Limited liability companies, as a form of business organization, have exploded in popularity over the past two decades or so. Many startups have chosen to organize themselves as LLCs, preferring the flexibility and simplicity of a LLC over a corporation. But for many kinds of startups, organizing as an LLC may be a really bad idea for a number of reasons.
1. Taxes — some startup founders are concerned about the double-taxation of a C-corporation, and so seek LLCs, which by default are treated for taxation purposes as a disregarded entity (when the LLC only has one owner) or as a partnership (when the LLC has multiple owners). LLCs can also elect to be taxed as a corporation, including under Subchapter C, or Subchapter S (assuming the LLC qualifies). But the thing with pass-through taxation is that the members of the LLC are responsible for paying their share of the LLC’s taxes, whether or not cash is actually distributed to the members. And, depending on the LLC’s operations, members may be required to pay taxes in a number of states, significantly complicating the filing process for
2. Issuing equity — Issuing equity, such as for employee compensation or to raise capital, can be difficult with LLCs. If the LLC is subject to pass-through taxation, investors may not want to take on the added burden of filing their share of the LLC’s tax liability, or paying it (assuming the LLC’s operating agreement doesn’t provide for automatic distributions to cover members’ tax liabilities). Moreover, it can be incredibly complex to issue equity to employees as incentive compensation. Again, if the LLC is taxed as a partnership, issuing equity to employees turns them into members, who cannot also be W-2 employees.
3. Management may not be so easy — Some like LLCs for their simplicity and flexibility, but I’ve found that the more you exercise that flexibility, the less simple LLCs can get. The structure of a LLC is largely an agreement among the members of the LLC, which can (for the most part) take the form the members want, as opposed to the more structured rules of a corporation. But LLCs are a relatively new form of business organization compared to corporations, so the caselaw supporting LLCs is nowhere near as developed as that of corporations. As a result, with a unique and complex structure of a LLC, it is difficult to predict how that structure would be view by courts or government agencies.
LLCs can work well for smaller family-owned or several-partner businesses, as it can free owners from some of the paperwork requirements of corporations. But for a startup that will need to raise capital or will need a complex equity or management structure, a LLC may not be as an ideal choice.