The Downfalls of Forming an LLC

A Limited Liability Partnership or LLC, is meant to be a simple, easy to form structure for a business.  It is a blend between a corporation and a partnership.  One of the largest benefits of an LLC is its ability to pass through income or losses to its owners.  This prevents what is called the double taxation of corporations – taxation at the corporate level and at the individual level upon distribution.  The owner(s) of the LLC can choose to be taxed as a sole proprietor, partnership, S corporation or a C corporation.  This structure also provides individual protection from the LLCs debts – i.e. the owner(s) are not liable for the LLCs debts.  There are exceptions to this, however.  If the owners of the LLC treat the LLC money like their own personal bank accounts, and use any income for non-LLC purposes, in a lawsuit the plaintiffs can attempt to “pierce the corporate veil” and go after the individual owners of the LLC personally.  Further, in Florida, a one-member LLC does not provide protection from individual liability to the owner.  That is why it is necessary to have more than a one-member LLC.

Issues arise, however, when bringing on partners and deciding how the LLC will be run.  How profits and losses will be distributed, and taxed, to the individual owners is a prime consideration.

Further, for start-up companies looking for venture capital, there is an even larger issue with the LLC format.  Any equity granted to workers, such as stock options, makes them technical partners in the LLC for tax purposes.  This means that they must be issued Schedule K-1 tax forms that disclose information about the LLC’s finances, which many employers would not want their employees to know.  The employee/partners would also be responsible under IRS rules for withholding their own quarterly taxes.

A further difficulty with an LLC that will be seeking venture capital is that venture capitalists (VCs) do not like this form of structure and will refuse to invest.  The reason is that VCs are structured as pass-through entities also, and they do not want the LLC’s income or losses passed on to their own limited partners, who could be taxed on this income when they would not otherwise have to pay.

While a corporation might have higher renewal fees, more paperwork, and double taxation, a business seeking venture capital might be wiser to start as a corporation.



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