A limited liability company (LLC) is a popular business structure for small business owners as it provides liability protection, management flexibility, and tax advantages. Before starting an LLC, it is best to understand the benefits and disadvantages of an LLC, how to create an LLC, where to form your LLC, and other key topics.
What is an LLC?
A limited liability company (LLC) is a business structure that legally exists as a separate entity from its owners. An LLC provides limited liability protection and pass-through taxation, therefore owners cannot typically be held personally responsible for business debts and liabilities.
In terms of tax, LLC allows for pass-through taxation meaning that income is not taxed at the entity level. However, a tax return for the LLC must be completed if the company has more than one owner (or member). Any LLC income or loss is then passed through to the owner(s). The owner(s) must then report the income or loss on their personal tax returns and pay any necessary tax.
Advantages of an LLC Formation
Creating an LLC comes with its own unique set of benefits as opposed to operating as a sole proprietorship or general partnership, or forming a corporation. Below outlines some of the advantages of creating an LLC.
Limited Liability – Members (or owners) are shielded from personal liability for acts of the LLC business and its other members. LLC creditors cannot pursue personal assets such as the house, savings accounts, etc. of the owners to settle any business debts. However, personal assets of sole proprietors and general partners can be pursued against business’ debts.
Flexible Membership – LLC members can include individuals, partnerships, trusts, or corporations with no limit on the number of members. S corporations (a corporation that has chosen to be taxed as a pass-through entity under Subchapter S of the Internal Revenue Code) are restricted in who can be a shareholder with a maximum limit imposed.
Management – Members have the authority to manage the LLC or elect a management group to do so. This is different compared to corporations as those are handled by a board of directors, not shareholders.
Pass-through Taxation – LLCs typically do not pay taxes at a business entity level. Instead, any business income or loss is passed-through to the owners and reported as part of their personal income tax returns. Any tax due is paid at an individual level. Those that choose to not be taxed as an S corporation are known as C corporations and are taxed at the business entity level while the shareholders are taxed on the income distributed to them.
Heightened Credibility – An LLC helps a new business establish credibility more than a sole proprietorship or partnership.
Limited Compliance Requirements – LLCs face fewer state-imposed compliance requirements as well as ongoing formalities compared to sole proprietorships, general partnerships, or corporations.
Disadvantages of Creating an LLC
While the benefits of an LLC are plenty, forming a limited liability company has its disadvantages too.
Cost – A limited liability company (LLC) usually costs more to set up and maintain than a sole proprietorship or general partnership. Not only will states charge an initial formation fee, but many states also impose ongoing fees such as annual reports and/or franchise tax fees. To know what fees are due when forming an LLC, it is best to check with your Secretary of State’s office.
Transferable Ownership – Ownership of an LLC is harder to transfer compared to a corporation. Shares of stock can be sold by the corporation to increase ownership whereas LLCs must have all their members approve before adding new members or altering the ownership percentages of existing members.
Comparison of LLCs with Other Entity Types
When forming a business, you will need to decide on the business structure.
LLCs versus S Corps
While the S corporation and LLC both have pass-through taxation, the S corporation lacks the flexibility of an LLC in terms of allocating income to the owners. Additionally, an LLC may offer several classes of membership interest while an S corporation only has one class of stock.
LLCs versus Partnerships and Sole Proprietorships
Unlike a sole proprietorship, LLCs are separate entities from the business members. Most sole proprietors would benefit from converting their sole proprietorships to LLCs because LLCs offer liability protection and are rather inexpensive to maintain.
Only businesses with zero liability are advised to operate as sole proprietorships since there isn’t any legal separation between a sole proprietor and the business.
How to form an LLC?
Although it is easier to form than a corporation, starting an LLC business requires some administrative and compliance tasks to be done. To help you start an LLC successfully, follow these eight steps in the guide below:
Step 1: Choose a State in Which to Form your LLC
You can choose to form an LLC in any state – even if you don’t plan on doing any business there. Nonetheless, most LLC owners choose to form an LLC in the state in which they plan to do business. One main reason for this is that LLCs will have to register as a foreign LLC to do business in a different state, which can lead to an increase in formation and administrative costs.
It is also important to note that cost, taxation, and LLC laws vary from state to state, making some states more advantageous for certain small business owners. Hence, it is important to pick the right state for LLC formation that’s best for your business nature.
Step 2: Choose a Name for your LLC
In order to form an LLC, you’ll need a name that’s not already on the Secretary of State’s records, meaning the company name should be different from another domestic or qualified LLC or other business entity. Many sole proprietors operate under a registered “doing business as” (DBA) name or trade name when they want to use that as their LLC’s legal name.
