When starting a business, one of the most important choices that is frequently overlooked is the business entity selection. The choice between forming your business as a sole proprietorship, partnership, LLC, C Corporation or S Corporation is much more than a choice of letters. Each entity alters how the business must be structured, how taxes are reported and paid by the owners, and impacts the business' ability to raise capital. Further, it is difficult to change business entities once the business is running, and doing so may incur substantial costs. This post will be the second in a series of explanations of the different corporate entities as well the features that make them attractive or unattractive to new businesses.
An LLC is an unincorporated business organization established by a single member, or group of people, who have limited liability for the debts and liabilities of the business. State law determines the formation and operation of an LLC. To form an LLC in New York, the organizing members must file the business' Articles of Organization with the state and pay the requisite fee. Subsequently, a notice that the LLC was formed must be published in two newspapers (that are designated by the county clerk of the county where the LLC is located) consecutively for six weeks. A Certificate of Publication, affidavits of publication in the newspapers, and the requisite fee must then be filed with the Department of State within 120 days of the initial filing of the Articles of Organization. The timing of the submission is important, as failure to provide this documentation would result in the suspension of the LLC's ability to conduct business. Additionally, the members of the LLC are required by New York law to adopt a written Operating Agreement. Under New York law, this agreement must be entered into no later than 90 days after the filing of the Articles of Organization. This document does not get filed with the State but is maintained internally by the LLC. Lastly, depending on the industry the LLC does business in, the members may have to comply with other tax and regulatory requirements. Although there are fees and several steps required to form an LLC, the benefits to its members are substantial.
The LLC is a flexible business structure that avoids some of the pitfalls of sole proprietorship. This entity allows the business to add members as it sees fit, unless otherwise provided for in the Operating Agreement. The necessity of an Operating Agreement also allows businesses to create its own organizational structure. One of the greatest advantages to the LLC is that members enjoy limited liability. This means that the members do not share in the liability of the business' debts or judgments like sole proprietors do. Essentially, the business insulates its members from liability by absorbing any debt or judgment. Limited liability is extremely beneficial to the members as their personal lives are not on the line with every debt or lawsuit. Additionally, LLCs are usually taxed like sole proprietorships, as they are considered "pass-through" entities. This means that the LLC's members report their share of the business' profits on their personal tax return. LLCs can also elect to be taxed as a C or S corporation instead of "pass-through" taxation (which will be discussed in a future blog post).
The disadvantages of LLCs are few, but could be impactful to a business. Firstly, it may be difficult for LLCs to raise money from investors. Generally, investors are hesitant to invest in LLCs due to the lack of a mandatory corporate structure and "pass-through" taxation structure. Simply put, investors may not be amenable to investing in LLCs because they would be taxed on a share of profits from the LLC, despite potentially not receiving any money to pay the taxes, and/or have tax-exempt partners who do not want to receive business income. The need for investor funding should be heavily weighed during business formation. If investor funding is, or will be, necessary for the business to thrive, it may be more advantageous to form a C corporation. Additionally, it is a disadvantage that there are no structural requirements to an LLC because it necessitates an all encompassing, tightly drafted, Operating Agreement. Such an agreement can be difficult to draft, review, negotiate and agree upon between the members.
These are just some of the advantages and disadvantages of LLCs. It is important to remember that the best choice of entity varies business to business.
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