Starting a business is an exciting prospect. If you’ve talked about forming a business, then maybe you’ve heard the advice, “You should form an LLC!” But what does that mean?
LLCs are a popular choice for new businesses for several reasons. In this guide, we’ll cover everything you need to know about LLCs. By the end, you’ll have a pretty good idea whether or not an LLC is right for you.
What it is:
LLC is short for “Limited Liability Company.” This incorporated entity type blends elements of a corporation with components of a proprietorship or partnership. For example, an LLC is treated as if it were an individual: the LLC can buy property, have a bank account, hire employees, and more. More importantly, the LLC provides personal asset protection. If your business falls into debt or legal trouble, your personal belongings cannot be taken as compensation—just the LLC’s assets.
The owners of an LLC are commonly called “members.” Each member may or may not have the same percentage of ownership in the business. In some cases, an LLC may be owned by a single member. Because an LLC combines personal asset protection with the possibility of having multiple business owners, it is a fairly popular choice for new businesses.
What it isn’t:
Even though LLCs can be owned by multiple people, you can’t simply “buy in” to become an owner of the business. This often happens with the shares of stock issued by a corporation. LLCs and corporations have much in common, but the LLC cannot issue stocks. Corporations can. As a result, the LLC cannot raise capital by selling stocks. External investments have to come from other sources.
The LLC also is not required to file the same paperwork as a corporation. This paperwork is one of the primary reasons that businesses choose an LLC over a corporation; corporations have to maintain detailed records, including bylaws, minutes from the board of directors’ meetings, minutes from the annual shareholder meetings, stock ledgers, and the list goes on. LLCs need to file annual reports and a few other items, but the paperwork burden is quite reduced.
How it’s formed:
In terms of incorporated entities, LLCs are arguably the easiest incorporated entity to form. Almost anyone can form an LLC in their state. To do so, the LLC’s organizer should file the Articles of Organization with the Secretary of State. The Articles of Organization serve to officially establish the business. (Note: the name of this document can vary from one state to another. The document is called the Articles of Organization most often).
The Articles of Organization usually require the following information:
- Proposed name for the LLC
- Names, addresses, and signatures of the LLC’s members (can be just one member)
- Name and address of your registered agent
- Mailing address for the business
- Whether the LLC will be managed by the members themselves or by managers (employees selected by the members to run the day-to-day business affairs)
- A signature of an authorized representative (usually the LLC’s organizer or a member)
For practical and financial purposes, the members of a newly-formed LLC should create an operating agreement. This agreement dictates how your business functions. (It’s similar to the concept of bylaws for a corporation). While you don’t have to file this document with the Secretary of State, you should write up an agreement. It can include elements such as what percentage of the business profits will pass to each member, what happens if a member wants to leave the business, how to add new members, and more.
You can take several different approaches to set up your operating agreement. Ideally, you can draft your own agreement with a little legal advice from an attorney. This approach guarantees that your agreement will best fit the unique needs of your business. However, you can also use a template from an online business formation service such as Incfile, LegalZoom, or Rocket Lawyer.
In fact, if you don’t have the time to file the formation documents yourself, you can hire one of these services to do the paperwork for you. This option would allow you to focus on advancing your business concept.more.
Why an LLC?
As we’ve mentioned, an LLC is relatively easy to form and maintain. The formation paperwork is relatively minimal, and your list of annual requirements is usually pretty short, too.
Escaping paperwork shouldn’t be your only motivation to form an LLC, however. There are a few other factors to consider. The primary advantage an LLC has over a sole proprietorship is personal asset protection. As a sole proprietorship, your business finances and personal finances are one and the same: yours. That’s why your car, house, and other assets can be taken as compensation if your business runs into trouble. As an LLC, though, you won’t run into that issue.
Another advantage of the LLC is that you can choose the taxation process that works best for you. The two options are taxation as a corporation or as a pass-through entity. As a pass-through entity, your business will not file its own tax return—just an annual report of your business activities. Your individual members will receive income from the LLC (how much each member gets is dictated by the operating agreement). Each member then reports that income on his or her individual tax return and pays the resulting taxes. As a result, the total amount of money that is paid as tax for the LLC’s profits is lower than it would be as a corporation.
If your LLC was taxed as a corporation, the LLC will pay taxes itself as an entity, using the corporate income taxes. Corporate tax rates are usually higher than personal income tax rates. That said, taxation as a corporation actually reduces the personal tax liability of each member. More money goes to the government, but it is paid by the entity, not the members.
Why not an LLC?
Overall, the LLC is a very favorable entity type. However, some states discourage the use of LLCs by charging extensive fees. For example, the fees for the Articles of Organization cost a whopping $500 in Massachusetts and $350 in Tennessee. And this does not include annual fees for business licenses or annual report fees. You should consult your Secretary of State’s LLC Fee Schedule to learn what fees apply in your state.
The LLC is a great choice for business start-ups due to its combination of flexibility and personal asset protection. However, it is not without its drawbacks. Thanks to this guide, you know what an LLC is. Now you’re fully informed and ready to make the right decision for your business type.