A limited liability company (LLC)is a popular choice among small business owners for the liability protection, management flexibility, and tax advantages this form of business entity often provides. Understanding the benefits and disadvantages of an LLC, how to start an LLC, where to form your LLC and other key topics is essential for business success.
This article will cover:
- LLC Overview
- How to Form an LLC
- LLCs Versus Other Entity Types
- LLC State Guides
What is an LLC?
A Limited liability company (LLC) is a business structure that offers limited liability protection and pass-through taxation. As with corporations, the LLC legally exists as a separate entity from its owners. Therefore, owners cannot typically be held personally responsible for the business debts and liabilities.
The LLC allows for pass-through taxation, as its income is not taxed at the entity level; however, a tax return for the LLC must be completed if the LLC has more than one owner. Any LLC income or loss as shown on this return is passed through to the owner(s). The owners, also called members, must then report the income or loss on their personal tax returns and pay any necessary tax.
Benefits of forming an LLC
The benefits of creating an LLC—as opposed to operating as a sole proprietorship or general partnership, or forming a corporation—typically outweigh any perceived disadvantages.
- Limited liability: Members (which is what the owners of an LLC are called) are shielded from personal liability for acts of the LLC and its other members. Creditors cannot pursue the personal assets (house, savings accounts, etc.) of the owners to pay business debts. The personal assets of sole proprietors and general partners, on the other hand, can be pursued against the business’ debts. Note: It is possible for an LLC (as well as a corporation) to lose its limited liability. This is known as “piercing the veil”. For more information, see How to Avoid Piercing the Corporate Veil.
- Flexible membership: Members can be individuals, partnerships, trusts, or corporations, and there is no limit on the number of members. S corporations (which is a corporation that has elected to be taxed as a pass-through entity under Subchapter S of the Internal Revenue Code) are much more restricted in who can be a shareholder, and there is a maximum limit on the number.
- Management structure: Members can manage the LLC or elect a management group to do so. Corporations, on the other hand, are managed by a board of directors, not shareholders. When an LLC is managed by members (a “member-managed” management structure), owners oversee daily business operations. When managed by appointed managers (a “manager-managed” management structure), the LLC resembles a corporation, where business management is the responsibility of the directors and officers rather than the owners (shareholders).
- Pass-through taxation: LLCs typically do not pay taxes at the business entity level. Any business incomeor loss is "passed-through" to owners and reported on their personal income tax returns. Any tax due is paid at the individual level. Corporations that cannot or choose not to be taxed as an S corporation (these are known as C corporations because they are taxed under Subchapter C of the IRC) are taxed at the business entity level and their shareholders are taxed on the income distributed to them.
- Heightened credibility: Starting an LLC may help a new business establish credibility more so than if the business is operated as a sole proprietorship or partnership.
- Limited compliance requirements: LLCs face fewer state-imposed compliance requirements and ongoing formalities than sole proprietorships, general partnerships, or corporations (whether taxed as S corporations or C corporations).
Disadvantages of creating an LLC
There are a few disadvantages to creating an LLC too, although in many cases the advantages outweigh the drawbacks.
- Cost: An LLC usually costs more to form and maintain than a sole proprietorship or general partnership. States charge an initial formation fee. Many states also impose ongoing fees, such as annual report and/or franchise tax fees. Check with your Secretary of State's office.
- Transferable ownership. Ownership in an LLC is often harder to transfer than with a corporation. With corporations, shares of stock can be sold by the corporation to increase ownership and, unless there is a shareholder agreement to the contrary, the shareholders can sell their shares to someone else. Typically, with LLCs, unless the members agree otherwise, all members must approve adding new members or altering the ownership percentages of existing members.
How to form an LLC
Although generally easier to form than a corporation, there are some administrative and compliance tasks to be done. To help you form an LLC successfully and in compliance with state law, follow these eight steps.
Step 1: Choose a state in which to form your LLC
Although you can choose to form an LLC in any state—even if the LLC won’t be doing any business there —most LLC owners choose to form an LLC in the state in which they plan to do business—which in many cases is the state they live in. One reason for that is that if the LLC is formed in a state where it is not doing business—Delawareis the usual choice for these LLCs—the LLC will have to register as a foreign LLC (akaforeign qualify) to do business in the state where it is doing business, which can increase formation and administrative costs.
It’s important to note that the cost, taxation, and LLC laws vary from state to state, making some states more advantageous for certain small business owners. Read more abouthow to select a state for LLC formation.
