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What Is a Limited Liability Company (LLC) and How to Form One

Priyanka Prakash, JD
Updated on May 25, 2020
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What Is an LLC?

A limited liability company (LLC) is a business entity structure in which owners aren’t personally liable for the business’s debts and obligations. LLCs are treated by default as pass-through entities for tax purposes. This means the LLC itself doesn’t pay income taxes, but the profits and losses of the LLC pass through to the owners’ tax returns. An LLC can choose to be taxed as a corporation.

The LLC, or limited liability company, is a relatively new business entity type and is somewhat of a hybrid between a corporation and a partnership. LLCs are considered a legal entity that’s separate from the owner or owners, meaning you aren’t personally liable for any legal or financial issues your business may run into.

There are many things to consider when deciding whether or not you should form an LLC, including the costs of formation and where you see your business headed. Keep reading for a comprehensive breakdown of the pros and cons of LLCs, how to form one, and more.

In this article:

Benefits of Forming an LLC

There are many things that you will need to consider when deciding whether or not to form an LLC, including your business’s needs and your plans for the future.

Here are the main benefits of forming an LLC:

Reduce Liability

LLCs create a level of separation between owners and their business. This means that if their company were to be sued, the owner would not be personally sued, only the business. In addition, the personal assets of owners in a limited liability company are not on the line if the company were to go into debt. Of course, there are exceptions where a court will pierce the veil and hold owners personally liable, but as long as the business maintains independence from the owners’ finances, you should be safe.

Less Complex Than Corporations

A reason that LLCs are often favored for smaller individually run businesses is that they require less paperwork to establish and operate. In contrast to corporations, LLCs need less record-keeping and do not require shareholder or director meetings in the same way that C-corporations or S-corporations do. If you find yourself busy and don’t plan on hiring additional staff to help with paperwork any time soon, you might find this attribute incredibly useful. That said, LLCs do require more paperwork than a sole proprietorship or general partnership.

Avoid “Double Taxation”

By default, LLCs are taxed as pass-through entities. This means that the LLC itself doesn’t pay taxes. Instead, the business’s income and expenses are reported on each owner’s personal income tax return. LLCs can choose to be taxed as a C-corp or S-corp. If you opt to be taxed as a C-corporation, then your business earnings could be subject to double taxation. The company first pays taxes on profits, and any dividends that owners receive are taxed at their personal income tax rate.

Make Your Business Official

Once you file to become a limited liability company, you’ll legally have “LLC” in the title of your business, on checks, or on invoices. This title demonstrates a level of organization and professionalism to potential customers and clients. While this isn’t a good enough reason in itself to start an LLC, it is a perk.

Ownership Flexibility

Most states don’t place restrictions on LLC management and ownership. The day-to-day decisions of an LLC can be entrusted to the members, or the LLC can be manager-managed. The members can elect one of their own to be the manager, or they can elect a professional manager from outside the organization. Unlike S-corporations, there’s no limit on the number of LLC owners. LLC owners can include individuals, domestic entities, foreigners, and foreign entities. If any of these situations apply to your business, an LLC is probably a good option for you to consider.

The Disadvantages of Forming an LLC

There are certain downsides to forming an LLC, including complications due to the requirement for LLCs to distribute profits to all owners. Plus, if you need investors or plan on going public someday, there are several potential disadvantages to consider.

Here are the disadvantages of forming an LLC:

Equity Compensation Is More Difficult

Many businesses choose to offer incentives to employees in the form of equity, which is the value of a company in shares. It’s possible for LLCs to grant profits interest, which is a right to a portion of the LLC’s future profits and appreciation in value. However, LLCs cannot grant stock options or give employees actual shares in the company. This could be a disadvantage if you have a startup and are trying to recruit talent.

Investors Often Prefer C-Corporations

C-corporations are more attractive investment opportunities because they can offer stocks that do not require the holder to pay taxes until the asset is sold. As an LLC, raising capital from investors requires drawing up more complicated agreements. Many investors are much less likely to contribute because the governing contracts of LLCs can vary more widely than C-corporations, which require less effort to assess before investing.

Some Paperwork Is Required

LLCs with multiple owners, or that are taxed as corporations will need a new employer identification number (EIN) to file federal taxes. You’ll also need to set up new business bank accounts to keep track of business income and expenses for tax purposes. While this isn’t very hard, having multiple accounts can pose a difficulty when you’re used to only having your personal bank account to manage. And once your business has a bank account, it shouldn’t be used for personal deposits or withdrawals.

Tax Disadvantages

While the structure of an LLC allows for pass-through taxation, this means that all income will be taxed at the owner’s personal income tax rates. Under current tax law, pass-through entities can claim a 20% business tax deduction, which can lower your tax bill. However, you might still end up paying less if you organize your company as a C-corp.

