Asset Protection, Tax Planning

7 Reasons a Startup Should Not Be an LLC

7 Reasons a Startup Should Not Be an LLC

You may have heard that limited liability companies (LLCs) are excellent business structures because of their many benefits, including simplicity, certain tax advantages, asset protection. It is true that LLC benefits can be a perfect combination for some businesses. However, an LLC will not work for every startup, and business owners should not assume that creating an LLC is always the answer. In fact, there are a few very specific reasons that you may not want your new business to be an LLC.

Some Investors Simply Do Not Like LLCs Taxed as S Corps

Technology and growth companies want to be able to move quickly when it comes to attracting investors and expansion so they may not want to start out as an LLC. Many investors do not like LLCs for a couple of reasons.

First, LLCs are often taxed as if they are a partnership, which means that when an investor becomes a member, then they become a “partner” in the business. They receive a K-1 Form that is then reported on their personal tax return. Although it is not too difficult to report on their income taxes, the investor would likely pay less in income taxes if he or she received a dividend instead of income from a partnership.

As a partner, the investor is taxed on income regardless of whether it is actually distributed to the investor. That is, the money could sit in the LLC’s bank account, and the investor would still have to pay income tax on it. That factor alone would deter some investors.

Many Investors Cannot Invest in LLCs

Some investors, particularly venture funds, may not be able to invest in pass-through companies like LLCs that are taxed as S Corps. They often have tax-exempt partners that do not want to engage in activities that could be considered “active” business income due to their tax-exempt status. Venture capitalists may also want to utilize special preferred stock options, which often isn’t doable in an LLC.


Investors Are Not As Familiar with LLCs

Even when investors can invest in LLCs, they may choose not to because they assume they cannot. Investors are generally less familiar with LLCs, so they may be unaware of how particular laws or regulations are applicable to them. They may not want to spend the time and effort of learning about LLCs generally or about your particular LLC when deciding whether to invest. For many, not having to re-learn the ropes of investing in a corporation is appealing.

LLCs Sometimes Open Investors Up to Additional Tax in Other States

If the business operates in more than one state, even passive investors may open themselves up to paying taxes in more than one state if they are a “partner” in an LLC. When the LLC has an active business there, even passive investors may end up being taxed as if they are an active participant in the company as to that state’s tax. This potential can be daunting for some investors.

Some Single Member LLCs Do Not Have Charging Order Protection

One of the primary reasons that business owners choose to create an LLC is for the asset protection they provide. However, single-member LLCs do not offer to charge order protection in most states. That means that when you incur personal liabilities, creditors can still reach your business assets, even when they are in an LLC if there is only one member.

While single-member LLCs still have corporate veil protection – where your personal assets are protected from your business’s creditors – not having charging order protection can be a serious problem for some business owners. As a result, if you are an alone business owner, having a single-member LLC may not be the best business entity choice. Instead, you may want to consider a corporation or adding more members to your LLC.


You May Have More Tax Benefits as a Corporation

Depending on your situation, it may be more advantageous from a tax perspective to choose a corporation instead of an LLC. For example, LLC members are considered self-employed business owners. That means that they are subject to self-employment tax in addition to their regular income tax. As a corporation, you can pay yourself a salary and take the rest as dividends. In some situations, this type of arrangement is more advantageous than being subjected to self-employment tax.

Corporations can also deduct certain employee fringe benefits from their income as well. In most situations, LLCs do not have the same tax advantage because owners are not “employees.”

As members, LLC owners are taxed on everything that the company makes, regardless of whether that revenue ever hits your pocket. If your business requires more cash on hand, it may be a good idea to choose a corporation as your business structure to avoid potential issues related to retained earnings.

You Want to Give Your Employees Equity

Many companies provide stock options or other similar incentives to their employees. This allows them to “invest” in the enterprise in a way that also benefits the business itself. You cannot use this type of incentive program in an LLC.

In a corporation, you could provide stock to employees. In an LLC, the members own all of the company, which means that the members would have to adjust ownership to provide interest to an employee. This process can be complicated and cumbersome, and it may trigger unfortunate tax consequences.

Getting More Information

LLCs are a great business entity option, but they are not always the right answer. Whether an LLC will work for you depends on many factors.

You can learn about the benefits of LLCs and other business entity options in Protect Wealth Academy’s extensive video library, which has over 100 hours of valuable information about asset protection, wealth management, and more. Learning about each business entity option will help you find the structure that will work best for you. Sign up for free membership now.

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