A limited liability corporation (LLC) is a type of business entity commonly adopted by small businesses in the United States. For many entrepreneurs, forming an LLC is a big step toward transforming a side hustle into a formal business. Even budding solopreneurs can benefit from switching their business structure from a sole proprietorship to an LLC.
Individual state laws regulate the formation and operation of LLCs, so before you incorporate your business, you’ll want to learn the ins and outs of how this structure works, plus the potential benefits and drawbacks that come along with it.
What is an LLC?
An LLC is a business structure that provides liability protection for the business’ owner(s). This means that the owner(s) of the business cannot be held financially responsible if legal claims are brought against the business.
This type of business can be formed by one or more owners. Each owner is a “member.” If you’re the only member, your business is considered a single-member LLC. Otherwise, it’s called a multi-member LLC.
How to form an LLC
The process for forming an LLC varies slightly from state to state, but generally follows these six steps. Be sure to check the guidance from your state’s government office that handles LLCs (such as the secretary of state’s office or the department of commerce).
- Pick a name for your LLC. Your name must be unique in your state, so check an online business name database before choosing. The business name must also end with “LLC,” its entity type. Once you choose a name, no other company can use that exact same name in your state.
- Select a registered agent. This individual is responsible for receiving communications to the LLC (like bills for annual fees, or lawsuits). It can be one of the LLC’s members, or it can be a third party. Your state should have a list of private registered agents if you prefer to hire out.
- File articles of organization with your state. Once you have a name and registered agent, you’ll file your articles of organization. Some states call this paperwork by a different name, like “certificate of organization.” The forms should be available on your state’s website.
- Create an LLC operating agreement. The operating agreement outlines the ownership structure of the LLC. It’s not required in every state, but can be helpful—particularly for multi-member LLCs. An operating agreement provides a clear approach to how profits and losses are handled, along with the rights of each member.
- Address local, state, and federal business requirements. A federal requirement of forming an LLC is to get an employer identification number, or EIN, from the IRS. This is like a Social Security number for businesses. You must also register for a business license with your state and/or local government.
Forming an LLC covers your legal structure, but you also need to pick how that business entity will be taxed. There are a few different tax designations available. Sole proprietor is the default tax designation for single member LLCs, and general partnership is the default tax designation for multi-member LLCs. But LLCs can also elect to be taxed as a corporation.
The tax classification is a big one—and merits a more detailed explanation.
How LLCs are taxed
An LLC is a legal entity, and there are various ways an LLC may elect to be taxed. That means that forming an LLC may or may not change the way the owner(s) pays taxes. Here are the four most common ways that LLCs choose to organize for tax purposes.
- Sole proprietor (single-member LLCs only). In a single-member LLC, the business profits pass through to the owner(s), and they pay personal income tax on the full amount. Owners are considered self-employed and must also pay self-employment taxes, covering Social Security and Medicare.
- Partnership (multi-member LLCs only). In a partnership, the business profits pass through to each member, and each must pay income tax on their portion. In most cases, each member also pays self-employment taxes.
- S corporation (single or multi-member LLCs). Owners of an S corp may choose to pay themselves a salary and pay payroll taxes on their salary amount. The balance of the business profits pass through to the owner(s) as income, but they do not have to pay self-employment tax on these profits. S corps also do not pay corporate taxes, as they are pass-through entities.
- C corporation (single or multi-member LLCs). All business profits are taxed at the corporate rate. Any profit distributions taken by LLC members are also subject to personal income taxes; this is known as double taxation. Members of a C corp don’t have to pay self-employment taxes, but any member that is paid a salary by the LLC will pay payroll taxes on their wages.
Regardless of which taxation status they choose, owners must distinguish their personal finances from their business finances. This could mean opening a separate bank account for their business and tracking business expenses.
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What are the advantages of forming an LLC?
The advantages of an LLC include legal protection and potential tax benefits for businesses of all sizes, whether it’s a one-person shop or a small business with a team of employees.
