If you’re an entrepreneur, you may be curious about which business structure you should choose for your new company. The organizational structure you choose can have a significant impact on things like taxes and liability protection.
One of the most popular business structures for small business owners is a limited liability company, otherwise known as an LLC. LLCs have been around for the past three decades or so, although they’ve recently grown more and more popular with entrepreneurs.
In this guide, we’ll answer all of your questions about, “What is an LLC?” We’ll detail the requirements for LLC formation and look into the various pros and cons of doing so. We hope that after reading this guide, you’ll have a better understanding of whether you should register your business entity as an LLC.
What is an LLC?
An LLC is a legal entity designed explicitly to protect business owners from any liabilities accumulated by the company. Liabilities are financial commitments that the business has made, but has yet to pay — think of things like debts and loans. An LLC protects an owner’s personal assets from any liabilities accrued by the company.
The personal liability protection that owners receive is similar to that offered by a corporation. Additionally, an LLC provides tax benefits to its owners. LLC owners can elect pass-through taxation, meaning that they can report business earnings on their personal tax returns.
Entrepreneurs will find that LLCs are cheaper to form than other types of businesses. Additionally, there are fewer requirements to do so. To be considered an LLC, you must:
- Choose a business name that’s not already listed with your Secretary of State’s office
- Create your Articles of Organization
- Choose a registered agent to handle all legal correspondences
- File with your Secretary of State’s office
- Pay the necessary filing fees
- Secure the required business licenses or permits
- Create an operating agreement
Filing as another type of entity, such as a corporation, could require you to draft Articles of Incorporation, write bylaws, and issue shares of stock. Corporations are also required to host annual meetings. LLCs tend to be appealing to new business owners because the owner can submit the paperwork and filing fees easily without having to meet as many regulatory requirements.
What is limited liability protection?
Businesses often take on liability and debt. When companies cannot pay this debt, creditors can seize assets. If you’re a business owner working without the protection of the “corporate veil,” or the metaphorical layer of protection surrounding the owner’s personal assets, you could be responsible for the liabilities incurred on behalf of your business.
Say, for instance, you promise to pay a vendor. However, your business stops making money, and you cannot do so. The vendor sues you for the money owed. Because you don’t have any corporate protections in place, creditors can come after things like your personal income, your car, and your home.
Limited liability protection shields LLC members from liabilities. If the business owner has registered as a single-member LLC, creditors can only come after business assets. The liability protection that LLC members receive is the same afforded to owners of a corporation. Owners won’t have to worry so much about losing their personal assets due to the business debts of the company.
Within an LLC, there are multiple types of management structures that you can choose from. The type that you choose depends on how you will run your business.
The LLC owners make up the membership of the company. Each member has a vote when it comes to making business decisions. Everyone’s vote counts equally and must be considered when making changes to company management or operations.
In this type of LLC, the LLC members are not in control of the day-to-day business operations. Instead, LLC owners elect managers to run the company. The owners are in charge of filling management positions. Those in management positions are then responsible for handling business activities. Owners take a much more hands-off role.
A single-member LLC exists when there is only one person associated with the company. Filing as a single-member LLC is advantageous because of the liability protection the owner receives. If an individual were to form a sole proprietorship instead of a single-member LLC, he or she would be responsible for the business’s debts and liabilities.
Taxes for an LLC
The tax benefits that owners receive when forming an LLC are quite notable. Depending on how the LLC elects to file its taxes, owners can save themselves considerable money by selecting the LLC business structure.
LLCs are an attractive option because owners receive pass-through taxation. With pass-through taxation, owners include business profits on their federal and state income tax statements. Say there are three owners of an LLC that has taxable income of $30,000. Each owner would pass through $10,000 to their personal tax returns.
LLCs are pass-through entities by default. However, if LLC owners would like, they can elect to be taxed as a C Corporation, although this is very rare. Were they to opt for this, cash dividends would be subject to double taxation. Cash dividends are taxed once as profit at the corporate level and then again as a payout at the personal level.
The tax structures that provide LLC owners with pass-through taxation include sole proprietorships, partnerships, and S corporations.
Pros and cons of forming an LLC
Now that you have a better idea of what an LLC is, let’s take a more in-depth look at some of the pros and cons of this business structure.
There are many positives that help set an LLC apart from other organizational structures. Here’s a look at each one.
Without a doubt, one of the most significant benefits of forming an LLC is pass-through taxation. Business owners won’t have to worry about having their earnings and losses taxed at the corporate tax rate. Instead, LLC owners merely “pass the income through” to their personal tax returns, and then pay one tax at the individual level. The ability to pass income through to personal returns can be useful for tax purposes.
No restrictions on membership
There are membership restrictions that come with other types of business entities. For instance, if your business registers a sole proprietorship, you can exist only as yourself. If you register as a partnership, you can exist only with one other person.
