If you’re starting a business or are already a small business owner, you may be wondering which type of business structure will help you achieve success. You have likely had to adapt to changes as your business has grown and are ready to take the next steps. With so many different kinds of business entities out there with different benefits, it can be hard to determine if you need an LLC. Business owners usually form LLCs to reduce their financial risk and to keep their taxes simple.
The LLC is a relatively new business type, as the first LLC formed in 1977 as a hybrid between a corporation and a partnership. As a middle ground between these two entities, LLCs incorporate the benefits of both business types to serve a growing need among companies that are larger than one to two people, but not as big as corporations.
There are many things to consider when deciding whether or not you should form an LLC, including the costs associated with forming your business, and where you see your business headed. Keep reading for a comprehensive break down of the pros and cons of LLCs and other options out there, or jump to our infographic to quickly determine if you need an LLC for your business.
What Is an LLC?
A limited liability company is a legal category of business that combines some of the tax benefits of sole proprietorships and partnerships with the reduced liability of corporations. They allow their owner or owners to choose to have the income of the entity reported with the income of the owners on their personal taxes. This is known as pass-through taxation because the profits are passing through to the owners. While personal income tax rates are higher, this structure has the benefit of allowing losses to be written off on your personal taxes, possibly saving you money. In addition, the financial liability for owners of LLCs is limited to the business itself. If the business were to be sued for an amount owed on a debt, only the assets of the business itself could be seized, and the business owner would not need to declare bankruptcy.
The Benefits of 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 some of the main benefits of structuring your business as an LLC:
Limited Liability Companies 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, shareholders and owners in a limited liability company are not on the line if the company were to go into debt.
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 annual shareholder meetings. If you find yourself busy and don’t plan on hiring additional employees to help with paperwork any time soon, you may find this attribute incredibly useful.
Avoid “Double Taxation”
LLCs do not have a set classification in the way that they are taxed. Based on whether there is one owner or a partnership, you can decide to be taxed as a sole proprietorship, an S corporation, or a corporation. Double taxation means that revenue is first taxed on a company, and then what the owner makes from the business is also taxed. LLCs allow the business’s income and expenses to “pass-through” to the owner’s personal income report, meaning that the profits of the business are only taxed once.
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 one small perk.
Unlike entities like S corporations, LLCs can have over 100 shareholders, can include foreign shareholders, and can have owners that are corporations. If any of these situations apply to your business, an LLC is probably a good option for you to consider.
The Disadvantages of an LLC
There are certain downsides to forming an LLC including complications due to the requirement for LLCs to distribute its profits to all owners. Depending on whether you still need investors or plan on going public someday, there are several potential disadvantages to consider:
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. LLCs taxed as partnerships and following the traditional path of granting multiple rounds of equity to employees will experience more complicated and expensive processes than S or C corporations.
Investors Often Prefer C Corporations
Due to the special tax advantages for LLC owners, investors face additional taxation and filing requirements when they invest in LLCs. For investors, 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. It can be hard or impossible for investors to sell their shares in an LLC.
Finally, raising additional capital from investors requires drawing up more complicated agreements. Many investors are much less likely to contribute because governing contracts of LLCs can vary more widely than in C corporations, which require less effort to assess before investing.
New Bank Accounts Need to Be Set Up
Unless you are the sole owner with no employees and you work from home, your business becomes a separate entity, it will need a new EIN or Electronic Identification Number. This is what the IRS uses to calculate taxes. With a new business EIN you’ll need to set up new bank accounts to keep track of 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 its bank, the account cannot be used for anything unscrupulous.
While the structure of an LLC allows for pass-through taxation, this means that all income will be taxed at the higher rate of personal income tax. In addition, members must pay taxes on their share of the company, even if they are never distributed to them in the form of dividends. LLCs also aren’t exempt from property taxes like corporations, and LLC owners must pay the full amount of self-employment taxes themselves.
How to Set up 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:
1. Choose a Name
Depending on the state you live in there are varying requirements for your LLC’s name. Often across all states, the name must include “limited liability company” or “LLC” somewhere in the title. In addition, the name cannot be easily confused with a government organization or an LLC that is already registered with the state.
2. File Articles of Organization
Where you submit your LLC’s name and location will depend on the state, but commonly you will file with the secretary of state’s office. You will need to include a statement of the LLC’s purpose, guidelines for management, and the duration of the LLC. The purpose and duration are usually allowed to be very broad in nature, so you don’t even need to list what type of business you are.
3. Create an LLC Operating Agreement
Though these are not often required by state law, operating agreements are essential as they govern 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.
4. Obtain Permits
Once your LLC is official, there is still one more step before you can open your doors. You’ll need to obtain necessary permits including a business license, a federal employer identification number for tax purposes, and a seller’s permit. In some cases, you may also need to get a zoning permit.
5. Maintain Your LLC
Now that your business is officially an LLC, there are requirements in place by the state to keep your company a separate entity. 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.
Other Types of Entities to Consider
You’re likely wondering how an LLC differs from a corporation or the benefits of an LLC versus a sole proprietorship. Here’s a quick overview of the different types of entities that a business may form. Think through all your options and plans for the future of your business before committing to a structure.
Sole proprietorships cost nothing to start and are the simplest form of small businesses because they don’t have to register with the state. This is usually the best option when an owner only works on their business part-time and has no employees. With sole proprietorships, the company is not a separate entity and the owner has little to no liability protections.
Partnerships require at least two owners and generally offer no liability protection. However, limited partnerships (LLP), do offer similar liability benefits to LLCs, but the LLC provides more protection to the individual owners. Partnerships are slightly cheaper than LLCs and limit the input of investor-owners.
S corporations refer to “small business corporations” that elect to be a pass-through entity. Owners in S corps are also employees who must receive a reasonable salary and receive liability protection. While they can be very similar to LLCs, the difference is that S corporations cannot have more than 100 shareholders, foreign owners, or owners that are companies.
C corporations are standard corporations and can be more expensive to own and operate than other business structures. As with LLCs, they are separate entities that provide limited liability for owners. Corporations can go public, easily offer equity to investors, and obtain financing via venture capitalists. However, they require more structure, boards, and meetings, and do not receive pass-through tax benefits.
Take a look at this simple chart that highlights the differences between these structures:
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