- Easy and inexpensive formation process. LLCs are generally simple and inexpensive to form compared to other business entities. Incorporation fees vary from state to state, but it usually doesn’t cost more than a few hundred dollars to form an LLC. There’s also a minimal amount of paperwork that needs to be filed at the time of formation, which typically includes a short form from the state’s business commission. Check with your state government’s website for the local application process and fees.
- Personal assets are protected. Establishing an LLC helps you avoid being held personally responsible for your company’s failings. That means if someone files a lawsuit against the business, the plaintiff cannot go after your personal assets, such as your home, car, or cash savings. The protection extends to creditors, who cannot collect any assets outside of the business in order to recoup losses (like defaulted loans).
- Avoid double taxation. Unless an LLC elects to be taxed as a C corporation, it works as a pass-through entity. That means profits bypass the federal corporate tax rate of 21%. Instead of paying corporate taxes and personal income tax, members of the LLC take profit shares and pay personal income tax on the earnings.
- Flexible taxation. LLCs can choose how they want to be taxed. No other entity type comes with this choice.
What are the disadvantages of forming an LLC?
LLCs entail more complexity at tax time and some startup cost. Liability protection is also not 100% guaranteed—it’s contingent on business owners following correct procedures for maintaining their business as an entity separate from themselves. Here’s what to consider as you choose the best entity type for your business.
- There are startup costs. There is usually a small incorporation fee associated with forming an LLC. Owners may also choose to employ a tax professional to handle the formation paperwork on their behalf, which adds cost to the process.
- There are exceptions to personal liability protection. In most cases, LLC members’ personal assets are considered to be separate from the business, and thereby protected from any litigation involving the business. A judge may rule otherwise, however, if LLC members do not keep the business finances and operations separate from their personal finances, or if the company committed fraud in a way that negatively impacted others.
- Self-employment taxes may apply. Profits for LLCs that are taxed as sole proprietorships or partnerships are subject to self-employment tax in addition to income tax. Self-employment taxes cover both Social Security and Medicare taxes for the owner(s). Combined, the federal self-employment tax rate for 2021 was 15.3%.
- An IRS K-1 form is required to file taxes. Being part of a member-managed LLC partnership adds an extra layer of paperwork to your taxes. Each member of the LLC must file a Schedule K-1 (Form 1065). This document outlines each partner’s income, deductions, and credits from the company, and members can’t file personal taxes without it.
- Some states require an LLC to reform if a member leaves. In some states, you may be required to dissolve your existing LLC and reform as a new one if a member leaves the company. Whether they exit the venture or pass away, new paperwork might be required.
How do LLCs compare to other entity types?
Here’s how an LLC stacks up against other types of business entities and taxation structures.
- LLC vs. sole proprietorship: Forming as an LLC rather than a sole proprietorship allows you to protect your personal assets from business debt and lawsuits. While LLCs are fairly lightweight compared to other corporate structures, paperwork and taxes are more cumbersome as an LLC than they are as a sole proprietor. There are also filing fees associated with forming an LLC. Sole proprietorships don’t have this overhead cost.
- LLC vs. corporation: Corporations are a tax designation available to LLCs (a legal entity). LLCs that elect to be taxed as C corporations pay corporate taxes. LLCs that elect to be taxed as S corporations (or as sole proprietorships or partnerships) remain pass-through entities and do not pay corporate taxes.
- LLC vs. LLP: While an LLC has one or more members, a limited liability partnership has at least two owners, called partners. Liability protection for LLP partners is sometimes more individualized than it is for LLC members. Forming as an LLP is often restricted to certain professional services, like lawyers or accountants. Each state has its own rules about what types of businesses may incorporate as an LLP.
An LLC can be an advantageous entity type for some businesses, especially for those who want liability protection for their personal assets. However, it’s important to carefully review and choose taxation options; while there are benefits, such as protection of your personal assets, there are also some trade-offs to consider, like startup costs and more complicated taxes.
Overall, the ease and convenience of forming an LLC makes it a strategic choice for many entrepreneurs and business owners.