As an accounting firm, we get asked all the time.
“What should my business entity be? I heard that I should have an LLC.”
Well, the truth is, sometimes you need an LLC, and guys, sometimes you don’t.
So in this post, we want to set the record straight, eliminate the confusion, and breakdown who needs an LLC and who doesn’t.
Let’s get into it!
We got 6 disadvantages of LLC and reasons why you don’t need an LLC. Some of the things you may know and there likely will be some things you don’t know.
So for the people who are new, let’s start with…
What is an LLC?
LLC stands for Limited Liability Company. Essentially, it is a business entity that you can set up for your business.
Now it’s so popular because of the “limited liability” part. You see with an LLC you are able to separate your business assets from your personal assets.
So if someone sues your business and you lose then the only thing that they can go after legally are assets within your business.
And your personal assets are completely safe. So, it gives you this sense of security through having a legal shield.
And it sounds great, right?
But let’s go and dive into some of the disadvantages of LLC and obvious reasons why an LLC still may not be a good fit.
Disadvantages of LLC: 6 Reasons Why You Don’t Need an LLC
1. People Who Don’t Have Assets – may not need an LLC
So of course, if you don’t have a lot of personal assets then a limited liability company does nothing for you.
For example, if you are a homeowner and your home is majority paid off then an LLC can offer you some protection. But if you don’t own a house then there’s no need to protect it.
The same thing for a car, if you own a car, but it is not close to being paid off, then you don’t likely need to protect it.
The good news is that if you start to gain more personal assets, you can always create an LLC.
But for some people, they jump into getting an LLC early for protection without EVEN considering what assets they are trying to protect.
This is especially important if you are young and you’re just getting started in the business, you don’t have many personal assets that need to be protected.
Let’s say you’re a college student or you’re fresh out of college, and you’re looking to build yourself up, then an LLC is likely not the best option for you.
And setting up an LLC can be costly if you do it the right way and you have to pay an annual registration fee.
And this is something you DON’T need to do if you have a sole proprietorship or regular partnership.
2. People Who Don’t Make Money – may not need an LLC
This one is another no-brainer. Just because you set-up an LLC does not mean your business is going to make money, right?
In fact, as we just mentioned, you actually have to pay to start and operate an LLC. So it takes money from you.
But sometimes we see that when people get an LLC, they are super excited because they can finally feel and say they’re official.
They start telling everyone, “Hey look, I just got my articles incorporation and now I’m an LLC and I’m ready for business.“
But the truth is, that is just the start of a new challenging journey. And as we all know, entrepreneurship can be extremely difficult.
In fact, something like 9 out of 10 businesses fail after their first 5 years.
Now we’re not saying this to discourage ANYONE. In fact, we love to see people start new businesses.
But, we’re saying this with love, so you can approach starting a business with the right mindset.
Anyway, the point here is that you should try to prove your revenue model and make sure that you will be able to make money before rushing into an LLC.
Because you can still prove your business concept while being a sole proprietor or partnership.
And mainly if you’re NOT making money there’s a HIGH percentage, we would guess 99% of the time, you are NOT going to get in any legal troubles.
Like usually, you would need a customer or a client that you are actually responsible for, in a legal sense, for an LLC to be necessary.
3. People Who Have No Legal Responsibility – may not need an LLC
If you are in a business that makes people sign a contract…
…and in that contract, you specify that you have no legal liability and the nature of your business carries a very, very small risk of legal liability then you MAY NOT need an LLC.
Let’s remember an LLC protects you in a legal sense – that’s the most popular advantage.
However, for example, if you’re a remote/virtual coach and you’re just teaching people generally ordinary things like how to speak a new language, then more than likely you’re not going to have a lot of legal risks.
You’re worst outcome is likely you just didn’t teach them correctly.
But the chances are probably ZERO that your business will get sued and they will take all your personal assets, right?
The more likely scenario is that your customer ends up really mad and walks away.
Or maybe they’re mad enough to go out and write a bad review. Or maybe they try to take you to court and the judge looks at the case and says this is a complete waste of time, right?
Now, of course, if you have a physical store then you would be exempt from this because there is some responsibility of taking care of people while they are on your property.
Or for example, if you own a restaurant then you’re likely responsible for food that people are eating and digesting into their body.
So we suggest that you check with your federal and state laws to see what your business and the nature of your business may be liable for.
A good place to start would be looking at the FTC which is the Fair Trade Commission’s regulations and then look at what consumer and business protections that they have that you need to abide by.
And even if you have an LLC, this is still a good idea because you want to protect your business from a devastating lawsuit as well.
We mean forget about your personal assets for a second. If you do build a big business, the last thing you want to do is lose your business to a lawsuit.