In addition, members must pay taxes on their share of LLC earnings, even if they are never distributed to them. LLCs also aren’t exempt from property taxes like corporations, and LLC owners must pay the full amount of self-employment taxes themselves. Corporations can save on self-employment taxes by distributing dividends, which are exempt from self-employment taxes.

Do I Need an LLC?

Based on the above advantages and disadvantages, you likely have a good idea of whether you should form an LLC for your business. To recap, an LLC may be right for your business if you’re looking to protect your personal assets, you want the option to be taxed as a corporation or a pass-through entity, and you want a flexible ownership structure and easily maintained business entity.

However, if you plan on raising capital for your small business through investors, you will likely not want to become an LLC, as this is not a favorable entity for investors. In this case, you’d likely want to opt for a corporation.

On the other hand, if you have a very small operation that’s in its early stages and is more like a side gig, you may want to hold off on forming an LLC and function as a sole proprietorship or general partnership.

It’s also worth mentioning that many states recognize a special type of LLC for professional industries, such as doctors and lawyers. This special type of LLC is called a professional limited liability company (PLLC). In several states, the rules for PLLC formation vary from the regular LLC formation process.

When deciding which business entity is best for you, it’s always a good idea to consult a business attorney or tax professional to make sure you understand how your entity will affect your business and finances.

How to Form an LLC

Forming an LLC requires filling out some paperwork and paying some fees, but it is a relatively straightforward process that should be easy with the help of your lawyer and knowledge of your state’s individual requirements.

Here are the steps you need to take to form an LLC:

1. Choose a Name for Your LLC

Depending on the state where you live, there are varying requirements for your LLC’s name. Often across all states, the name must include “limited liability company,” “LLC,” or “L.L.C.” somewhere in the title. In addition, the name cannot be easily confused with a corporation or an LLC that is already registered with the state. Certain terms, such as “insurance” or “bank,” can’t be used in your business name unless you’re licensed to operate in that industry.

2. Designate a Registered Agent

A registered agent is an individual or company that accepts legal mail on your business’s behalf and forwards the documents to you. LLCs in all states must designate a registered agent, sometimes also called a statutory agent. If an individual serves as your registered agent, they must be at least 18 years old and a resident of the state that you’re operating in. Alternatively, you can choose a registered agent service such as IncFile.

3. Obtain Business Permits

The next step is to obtain permits that your company needs to operate. States and local governments issue business licenses to companies in a range of industries. Companies that sell tangible goods or taxable services need to register for a seller’s permit and collect and report sales taxes. In some cases, you might also need to get a zoning permit.

4. File Articles of Organization

Filing your articles of organization with your Secretary of State’s office makes it official. The articles contain your business name and address, statement of the LLC’s purpose, guidelines for management, and the duration of the LLC. After the state accepts your articles of organization, you are ready to start operating.

5. Create an LLC Operating Agreement

Though it’s not often required by state law, an LLC operating agreement is essential as it governs the role of members and how the company will function. Typically, this is where members’ percentage stake in the company, responsibilities, and voting power are listed. This agreement also includes how the LLC will be managed, rules for meetings, and how profits will be allocated.

6. Maintain Your LLC

Now that your business is officially an LLC, there are requirements in place by the state to keep your company in good standing. You will need to keep financial records and minutes of any major decisions. To ensure your business is not dissolved, you’ll need to keep records of employees, appoint a registered agent who can receive legal notices, and file taxes.

State Guides to Forming an LLC

The process of forming an LLC is slightly different in every state. Review our state guides to LLC formation to learn more details about your state’s requirements:

The Bottom Line

An LLC can be an excellent choice of business structure for small businesses. You enjoy a mix of tax flexibility, operational choice, and minimum compliance requirements. For help forming an LLC, we suggest an online legal service like IncFile. IncFile will help you file your articles of organization and create an LLC operating agreement. They will also include one year of free registered agent service.

For a summary of what we’ve covered, and to quickly determine whether you should form an LLC, check out our infographic below:

Sources:
MoneyUnder30 | LegalZoom | GetButtonedUp | Nolo | FreelancersUnion | Entrepreneur | Timbertax | JohnCunningham | Entrepreneur | FreelancersUnion | NerdWallet | StartupLawBlog | NSBA | LegalZoom | BusinessTown | TheBalance | USAToday | BloomLawfirm | LegalZoom | BizFilings | QuickSprout | LLCUniversity | Nolo

Senior Contributing Writer at Fundera

Priyanka Prakash, JD

Priyanka Prakash is a senior contributing writer at Fundera, specializing in small business finance, credit, law, and insurance. She has a law degree from the University of Washington and a bachelor's degree from U.C. Berkeley in communications and political science. Priyanka's work has been featured in Inc., Fast Company, CNBC, and other top publications. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup. Email: priyanka@fundera.com.
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