LLCs Compared to General Partnerships and Sole Proprietorships
The limited liability company offers the greatest benefits when compared to partnerships and sole proprietorships. Most partnerships and sole proprietorships switch to an LLC.
Advantages of an LLC
- Limited liability. The main reason for forming a limited liability company or corporation is to limit the liability of the owners. In a sole proprietorship or partnership, the owners are personally liable for the debts and liabilities of the business. Also, creditors are able to go after all of their assets (business and personal) to collect. If an LLC is formed and operated properly, the owners can be protected from such liability.
The creditors can take the bank accounts, cars, real estate, and other property of any partner to pay the debts of the partnership. If only one partner has money, he or she may have to pay all of the debts accumulated by all the other partners. When doing business as an LLC, the company may go bankrupt and the members may lose their initial investment, but the creditors cannot touch the assets of the owners.
Note: If a member of a limited liability company does something negligent, signs a debt personally, or guarantees a company debt, the limited liability company will not protect him or her from the consequences of his or her own act or from the debt. Also, if a limited liability company does not follow the proper formalities, it may be ignored by a court and the owners or officers may be held personally liable. The formalities include having separate bank accounts, filing annual reports, and following other requirements of state law.
- Continuous existence. A limited liability company may have a perpetual existence. When a sole proprietor or partner dies, the assets of his or her business may go to his or her heirs, but the business may no longer exist. If the surviving spouse or other heirs of a business owner want to continue the business in their own names, they will be considered a new business—even if they are using the assets of the old business. With a partnership, the death of one partner may cause a dissolution of the business.
Example: If a person dies owning a sole proprietorship, his or her spouse may want to continue the business. That person may inherit all of the assets, but will have to start a new business. This means getting new licenses and tax numbers, registering the name, and establishing credit from scratch. With an LLC, the business continues with all of the same licenses, bank accounts, etc.
- Ease of transferability. A limited liability company and all of its assets and accounts may be transferred by the simple assignment of an interest (stake) in the company. With a sole proprietorship, each of the individual assets must be transferred and the accounts, licenses, and permits must be individually transferred.
Example: Jack sold his sole proprietorship to Kim. Kim, as the new owner, will have to get a new business license, and set up her own bank account. The title to any vehicles and real estate will have to be put in her name. Also, all open accounts will have to be changed to her name. She will probably have to submit new credit applications. With an LLC, all of these items remain in the same company name.
Note: In some cases, the new owners will have to submit personal applications for such things as credit lines or liquor licenses, because these are granted to the owners of the company, not to the company.
- Sharing ownership. With a limited liability company, the owner of a business can share the profits of a business without giving up control. This is done by setting up the share of profits separate from the share of ownership.
Example: If a person wants to give her children some of the profits of her business, she can make them members of the company, entitling them to a share of the profits but not giving them any control over management of the company. This would not be practical with a sole proprietorship or partnership.
- Ease of raising capital. A limited liability company may raise capital by admitting new members or borrowing money. In most cases, a business does not pay taxes on money it raises by the sale of its shares.
Example: If an LLC or corporation wants to expand, the owners can sell off ten percent, fifty percent, or ninety percent of the ownership and still remain in control of the business. The people putting up the money may be more willing to invest if they know they will have a piece of the action than if they were making a loan with a limited return. They may not want to become partners in a partnership.
Note: There are strict rules about selling interests in businesses with criminal and monetary penalties for violators.
- Separate record keeping. An LLC has all its own bank accounts and records. A partner or sole proprietor may have trouble differentiating which of his or her expenses were for business and which were for personal items.
- Ease of estate planning. With an LLC or corporation, ownership of the company can be distributed more easily than with a partnership or sole proprietorship. Different beneficiaries can be given different percentages and control can be limited to those who are most capable. This is done by having different classes of ownership, different distribution of profits, and different levels of control. Death taxes can be avoided if small amounts of ownership are transferred tax free each year before death. But for this you should consult a tax expert because the IRS rules must be followed carefully.
Example: A person owning an LLC who wants to leave it to three children could set it up so that only the child with the good business judgment becomes the company manager, and the child that has special needs gets a larger percentage of the profits.
- Prestige. The name of an LLC or corporation sounds more prestigious than the name of a sole proprietor to some people. John Smith, DBA: Acme Builders sounds like one lone guy. Acme Builders, LLC, sounds like it might be a large, sophisticated operation. No one needs to know that it is run out of a garage.
- Separate credit rating. An LLC has its own credit rating, which can be better or worse than the owner's credit rating. An LLC can go bankrupt while the owner's credit remains unaffected, or an owner's credit may be bad but the corporation may maintain a good rating.
Disadvantages of an LLC
The LLC does have some disadvantages that should be weighed against the advantages.
- Cost. Compared to a sole proprietorship or partnership, an LLC is a little more expensive to operate. The startup cost is only slightly more than for a corporation, but proprietorships and general partnerships do not have many startup or annual fees.
- Taxes. A limited liability company owner may have to pay unemployment compensation for him- or herself, which she or he would not have to pay as a sole proprietor.
- Separate records. The owners of a limited liability company must be careful to keep their personal business separate from the business of the limited liability company. The limited liability company must have its own records. Money must be kept separate. Records should be separate in every business and the structure of a company might make it easier to do so.