One way to ensure the availability of your preferred LLC name is to conduct a search on your formation state’s website. Even if you’re not ready to file your LLC formation document quite yet, it is still a good idea to reserve the name for a small fee in case it gets taken up by other businesses in the near future.
Step 3: Choose a Registered Agent
When forming an LLC or registering an existing one to transact business in a foreign state, you must have a registered agent in the state of formation or qualification. This is a fact that many new business owners are either unfamiliar with or do not understand the purpose of having a registered agent.
A registered agent (agent for service of process which you can get from one of the many registered agent service providers) is responsible for receiving important legal notices and tax documents on behalf of the company. Such documents include legal documents, notices, and communications mailed by the Secretary of State and tax documents sent by the state’s department of taxation. They must be well received by your registered agent instead of someone else.
A registered agent must also be available to receive service of process (Notice of Litigation) for summons, complaints, or lawsuits filed against the LLC. Other court documents such as garnishment orders and subpoenas will also be served to the registered agent.
The LLC owner can choose to serve as the LLC’s registered agent. However, many business owners choose to hire a registered agent service provider to assist as they understand that the LLC can be negatively impacted if the registered agent is not available when these time-sensitive documents are delivered or if the person receiving them mishandles the documents. Regardless, a registered agent must have a physical address in the state and cannot use a PO box.
Step 4: Prepare an LLC Operating Agreement
An LLC operating agreement is generally required in almost every state, although most states allow an oral agreement. Nonetheless, it is highly recommended for every LLC to have a written operating agreement to clearly state how the company will be operated.
It is particularly important for multi-member LLCs to have a well-drafted operating agreement to spell out the division of ownership, labor, and profits.
The operating agreement should detail who has authority over what, what vote is required to approve certain transactions, how membership interests can be transferred, how to add new members, how to distribute losses and profit, and more. It is also better for the operating agreement to be reviewed by an attorney to ensure all bases are covered.
Step 5: File your LLC with Your State
To make your new limited liability company official, you must file LLC formation documents (also known as a Certificate of Organization, Certificate of Formation, or Articles of Organization) with the Secretary of State’s office or the relevant department that handles business filings in the state you’re forming.
While each state’s LLC Articles of Organization is different to some extent, there are several common elements which include the following:
- Name, principal location, and purpose of business
- The name of registered agent and his physical address
- Whether the company is member-managed or manager-managed
Standard forms of the Articles of Organization for an LLC can be obtained from each state. The person who formed the LLC must sign the paperwork for the filing of Articles of Organization. Once approved and filed, the state will issue a certificate or other form of confirmation document.
The certificate serves as legal proof of the LLC’s status and can be used to open a business bank account, obtain an EIN, and so on. Some states may even require you to publish a notice, often in a local newspaper, confirming the formation of your limited liability company.
Step 6: Obtain an EIN
After establishing the business entity, you must apply to the Internal Revenue Service (IRS) for an employer identification number. This identification number will be used on all company bank accounts, as well as income and employment tax filings. Also, you must also apply to the state’s tax department for a sales tax identification number and register with the state’s labor department for every state your LLC is doing business in.
Step 7: Open an LLC Bank Account
Though this is not a legal requirement, it is best practice for anyone creating an LLC, and that’s why it is outlined in our article today. It is crucial to separate business finances from personal ones, which is one of the main factors courts consider when deciding whether to pierce an LLC’s veil and hold the members liable for any debt.
Most banks require company details, such as formation date, business type, members name, and addresses. However, some banks may require other documentation and it’s best to contact your bank about requirements prior to opening an account.
Step 8: Register to Do Business in the Other States (If Necessary)
An LLC that’s planning to do business in more than just the formation state will need to register – or foreign quality – in each “foreign” state. This generally will require filing an application for authority with the Secretary of State as well as a Certificate of Good Standing. The LLC will also have to appoint and maintain a registered agent in that state.
There are many factors that come into play when deciding whether you transact business in a state, and therefore need to foreign qualify. Some of the common criteria include:
- The company must have a physical presence in the state
- The company must have employees in the state
- The company must accept orders in the state.
Do note that different states will have different criteria. It is best to seek legal advice from an attorney to determine whether your LLC needs to foreign qualify in a certain state.
The Bottom Line
Starting an LLC is not a massive feat, but neither is it simple. Be sure that you’re familiar with all key terms and get all the guidance you need before you launch your company. Understand the structure and its implications to maximize the success of your business.
Frequently Asked Questions
Is it better to start a corporation or LLC for my small business?