So we just think that more people need to pay attention to overall legal risk within the business, and NOT just worry about their personal risk.
Because if you’re like us, your business is likely a huge chunk of your income.
That is because, for most entrepreneurs, their business income and their business assets actually outweigh their personal.
And if you’re only thinking about your personal assets, think about that for a second, do you really believe that you can build a big business?
Because if you did, then you would think about protecting your business overall because you know how critical that is to your income and your assets.
Anyway, so yes, think about your legal risks overall and then also, think about what the nature of your business is, and if you have assets that need to be protected.
4. People Who Want to Raise Money from Investors – may not need an LLC
Now, this probably one of the biggest reasons why you don’t need an LLC.
Because if you are not aware of this then you could be working hard for MONTHS, headed in the right direction, only to get to your big close just to realize that your LLC is what failed you.
Because an LLC can make it very difficult, and in some cases, literally impossible for investors to give you money.
Let’s look at the two reasons why.
a. Some investors (such as venture capital funds) literally cannot invest in pass-through entities like LLCs because they have tax-exempt partners.
And those partners do not want to receive active trade or business income because it will mess up their tax-exempt status.
That’s why when you look closely, you will see many tech companies who are trying to raise a lot of venture capital being advised to be incorporated as a C-Corporation by many accelerator programs.
So basically in order to limit severe tax outcomes, many investors will not invest in an LLC.
So if you have a really big idea and you already know without question that you will need to raise some money to make it happen, then think twice or 3 times before starting an LLC.
b. LLCs may find it difficult to raise money due to common investor practices.
You see many investors are less familiar with LLCs than they are corporations.
So, they typically have to spend more time on due diligence than actually deciding whether or not they want to invest in your company.
This means the investor will have an increase in due diligence cost if the investor were to hire an attorney for example.
And on top of that, it just wastes valuable time, and investors want to move fast when they’re looking at a start-up they want to invest in.
They want to acquire stock and they don’t want any tax implications until they decide to sell the said stock.
So the average big investor thinks about buying shares of private companies like they would buying shares of a public company on the stock market.
They want to find something that they love, make a quick and easy investment, and then look for the next deal. Unfortunately, LLCs make this process much more complicated.
Imagine for a second, you are networking event and you meet an investor who can help grow your business.
You introduced your accounting firm to him and the investor gets excited because it is exactly what he is looking for. He proposes to invest $1M dollars into your company…
But then when he asks you how your business is structured, your answer is an LLC. Then he abruptly goes uninterested.
See the investor knows he’s gonna have to go through due diligence, maybe hire an attorney…
…and then spend his own personal time just trying to figure out how to make the right investment into the LLC instead of taking that million dollars and giving it to another accounting firm who was likely structured and ready for an investment.
5. Disadvantages of LLC – Tax implications for you as the LLC owner.
Let’s say if you do happen to get a really committed investor, they love your business and they are willing to invest through the LLC, despite all the implications, then what will happen is that you will need to give them a share of your company.
When this happens, the shares that you sell in your LLC are taxed.
Yes, they are TAXED.
It’s like when you sell your home and you make some profit after a certain threshold, you pay taxes on it.
Now some other entities can use what is known as the Section 1202 Gain Exclusion.
This is a tax code that allows founders and investors to exclude up to $10M in capital gains from the sale of qualified small business stock or shares.
And the stock of most startups qualify as a small business stock.
So this is HUGE and unfortunately, Section 1202 cannot be used to exclude gains from the sale of interests in LLCs or other pass-through entities.
It’s also important to note that other business types like restaurants are also not eligible for section 1202.
So you may want to some research if you’re looking to raise the money and don’t want to be affected by these capital gains.
Now you may be thinking, “Okay, but I really don’t want to raise any money. I don’t want any debt on my business and I don’t really want to worry about any of this.“
But the thing we want to ask you is how committed are you about NOT raising money.
If your answer is 100% never, then an LLC may work out well for you.
6. Disadvantages of LLC – You may end up paying less taxes with another entity like an S-Corp
This again is going to only apply if your business is making money.
But once you start making over $100,000, the circumstances may shift to where you can pay yourself a reasonable salary, to get inside a lower tax bracket.
Then take a distribution through your S-Corporation later, which could end up reducing your overall tax liabilities.
IF it sounds confusing then you’re not alone.
Now you can learn more about LLC vs S-Corps in this post, which we highly recommend you read after.
Summing Up the Disadvantages of LLC
In summary, all this being considered, we still think LLCs are one of the most powerful and popular entities that you can create. And it more than likely will work for the majority of people out there.
But as you can tell by what we broke down in this post, it definitely is NOT for everyone. So just keep this in mind.
Contact us today to get started!