A limited liability company (LLC) is a generally newer entity type, which is a combination of a corporation and a partnership. Forming an LLC legally separates the business entity from the owner(s), and ensures that liability for financial and legal issues of the business do not fall to the owner. By default, LLC’s are treated as “pass-through” entities, meaning that the taxes attributed to the LLC are paid by the owners directly, rather than by the corporation itself. If it elects to, an LLC can be taxed directly like a corporation. If the LLC opts to be taxed like a corporation, it could run into a Double Taxation situation, in which the corporation pays taxes on profits and then the owners share of dividends are further taxed as personal income.
What are the Benefits of Forming an LLC?
When determining whether or not to form an LLC, you must weigh many factors, including your requirements and specifications and your business goals. Here are some things to consider when forming an LLC:
Reducing Liability: LLC’s establish a partition between the shareholders and their businesses. This ensures the proprietor would not be sued individually if his business takes on liability, just the business. Furthermore, whenever the corporation is in debt the personal properties of the members of a limited liability company are not at risk. There are some exceptions where a court “pierces the veil” and holds owners individually accountable for liabilities of the business, but you can generally avoid that risk, as long as the company’s finances and the owner’s personal finances do not become intermingled.
Simpler Than Corporations: One explanation why LLC’s are preferred by smaller businesses is because it requires less paperwork to get started. In comparison to Corporations, LLC’s are not subject to the laws which involve shareholder or director meetings.
Tax Benefits: As discussed above, by default, the LLC does not pay taxes itself, LLC’s are taxed as a pass through entity. Instead each owner’s personal income tax return records the revenue and expenses of the company. This arrangement helps the business avoid double taxation.
Ownership Flexibility: In many cases there are not many restrictive rules that apply to owning and managing an LLC. There are different management structures that can be used, depending on who the owners seek to entrust to run the business. LLC’s can be managed by a member who owns part of the organization, or managed by an outside manager hired for that purpose. There is no limit to the amount of owners of an LLC. Owners can include both individuals and corporate entities, both foreign and domestic.
Downsides of Forming an LLC
There are some disadvantages of creating an LLC, including profit sharing rules that may not be ideal for your situation. Additionally, if you plan on going public or seeking new investors there are some limitations.
Equity Compensation Benefits are more difficult: Many corporations offer compensation in the form of equity. In an LLC, this can be done through profits interest, which is similar, but does not actually convey any actual ownership in the company itself. This can be a disadvantage when recruiting for an early stage business like a startup, where equity and stock options can be used strategically to recruit high level talent.
Required Paperwork: Multiple-owner LLC’s, or those taxed as corporations, will need a new EIN (Employer Identification Number) in order to file federal taxes. In order to track income, expenses, and investments, new bank accounts will be required. Although it’s not necessarily a major hurdle, it can be a big change from running a sole proprietorship out of your personal bank account.
Tax Disadvantages: Although the arrangement of an LLC permits for pass-through taxation, it ensures that all money is charged at the personal income tax rate of the owner. Pass-through entities can claim a 20% income tax deduction under existing tax law, which would reduce the tax bill. However, if you form the business as a C-corporation, you may end up paying less. Members must still pay tax on LLC profits even if those profits are never actually distributed to them. LLC’s are liable for property taxes, unlike corporations, and the owners of an LLC must pay self-employment taxes personally. Shareholders in a corporation can avoid some of these costs through things like dividends.
Is an LLC What You Need?
Based on the pros and cons you may have already decided whether you want to create an LLC for your business.
To summarize, if you want to protect your personal assets, choose what form you will be taxed, and a stable ownership structure, and an easily managed firm, an LLC might be ideal for your company. However if you intend to collect money from investors in order to promote the growth of your small business, you certainly would not want to become an LLC because it is not an investment-friendly structure.
Steps to Form an LLC
Forming an LLC is a pretty simple process, requiring some paperwork and fees. The process is not overly complicated, but is slightly different in each state.
Pick a Name
There are various criteria for the name of your LLC based on the state you reside in. The names must include “limited liability company,” “LLC,” or “L.L.C.” in virtually all states. Any words, like ‘insurance’ or ‘bank,’ cannot be used with your company name until you have a permit. Additionally, the name cannot be easily mistaken with an already registered business or LLC.
Appoint a Registered Agent
A registered agent is a person or company that receives legal mail on behalf of your company. All LLC’s in the United States must have a registered agent. Your registered agent must reside in the state of your business and over the age of 18. In many states, you can designate the Secretary of State as your registered agent, although doing so has some drawbacks.
Acquire Company Licenses
Before you begin operations, you likely will need to acquire certain business licenses or permits. Many industries across various states require licenses and permits. If your company is in the business of buying and selling tangible, taxable goods, you will likely need to register for a seller’s permit, and properly account for sales taxes. If you are in certain regulated industries, you may also need to acquire a zoning permit before you start to operate.
File Articles of Organization
The official start to your LLC happens when you file articles of incorporation. The articles of incorporation tell the state you are forming in what the name of your company is, the address and purpose of your company, how it will be managed and by who, and other various information. Once you file your articles and pay the required fee, you have officially formed your LLC.
Creating an LLC Operation Agreement
Although it is typically not required to have an Operating Agreement in place to form an LLC, it is very important to the smooth functioning of your business once it is formed. Operating Agreements lay out things like ownership stakes, divisions of power, financial arrangements, including how profits and liabilities are divided, meeting rules, and decision making processes, among other things. Putting an operating agreement together should be one of the very first tasks of the LLC, as it is much easier to make these decisions before anything starts than after problems begin to arise.
Managing your LLC Business
With your company now formally an LLC, there are state provisions to preserve your business’s status. You should maintain accounting reports and minutes of all significant decisions. To maintain your company you must retain employee records and have a registered agent assigned. These requirements vary from state to state but are important to keep track of and stay up to date on.
An LLC can be a perfect option for a small business. An LLC provides you with a range of possible options for taxation and management structure, among many other things.