Setting up your business as a California limited liability company, or LLC, has both advantages and disadvantages. Depending upon the type of business structure being compared, a particular feature may be an advantage or a disadvantage.
Forming an LLC in California is often considered to have the advantage of offering owners the same limitation of liability as a corporation, but with less complexity. However, as will be seen, it's not quite that simple.
The Big LLC Advantage
An LLC has an advantage over every other type of business structure when it comes to options for federal tax purposes. An LLC with only one owner is called a single-member LLC, and can choose whether it will be taxed as a sole proprietorship, an S corporation, or a C corporation. An LLC with two or more owners is called a multiple-member LLC, and has the choice to be taxed as a partnership, an S corporation, or a C corporation.
A corporation only has two choices: S corporation or C corporation. A business operated as a sole proprietorship or a partnership does not have any option as to how it will be taxed.
Unless the LLC elects to be taxed as a C corporation, all California LLC profits are passed through to the members. This is the same as for a sole proprietorship, general partnership, limited partnership (LP), or S corporation. The LLC members will need to pay federal and California income tax, and federal self-employment tax, on their share of the profits, even if they do not actually receive a share of the profits.
LLC vs. Sole Proprietorship or General Partnership
Compared with a sole proprietorship or general partnership, an LLC also has the following advantages:
- Limitation of liability. This is the main reason most people set up an LLC for their business. The owners of an LLC, called members, are not personally liable for the debts of the business, including debts resulting from most lawsuits against the company. A sole proprietor, and all partners in a general partnership run the risk of losing their personal assets (house, car, bank accounts, etc.) to pay for the debts of the business.
- Transfer of ownership. An LLC operating agreement can provide for transfer of a member's interest, either by sale of the interest or upon death. This can be easier than with a sole proprietorship or a partnership interest.
On the other hand, an LLC has the following disadvantages:
- Registration costs. The cost of registering an LLC in California is $70. There is no registration requirement for a sole proprietorship or a general partnership.
- Annual California LLC taxation. There is no specific California LLC tax, but an LLC will need to pay a yearly California franchise tax, which is a minimum of $800. Sole proprietorships and general partnerships are not subject to the franchise tax.
- More formalities. California law does not require any organizational documents for a sole proprietorship. No organizational documents are required for a general partnership, however, most do create some type of partnership agreement. An LLC must file articles of organization with the California Secretary of State, and should also create an LLC operating agreement which spells out the details of how the business will be structured and operated.
- Registered agent. Unlike a sole proprietorship or general partnership, an LLC is required to have a registered agent for the purpose of receiving official documents, such as lawsuit papers and subpoenas. If your LLC hires an outside registered agent, it will cost from $40 to $500 per year, depending upon the agent you hire.
LLC vs. a Limited Partnership
Compared with a limited partnership, a multiple-member LLC also has the advantage of limited liability. Although limited partners in an LP have limited liability, the LP's general partners can be held personally responsible for business debts, unless the business registers as a limited liability partnership (LLP). With an LLC, all members enjoy limited personal liability. For most small businesses, there are no disadvantages to forming an LLC instead of an LP.
LLC vs. a Corporation
Compared with operating as a corporation, an LLC also has the following advantages:
- Less complexity. A corporation has a three-tiered management structure, with shareholders, a board of directors, and officers. An LLC may be managed by its member, or the members may select managers to run day-to-day operations. A corporation is required to hold an annual meeting of the shareholders, to hold board meetings, and to keep minutes of what takes place at those meetings. There is no requirement for the members of an LLC to conduct meetings and maintain minutes.
- Flexible membership. An LLC may have an unlimited number of members, but an S corporation may not have more than 100 shareholders. This is true even for an LLC taxed as an S corporation. A C corporation can have an unlimited number of shareholders, but will then be subject to double taxation, as well as more regulation regarding its operations.
Compared with an S corporation, an LLC has the following disadvantages:
- Difficulty raising capital. Many investors are more comfortable with the structure of a corporation, and tend to consider LLCs more risky. Therefore, a corporation may find it easier to attract new investors. Also, it is a more simple process for corporations to issue new shares of stock than for LLCs to take in new members.
- Difficulty obtaining loans. Some lenders may consider LLCs more risky than corporations, so a corporation may find it easier to obtain loans.
Before making a final decision on how to structure your business, you may want to visit the online resources of the California Secretary of State. You can also use DIY templates to file your paperwork and get your new business venture off of the ground.