While a limited liability company (LLC) offers many advantages over other forms of business entity, there are also some disadvantages. Some of the drawbacks to selecting an LLC over another entity are:
- Earnings of most members of an LLC are generally subject to self-employment tax. By contrast, earnings of an S corporation, after paying a reasonable salary to the shareholders working in the business, can be passed through as distributions of profits and are not subject to self-employment taxes.
- Since an LLC is considered a partnership for Federal income tax purposes, if 50% or more of the capital and profit interests are sold or exchanged within a 12-month period, the LLC will terminate for federal tax purposes.
- If more than 35% of losses can be allocated to nonmanagers, the limited liability company may lose its ability to use the cash method of accounting.
- A limited liability company which is treated as a partnership cannot take advantage of incentive stock options, engage in tax-free reorganizations, or issue Section 1244 stock.
- There is a lack of uniformity among limited liability company statutes. Businesses that operate in more than one state may not receive consistent treatment.
- In order to be treated as a partnership, an LLC must have at least two members. An S corporation can have one shareholder. Although all states allow single member LLCs, the business is not permitted to elect partnership classification for federal tax purposes. The business files Schedule C as a sole proprietor unless it elects to file as a corporation.
- Some states do not tax partnerships but do tax limited liability companies.
- Minority discounts for estate planning purposes may be lower in a limited liability company than a corporation. Since LLCs are easier to dissolve, there is greater access to the business assets. Some experts believe that limited liability company discounts may only be 15% compared to 25% to 40% for a closely-held corporation.
- Conversion of an existing business to limited liability company status could result in tax recognition on appreciated assets.