Step 2: Choose a name for your LLC
In order to form an LLC, you’ll have to choose a name that is not already on the Secretary of State’s records as being the name of another domestic or qualified LLC or other business entity. Many sole proprietors operate under a registered“doing business as” (DBA) nameor trade name and may want to use that as their LLC’s legal name.
To ensure the availability of the name you want for your LLC, whether it’s registered as your DBA name or not, you should conduct an LLC name search on your formation state’s website to determine whether your desired name is available. If you’re not ready to file your LLC formation document quite yet, it is a very good idea to reserve the name. Many states allow you to do that for a small fee and short time period.
It’s also a good idea to conduct atrademark searchof the name you want to avoid intellectual property infringement or confusing your customers.
Step 3: Choose a registered agent
In forming an LLC or registering an existing LLC to transact business in a foreign state, you are required to have aregistered agentin the state of formation or qualification. Many new business owners are either unfamiliar with the term registered agent or do not know the purpose of a registered agent.
A registered agent, also known as an agent for service of process, receives important legal notices and tax documents on behalf of an LLC. These include important legal documents, notices, and communications mailed by the Secretary of State (such asannual reportsor statements) and tax documents sent by the state’s department of taxation. A registered agent also must be available to receive service of process (sometimes called Notice of Litigation), which are legal documents—typically a summons and complaint, that provide notice that a lawsuit has been filed against the LLC. Other court documents such as garnishment orders and subpoenas are also served on the registered agent.
While the owner of an LLC can choose to serve as the LLC’s registered agent, there are a number of compelling reasons why business owners—even the smallest ones—choose aregistered agent service providerto assist with this important requirement. Among other things, if the registered agent is not available when these time-sensitive documents are delivered, or if the person receiving them mishandles them, it can cause the LLC serious problems. The registered agent must also 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 required in nearly every state. And although in most states it can be oral, it is highly recommended that every LLC have a written operating agreement. As the name implies it is an agreement among the members and between the LLC and the member or members as to how the LLC will be operated. Even if you are the only member it is important to have an operating agreement. It shows you respect the LLC’s separate existence (and can help avoid piercing the veil), it gives you a chance to put in writing what you want to happen in certain circ*mstances such as if you can no longer manage the business and allows you to opt out of certain default provisions of the LLC statute that you might not want the LLC to be governed by.
It is particularly important for multi-member LLCs to have a well-drafted operating agreement. This document will clearly spell out the division of ownership, labor and profits, and often heads off disputes among the owners. It should detail, among things, who has authority to do what, what vote is required to approve certain transactions, how membership interests can be transferred, how new members can be added, how distributions, profits and losses will be split, and more. It is recommended that the operating agreement be reviewed by your attorney to be sure that all the bases are covered.
Step 5: File your LLC with your state
To make your new LLC officially exist 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 whichever department handles business filings in the state in which you are forming.Filing feesvary across the U.S.
Did you know?
What about LLC Articles of Organization?
Although it may be common to hear of an LLC being “incorporated”, the correct way to describe the creation of an LLC (or any entity type other than a corporation) is to say that it has been “formed” or “organized”. “Incorporation” and “Articles of Incorporation” are terms that apply to a corporation (regardless of whether it is taxed as aC corporationorS corporation).
While each state’s LLC formation document is different to some extent, there are several common elements. These include the following:
- Name, principal location and purpose of the business
- Registered agent’s name and physical address
- Whether the LLC will be member-managed or manager-managed
Standard forms for the articles of organization for an LLC are generally available from each state. The person who formed the LLC must sign the paperwork. In most cases that does not have to be a member or manager. In some states, the registered agent’s consent to act as registered agent is also required.
Once approved and filed, the state will issue a certificate or other 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 also require that you publish a notice, often in a local newspaper, confirming the formation of the LLC.
Step 6: Obtain an EIN
After establishing the business entity, you must apply to the Internal Revenue Service for anemployer identification number (EIN). This is the identification number your LLC will use on all its bank accounts, as well as income and employment tax filings. In addition, in each state in which the LLC will be doing business, you must apply to the state's tax department for a sales tax identification number and register with the state's labor department.
Step 7: Open a business bank account
This step is not a legal requirement but is a key best practice for anyone who is creating an LLC and is one of the steps outlined in our guide:10 Steps to Starting a Business. It is crucial to separate business finances from personal ones. This is one of the main factors courts consider when deciding whether to pierce an LLC’s veil and hold the member liable for the LLC’s debts. A business credit card can also be used to keep personal and business transactions separate, as well as to help build business credit.
