as an S Corp. So you can’t have the benefits of both if you will. You can’t have an LLC that has all sorts of things that would not be permitted in an S Corp and then get the tax benefit of the S Corp. The IRS doesn’t permit that.
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