Corporations are a complex legal business entity that’s run by a board of directors and is owned by shareholders. Small businesses will only benefit from a corporation if they rely on outside investors or need to exchange stock publicly. Hence, it is recommended for small businesses to opt for LLC.
What forms are required to form an LLC?
To register an LLC, you will need to prepare and file Articles of Organization, sometimes known as Certificate of Organization with the state. Filing fees along with any other initial franchise taxes or initial fees (if applicable) must also be paid.
Who can form an LLC?
Anyone above 18 years of age can start an LLC. Typically, there are no residency or legal restrictions as to who can start an LLC.
Do I need an attorney to form an LLC?
No, you do not need an attorney to form an LLC. You can prepare and file the Articles of Organization yourself. However, be sure you understand the requirements of your intended state of incorporation. If you have questions, it is best to consult an attorney or accountant.
What should I name my LLC?
Choosing the name of your new company is an important decision. It is advisable to select a name that projects the company image you want. Selecting a name that’s easy for customers to remember and spell has tons of advantages.
Legally, you must also select an LLC name that’s not deceptively similar to any existing company in the state or must be distinguishable on the record of your state.
It is best to check your company name with a business name availability checker online to prevent that from happening. Additionally, most states require that your LLC name show your business is an LLC by including the words Limited Liability Company or the abbreviation of “LLC”.
How many people do I need to start an LLC?
There is no requirement specifying the maximum and the minimum number of members (owners) an LLC business can have. The IRS allows one-member LLCs to qualify for pass-through tax treatment. However, the taxation of one-member LLC at the state level may be different.
How is an LLC taxed?
LLCs are typically taxed like partnerships, with pass-through taxation. Multi-member LLC must file an informational tax return whereas a single-member LLC does not. In both cases, both profits or losses are “passed-through’ the business and are instead reported on the owners’ tax returns. Any tax due is then paid by the owners at the individual tax level.
An LLC can also elect to be taxed like corporations where profits are taxed at a business level. The state income tax treatment of LLC profits and losses may or may not mirror the IRS tax treatment, depending on the state.
Other than that, an LLC is also subjected to any franchise taxes imposed by the state of incorporation. A franchise tax is essentially a tax imposed for the mere privilege of being an LLC or registered to transact business in that state. Franchise taxes are typically due annually and the amount will differ by state.
What is the organizational structure of an LLC?
An LLC is owned by its members and is analogous to partners in a partnership or shareholders in corporations. Members will resemble more like shareholders if the LLC utilizes managers since the members will not actively participate in management.
In contrast, an LLC member will closely resemble partners if they have a direct say in the company decision-making. A member’s ownership of an LLC is represented by membership interest, just like how partners have an interest in a partnership and shareholders have stock in a corporation.
How is an LLC managed?
An LLC can either be member-managed or managers-managed. If the LLC is managed by its members, then it operates pretty much like a partnership where each member has an equal say in the company decision-making process.
If the members choose, they may also elect a manager or managers to act in a capacity similar to a corporation’s board of directors where the managers will then be in charge of the affairs of the LLC.
What is a publication requirement?
Several states require notice to be published for an LLC formation. States with this requirement include Arizona, Nebraska, and New York.
Does my LLC need a registered agent?
Tes, an LLC must appoint a registered agent in order to satisfy the state’s legal requirement to have an individual or company receive important legal and tax documents on behalf of the company.
How do I get started setting up an LLC?
After you decided to form an LLC, you need to file LLC forms and pay state and initial fees. After your LLC forms are filed, it is recommended that your LLC hold an organizational meeting of members and managers to start on the operating agreement, issue membership interest certificates, and undertake other preliminary matters such as authorizing the opening of a bank account for the LLC.
What is a single-member LLC?
A single-member LLC is a “disregarded entity” for federal tax purposes while still providing protection of personal assets. You can report taxable income and expenses of the business using Schedule C and carry that information over to your personal form 1040.
What are the benefits of an LLC?
AN LLC has many benefits, including tax benefits and flexibility advantages. You can learn more about LLC advantages and disadvantages in the section above.
What is a Professional LLC (PLLC)?
A professional LLC is an LLC organized to provide professional services in industries that require a state license in order to practice.
How do I get an EIN for my LLC?
Businesses need to apply for an EIN (Federal Tax ID number) by preparing the Internal Revenue Service (IRS) Form SS-4 and filing it.
How much does it cost to register an LLC?
LLC formation and incorporation filing fees will vary by county. It is best to check with your local state authority or secretary of state before registering your business entity.