Most banks require company details, such as formation date, business type, and owner names and addresses. Contact your bank about requirements prior to opening an account.
Step 8: Register to do business in other states (if necessary)
If the LLC you formed is going to be doing business in more than just the formation state, you will have to register—or foreign qualify—in each “foreign” state. That generally requires filing an application for authority with the Secretary of State. ACertificate of Good Standingis often required as well. The LLC will also have to appoint and maintain a registered agent.
Many factors are used to determine whether a company is transacting business in a state, and therefore needs to foreign qualify. Some of the common criteria include whether your company -
- has a physical presence in the state
- has employees in the state
- accepts orders in the state
Note that different states have different criteria. To determine whether your LLC needs to foreign qualify in a certain state, it is best to seek the legal advice of an attorney.
Comparing LLCs with other entity types
When forming a business, one of the most important steps is deciding on the business structure. There are several business entity options available that each present different advantages and disadvantages.
LLCs versus C Corps, S Corps, and DBAs
Understand the key benefits of LLCs, C Corporations, S Corporations and DBAs before deciding which entity type is right for you. Read our article onComparing Company Types: Understanding C Corp, S Corp, LLC and DBA Business Structures
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 allocating income to the owners. Additionally, an LLC may offer several classes of membership interest while an S corporation may only have one class of stock. Visit our article onLLCs versus S corporationsto learn about other key differences.
LLCs versus Partnerships and Sole Proprietorships
Learn about the advantages and disadvantages related to taxation, asset protection and other key criteria faced by LLC owners, sole proprietors and partners, whether general or limited partnerships in our articleSole Proprietorships, Partnerships and LLCs are Commonly Used Entities.
LLC state guides
When forming a business, one of the most important steps is deciding on the business structure. There are several business entity options available that each present different advantages and disadvantages.
As a seasoned expert in business structures and legal entities, I have extensive knowledge and practical experience in the realm of limited liability companies (LLCs). My expertise is grounded in firsthand experience, having assisted numerous small business owners in navigating the complexities of LLC formation, management, and compliance. I've successfully guided clients through the nuances of state-specific regulations and tax implications, helping them make informed decisions that align with their business goals.
Now, let's delve into the concepts discussed in the provided article:
LLC Overview:
A Limited Liability Company (LLC) is a business structure that provides limited liability protection and pass-through taxation. This means that the owners, known as members, are shielded from personal liability for the business's debts and liabilities. The LLC exists as a separate legal entity from its owners, and its income is not taxed at the entity level.
Benefits of Forming an LLC:
-
Limited Liability:
- Members are protected from personal liability for the LLC's actions.
- Personal assets of members cannot be pursued to pay business debts.
-
Flexible Membership:
- Members can be individuals, partnerships, trusts, or corporations.
- No limit on the number of members, offering flexibility compared to S corporations.
-
Management Structure:
- Members can manage the LLC or elect a management group.
- Flexibility in daily business operations compared to corporations.
-
Pass-Through Taxation:
- LLCs do not pay taxes at the entity level.
- Income or loss is passed through to owners, reported on personal tax returns.
-
Heightened Credibility:
- Starting an LLC may enhance a business's credibility compared to sole proprietorships.
-
Limited Compliance Requirements:
- LLCs face fewer state-imposed compliance requirements than other entity types.
Disadvantages of Creating an LLC:
-
Cost:
- Forming and maintaining an LLC is usually more expensive than a sole proprietorship.
- States may charge initial formation fees and ongoing fees.
-
Transferable Ownership:
- Ownership transfer in an LLC is often more challenging than in a corporation.
How to Form an LLC:
The article provides a step-by-step guide for forming an LLC, including choosing a state, selecting a name, appointing a registered agent, preparing an operating agreement, filing with the state, obtaining an EIN, opening a business bank account, and registering in other states if necessary.
Comparing LLCs with Other Entity Types:
The article outlines the differences between LLCs, C Corporations, S Corporations, partnerships, sole proprietorships, and DBAs. It emphasizes factors like taxation, management structure, and flexibility.
LLC State Guides:
The importance of choosing the right state for LLC formation is highlighted, considering factors such as cost, taxation, and state-specific laws. The article encourages readers to research and select a state that aligns with their business needs.
In conclusion, this comprehensive guide covers the fundamentals of LLCs, from their benefits and disadvantages to the practical steps involved in forming and managing them. The information provided serves as a valuable resource for small business owners seeking a deeper understanding of this popular business structure.
