LLC Disadvantages

While a limited liability company (LLC) offers many advantages over other forms of business entity, there are also some disadvantages. Some of the drawbacks to selecting an LLC over another entity are:

• Earnings of most members of an LLC are generally subject to self-employment tax. By contrast, earnings of an S corporation, after paying a reasonable salary to the shareholders working in the business, can be passed through as distributions of profits and are not subject to self-employment taxes.
• Since an LLC is considered a partnership for Federal income tax purposes, if 50% or more of the capital and profit interests are sold or exchanged within a 12-month period, the LLC will terminate for federal tax purposes.
• If more than 35% of losses can be allocated to nonmanagers, the limited liability company may lose its ability to use the cash method of accounting.
• A limited liability company which is treated as a partnership cannot take advantage of incentive stock options, engage in tax-free reorganizations, or issue Section 1244 stock.
• There is a lack of uniformity among limited liability company statutes. Businesses that operate in more than one state may not receive consistent treatment.
• In order to be treated as a partnership, an LLC must have at least two members. An S corporation can have one shareholder. Although all states allow single member LLCs, the business is not permitted to elect partnership classification for federal tax purposes. The business files Schedule C as a sole proprietor unless it elects to file as a corporation.
• Some states do not tax partnerships but do tax limited liability companies.
• Minority discounts for estate planning purposes may be lower in a limited liability company than a corporation. Since LLCs are easier to dissolve, there is greater access to the business assets. Some experts believe that limited liability company discounts may only be 15% compared to 25% to 40% for a closely-held corporation.
• Conversion of an existing business to limited liability company status could result in tax recognition on appreciated assets.

Corporation Disadvantages

The primary disadvantage to incorporation is the possibility of double taxation. The profits of a corporation are taxed first as income to the corporation, then second as income to the shareholder. However, all reasonable business expenses such as salaries and other operating expenses are deductions against corporate income which can minimize double taxation. Double taxation can be eliminated by making an S Corporation election. S Corporations only pay taxes one time at the tax rate of the shareholder(s). S Corporations can deduct the same expenses as a C corporation.

• Complexity and expense of forming a corporation.
• Legal formalities involved with a corporation.