Limited liability companies (LLCs) are a popular choice for new businesses for several reasons, but they’re just one option when forming a business.
In this guide we'll show you what forming an LLC looks like and all the tips, tricks and things to consider before doing so.
Select your state to form an LLC on your own. If you'd rather hire a professional, use one of the recommended best LLC services.
What is an LLC?
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?
Below 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.
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.
Advantages of an LLC
1) Easy to form and maintain
LLCs are the easiest formal business type to create in America today, especially in comparison to a corporation.
With an LLC, the basic formation requirement is simply to prepare and file your articles of organization with your state government, whereas other entity types have more legal hoops to go through.
Similarly, LLCs do not have as many maintenance requirements. In general, an LLC needs to file an annual report and any fees required by the state, and in some states there’s also a franchise tax payment as part of the maintenance process. In terms of ongoing compliance issues, these are fairly simple requirements.
2) Fewer formalities and paperwork
Corporations are legally required to maintain a heap of paperwork, including bylaws, minutes from shareholder meetings, minutes from director meetings, business ledgers, and much more.
The formalities required are often considered to be a hassle, and that’s without even mentioning the incorporation process itself, which requires far more time and effort than forming an LLC.
Luckily, LLCs do not have to worry about these requirements. An LLC does need to maintain some business records, but not to the same extent. Any meetings are held at the discretion of the members, whereas corporations must have meetings for both shareholders and the board of directors.
3) Personal asset protection
As a formal business entity, an LLC has what’s commonly referred to as a “corporate veil.” The veil establishes a line between your business finances and your personal finances.
This division is extremely important.
Here’s why: if the LLC runs into debt or legal trouble, someone has to pay up, but thanks to the corporate veil, the LLC itself will pay these costs. If your company’s finances are insufficient, your personal funds and assets cannot be taken to make up the difference.
For example, let’s say that you run a bicycle repair shop. You complete a standard tune-up for a client, but the cyclist wrecks because a part you replaced came loose. The client, who broke several bones in the fall, sues for damages. Your small repair shop lacks sufficient funds to pay for the settlement.
In this situation, if you are a sole proprietorship, you would be ordered to pay these expenses from your personal assets ― your car, house, and more would be at risk.
As an LLC, you would not encounter this problem. Hopefully, debts and lawsuits will be a rare occurrence in your business ventures, but when something does happen, the corporate veil will help protect you.
4) Flexible membership structures
Corporations operate under rigid structural formalities that can be a hassle to comply with. While the LLC has the freedom to choose managerial structures, corporations must comply with strict requirements, with a board of directors, appointed officers, and shareholders all filling distinct roles.
There are further restrictions on S corporations as well. Unlike an S corporation, an LLC or C corporation can have a single member, a dozen members, a hundred members — there is no restriction on the number of members an LLC or C corporation can have.
Similarly, your members can be foreign investors, not just U.S. citizens. With an S corporation, you cannot have any non-resident alien owners, and you can’t have more than 100 members either.
5) Tax flexibility
LLCs may choose to be taxed as a corporation or a pass-through entity. This flexibility is uncommon for businesses, and it allows the LLC’s members to pick the tax approach that most benefits them.
LLCs usually elect the default option, which is to be taxed as a pass-through entity. With this tax approach, the LLC itself does not pay taxes. Instead, the business income is passed through to the members of the LLC, who then report that income on their personal tax returns.
LLCs taxed as corporations work in the opposite way ― the LLC pays taxes itself. This approach requires the entity to pay the corporate income tax, and is typically only preferable if the LLC’s owners are high-income individuals for whom the corporate tax rate would be lower than their individual tax brackets.
Disadvantages of an LLC
1) Trickier to raise funds through investments
LLCs are allowed to raise capital through outside investments, but corporations are far more appealing to most investors.
First off, LLCs cannot issue stock, and shares of stock from a corporation are a preferred form of investment for nearly all private investors. Furthermore, venture capitalists almost never invest in LLCs, because the pass-through entity type is highly disadvantageous for VC investors.
2) Self-employment taxes
While taxation is typically an advantage for LLCs, it’s a disadvantage in the realm of self-employment taxes.
This is because all LLC owners are considered to be self-employed individuals, which means they’re subject to the 15.3% self-employment tax rate, a rate that includes both the employer and employee portions of Medicare and Social Security. By contrast, corporation owners are not legally viewed as self-employed people, and are therefore exempt from paying this tax.
3) Legalities vary from state to state
One downside of the LLC is the way each state is allowed to create its own guidelines for how they should be formed and maintained. Therefore, it can be difficult to figure out exactly what’s expected from your LLC, especially if your business operates in multiple states.
In addition, the LLC was introduced to the American business landscape fairly recently, so there can also be some inconsistency and confusion regarding how courts in different states handle lawsuits involving LLCs, because there’s a lack of precedent in some states.
4) More hassle than operating an informal business
While the LLC has an advantage over corporations in this area, it still requires more time, effort, and money to form and maintain than a general partnership or sole proprietorship.
With these informal business structures, there’s no formation process, no maintenance requirements, and no fees to pay. Of course, sole proprietorships and general partnerships have some significant disadvantages (like no personal asset protection), but the LLC is certainly more of a hassle to form and operate.
The limited liability company (LLC) is such a popular business entity type for a reason, as it combines some of the corporation’s advantages with those of informal businesses like general partnerships.
The result is a fluid and flexible business structure that still maintains its professionalism and legitimacy.
Still, the point we would like to drive home is that the LLC is not for everyone. While it does have several significant advantages over the corporation (as well as over informal entities), there are also some disadvantages that could apply depending on your exact situation.
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