LLCs are a popular business structure for small companies. They give you flexibility, liability protection, and (potentially) a lower tax bill.
But what exactly is an LLC? How do you form one? And is it worth the time and money to form one in the first place?
Here’s what you need to know.
What is an LLC?
An LLC—or “limited liability corporation”—is a business entity that behaves like a corporation at the state level, but is taxed like a partnership or sole proprietorship at the federal level.
An LLC is like a corporation because it gives its owners limited liability—that is, it prevents them from getting sued or going bankrupt.
Like partnerships and sole proprietorships, LLCs avoid double taxation—that is, they avoid getting taxed when they earn income, and then again when profits are distributed to owners. Instead, the profits (or losses) of an LLC “flow through” to its owners, and are taxed only once.
Because they’re created at the state level, the rules for LLCs vary by state. In most states, there’s no maximum or minimum number of owners for an LLC—you can have one, like your local veterinarian office, or thousands, like Google LLC does.
What are the advantages of forming an LLC?
A lower tax bill, potentially
LLCs are taxed like partnerships on the federal level and avoid double taxation. Instead of getting taxed when they earn income and distribute profits to shareholders, LLCs pass their gains or losses onto their owners and only get taxed once, which can result in a lower tax bill.
Here’s the best part of being an LLC: if getting taxed as a partnership or sole proprietorship doesn’t result in a lower tax bill, you can opt to file your taxes as a C corporation or S corporation instead.
Almost every aspect of an LLC—from its ownership structure, to the way it allocates profits and losses, to its members’ rights and responsibilities—can be modified to fit your specific needs. That includes the way it’s taxed. Switching from one tax status to another can sometimes save an LLC a lot of money.
If you have employees, for example, getting taxed as an S corporation can save you lots of money, because it lets you avoid paying self-employment tax on any profits you distribute to them or yourself.
Further reading: How is an LLC Taxed?
What are the disadvantages of forming an LLC?
As popular as LLCs are, they do have their downsides.
For starters, things can get real confusing if one member of the LLC decides to leave. Some LLCs just have to dissolve, which can be challenging for the remaining owners who want to keep operating. Other times, the departing member’s share can be “bought out.” LegalZoom has a helpful primer on how to release a member from an LLC.
Other drawbacks include:
LLC owners can’t pay themselves W-2 wages
Many states levy a tax on LLCs, which can get expensive for some businesses
Investors are generally more hesitant to hand over their money to an LLC than they are to a corporation
As flexible as it is, the LLC business structure isn’t right for everyone. Which is why it’s so important to talk to an expert—preferably a lawyer—before starting one.
How do I form an LLC?
Step 1: Pick a state of organization
Different states have different LLC rules, which is why picking the right state to file in is crucial. Many small companies decide to file in Delaware, for example, because of the state’s flexible rules around LLCs and generally business-friendly approach to corporations.
Read up on your state’s LLC rules, read up on the benefits of filing in Delaware, and most importantly, talk to a lawyer to find the best fit for you.
Step 2: Pick a name
The next step is to pick a name for your LLC that hasn’t been taken by any other company in the state you’re filing in. Use your state’s business registry to look up whether the name you’re considering is taken (here’s Delaware’s registry).
Run a Google search too, especially if you expect to do any business out of state. Pick a name you’re happy with, make sure that it indicates its standing as an LLC (e.g. “Joe’s Coffee, LLC”), and double-check to see that it doesn’t include any words that are restricted by your specific state (“insurance” is restricted in certain states, for example).
If you plan on doing business under a different name than your legal one, consider filing a DBA.
Step 3: File your articles of organization
Your LLC’s articles of organization are a simple signed document that states the name of your business, the names of its members, and the business’s address. Where you file this document varies by state, so consult your state government’s website for information about state fees and where to file (here, for example, is Delaware’s).
Within a few weeks, your state should get back to you with a letter officially certifying the creation of your LLC.
Step 4: Put together an operating agreement
The rules in your LLC’s operating agreement are a lot like the bylaws of a corporation. They lay out all of your LLC’s rules around ownership, members’ responsibilities, voting rights, who’s on the hook for taxes, how profits are distributed, what happens if the business fails, and so on.
When you go to an expert (in most cases, a lawyer), crafting an operating agreement that fits your business’ specific needs will be what you spend most of your time on.
Although operating agreements aren’t mandatory in most states, lawyers usually recommend creating one anyway, especially if you’re planning to form a multi-member LLC.
LawDepot’s handy operating agreement generator should give you a sense of what goes into an operating agreement. They run fairly long and can get complex quickly.
Step 5: Secure any licenses and permits you need
The rules for LLC licenses and permits vary a lot depending on your state and industry. Check with your state and get the proper business licenses and permits for your newly registered LLC.
Step 6: Get an Employer Identification Number from the IRS
The IRS uses your Employer Identification Number (EIN) to track your business for tax purposes, and you need one even if you don’t have any employees.
You can get an EIN two ways:
- By filing Form SS-4 (see the IRS’s instructions to SS-4 here)
- By applying for one using the IRS website here
If you’ve talked to an expert and decided that your LLC will be better off taxed as a C corp or S corp, you’ll also have to file Form 8832 or Form 2553, respectively. (Don’t do this unless an expert tells you to.)
Step 6: Announce your newly-formed LLC in a newspaper
It sounds old school, but some states require newly-registered LLCs to announce their formation in a local newspaper. Double-check with your state’s business filing office or your county clerk to determine which local publications are appropriate for this.
Don’t do any of this without talking to an expert
All businesses are different. As tempting as it might be to do all of this on your own, it’s important that you talk to an expert, preferably a lawyer, before finalizing your LLC. Going it alone could create problems down the line, especially if your company grows.