Starting a business is an exciting prospect. If you’ve talked about forming a business with friends or family, then maybe you’ve heard the following advice: “You should form an LLC!” But what does that mean?
Limited liability companies (LLCs) are a popular choice for new businesses for several reasons, but they’re just one option when forming a business. Is the LLC the best structure for your company, or would you be better served by a sole proprietorship, general partnership, corporation, etc.?
In this guide, we’ll cover everything you need to know about LLCs. By the end, you’ll have a clearer idea of whether or not an LLC is right for you.
Rocket Tip: If you decide forming an LLC is the right route for you, see our review of the best and most affordable LLC formation services. Compare the top 3 options (ZenBusiness vs Incfile vs Northwest) to see how they stack up.
What It Is:
The LLC is a formal business entity type that blends elements of a corporation with components of a sole proprietorship or general partnership.
For example, an LLC has corporate personhood, just like a corporation does: 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 — only the assets of the LLC itself are available to your creditors.
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 flexibility of having either one or multiple business owners, it is a 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 like you can with a corporation. While corporations can sell stock, 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, because 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 minimal by comparison.
How It’s Formed:
In terms of formal business entities, LLCs are arguably the easiest to form. To do so, the LLC’s organizer should file the articles of organization with the Secretary of State, as this document serves to officially establish the business.
The articles of organization usually require the following information:
- Proposed name for the LLC
- Names, addresses, and signatures of the LLC’s members
- Name and address of your registered agent
- Physical address for the business
- Management style (member-managed or manager-managed)
For practical and financial purposes, the members of a newly formed LLC should create an operating agreement, which dictates how your business functions.
While you don’t have to file this document with the Secretary of State, you should still write up an agreement to prevent disputes down the line. 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 ZenBusiness or Northwest Registered Agent.
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 more on advancing your business concept.
Why an LLC?
As we’ve mentioned, an LLC is relatively easy to form and maintain. The formation paperwork is minimal compared to corporations, and your list of annual compliance requirements is usually pretty short as well.
Escaping paperwork shouldn’t be your only motivation to form an LLC, however. The primary advantage an LLC has over a sole proprietorship or general partnership is personal asset protection.
As a sole proprietor or general partner, your business finances and personal finances are one and the same. 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 options include taxation as a corporation or as a pass-through entity. As a pass-through entity, your business will not file its own tax return — instead, you’ll just have to submit an informational report stating how much money your business earned or lost.
With this taxation model, your individual members will receive income from the LLC (how much each member gets is dictated by the operating agreement), and 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 typically lower than it would be as a corporation. The only issue is that your members will likely be required to pay self-employment tax, which is a 15.3% tax that combines the employer and employee portions of Medicare and Social Security.
If your LLC was taxed as a C corporation, the LLC would pay taxes itself as an entity, using the corporate income tax of 21%. With this form of taxation, your members would be subject to what’s commonly referred to as “double taxation,” because the profits are taxed once at the corporate level, then taxed again on the personal level after the company distributes the funds to the individual members. This taxation option is typically only advisable if your members are high-income individuals who can save money by avoiding high personal tax bracket rates.
Finally, you can also classify an LLC as an S corporation, which is basically a compromise between the two options we’ve discussed thus far. With S corp taxation, most elements of the pass-through model apply, with the only exception being that your owners can avoid self-employment tax due to the S corp model treating them as employees. However, there are many restrictions to S corp eligibility that make this option fairly rare.
The LLC is a great choice for a wide variety of business startups due to its combination of flexibility and personal asset protection. When it comes down to it, we think the LLC is the ideal structure for many different types of businesses.
Whether the LLC is the correct business structure for your specific company or not comes down to several important factors, including taxation, personal asset protection, company structure, and more.