Owners see these restrictions even more with S Corporations. S Corporations are not a business type. Instead, an S Corp is an electable tax status. So, for instance, a company could set up its business structure as a C Corp and then elect S Corp taxation, which means that its owners could pass income through to their personal returns.
However, the IRS has strict laws in place regarding S Corp shareholders. Shareholders make up the group’s membership and technically “own” the company. There can be no more than 100 shareholders in place. Shareholders must only be pre-qualified trusts, estates, or individuals. Furthermore, non-resident aliens are not permitted to be shareholders.
New business owners won’t encounter this problem when forming an LLC in their state. That’s because there are no restrictions on the number of members or owners that can exist in an LLC. There are also no restrictions on the types of members that can exist.
Limited liability protection
LLCs are also an attractive option because of the limited liability protection they offer. Upon registering as an LLC, owners immediately provide themselves with a “corporate veil” that is hard to pierce. This corporate veil directly protects owners against the debts and liabilities accrued by the business.
Flexible management structure
Other types of organizational structures, such as corporations, are subject to strict regulations regarding the company’s management structure. For instance, corporations must have a board of directors in place.
However, LLCs have a management structure that is much more flexible. There are no structure requirements that LLCs must meet. LLC owners can organize the business any way they see fit.
Other organizational structures can be challenging to maintain. For example, corporations are required by law to hold annual meetings and record minutes. However, this is not the case with LLCs. It’s easier to run an LLC than it is to run a corporation.
Although an LLC is likely quite appealing, there are some downsides that you’ll want to consider.
Minimal legal precedent
LLCs are attractive because they provide business owners with a corporate veil, but there is a severe lack of legal precedent for LLCs, especially when compared to other business types like corporations. Corporations have existed for hundreds of years, whereas the first LLC was formed in the 1980s.
Transferring ownership is difficult
If you have shareholders, it’s easy to transfer ownership of the company. The original shareholder can merely sell the shares to another individual. Unfortunately, transferring ownership of an LLC is not nearly as straightforward. Not only must all other owners consent to the ownership transfer, state law must permit it as well. Owners will need to complete dozens of legal documents indicating the transfer of ownership.
High costs of formation
Prospective business owners should also know that the cost of creation can be quite expensive, especially when compared with other organizational structures like general partnerships. The cost of formation varies from state to state, so be sure to look at your local Secretary of State’s website for more information about the cost of filing.
May not attract investors
If you’re a business owner looking to attract outside funding, you should know that an LLC may not be the best option. That’s because some investors would rather not do business with companies registered as an LLC.
Some investors are skeptical of an LLC’s lack of organizational structure. Many investors would rather work with corporations where they know that there will be a board of directors in place. A board can provide support, experience, and diverse views to younger entrepreneurs. A board of directors promotes both credibility and accountability to investors.
Investors also tend to like that they can buy and sell shares of a corporation whenever they’d like. If investors were to buy into an LLC, it would then be challenging for them to sell their ownership stake and exit the company.
Frequently asked questions about forming an LLC
Many new business owners are confused about the process of creating an LLC. Below, you’ll find some of the most commonly asked questions.
How do I register my LLC?
Each state has specific requirements regarding how to register your LLC. However, no matter which state you plan to file in, you’ll need to do so through the Secretary of State’s website. Be sure to check out the Secretary of State’s website in your intended state of filing to learn more about specific state laws.
Most states will allow you to submit your paperwork online. If you do so, you may be approved in a matter of days. If you send hard copies of your registration application, it can take a couple of weeks before you receive a decision.
Where do I register my LLC?
You’re going to need to register your LLC in any state in which you conduct business. You’ll file as a domestic LLC in your initial state. After that, you’ll file as a foreign LLC in other states. When registering as a foreign LLC, you’ll need to provide a Certificate of Good Standing. This form comes from your domestic state and is proof that you’re in good standing, meaning that you’re up to date with annual compliance paperwork and fees.
What’s the deal with registering in Delaware?
You may have heard that many new business owners elect to register their LLC in Delaware. More than 60% of Fortune 500 companies are registered in Delaware as a corporation or an LLC. Even companies based in California, like Facebook, are legally registered in Delaware.
Delaware tends to offer favorable tax laws to owners. There is no state corporate income tax for companies that exist in Delaware but do not conduct business there.
Furthermore, Delaware has a court system dedicated explicitly to cases that involve LLCs and corporations. This expedites the legal process considerably.
If you elect to register your LLC in Delaware, you’re going to have to receive foreign LLC status in every other state in which you conduct business. You cannot begin doing business in a state until you’ve received such status.
Ready to start your LLC?
If you’re ready to begin filing your LLC, you’ll want to carefully look into the steps required to do so. Also remember that keeping track of pass-through taxation and business expenses could become tricky, especially once you begin conducting business in other states. QuickBooks can help small business owners track expenses and grow their company.