LLCs are a popular business structure for small businesses. 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 about this business structure.
What is an LLC?
An LLC is like a corporation because it gives business 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 being taxed twice on the same income (this occurs in the corporate tax structure, when profits from the business are taxed at the corporate tax rate, and then at the individual tax rate when dividends are distributed to shareholders).
Instead, the profits (or losses) of an LLC “pass through” to its owners, and are taxed only once—on their personal tax returns. This is called “pass-through taxation.”
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.
An LLC also doesn’t need a board of directors (no annual meetings!) or multiple members. Single-member LLCs are an option for solo entrepreneurs (sometimes known as solopreneurs).
What are the advantages of forming an LLC?
Like C corps and S corps, members of an LLC benefit from limited liability. Limited liability (or asset protection) means that if the LLC ever goes bankrupt or gets sued, your personal assets are off limits. In other words, you have no personal liability for business debts.
A lower tax bill, potentially
Despite being a separate legal entity, LLCs are taxed like partnerships on the federal level and avoid double taxation. Instead of paying federal taxes on their earnings and distributing profits to shareholders, LLCs pass their gains or losses onto their owners and only get taxed once as income tax on their personal income tax return. This can result in a lower tax bill.
Here’s the best part of being an LLC: if getting taxed as a partnership or sole proprietor doesn’t result in a lower tax bill, you can opt to file your taxes as a C corporation or S corporation instead. Rather than LLC owners paying taxes on their individual tax returns, the LLC would then pay corporate taxes.
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 LLCs are 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.
How Bench can help
LLC owners already have plenty of responsibility on their shoulders. Bookkeeping and taxes are one area where you don’t have to go it alone!
Bench’s bookkeeping and tax experts can make sure your LLC taxes are filed correctly and on time, while also handling your business’s record-keeping. Plus, every client receives a free Year-End Financial Reporting package in addition to their monthly financial reports. Learn more about Bench’s services.
What are the disadvantages of forming an LLC?
As flexible 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.
Another thing to know about LLCs is that you’ll need a definitive separation between your personal and business bank accounts, credit cards, and other financial accounts. This isn’t as critical for sole proprietors, although separating business and personal expenses is always a good idea.
Other drawbacks include:
Owners of an LLC can’t pay themselves W-2 wages
Many state laws charge an annual fee or 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 all types of businesses. That’s 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 state laws 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. Once you have a state picked out, confirm their unique process of registering an LLC with their secretary of state.
Step 2: Pick a business 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 your business’s 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 articles of organization
Your LLC’s articles of organization is a simple signed document that states the name of your business, the names of its members, and the business’s address. How you file this document and the filing fee 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 an LLC operating agreement are a lot like the bylaws of a corporation. They lay out all of your LLC’s rules around ownership and management structure. It should cover the members’ responsibilities, setting a registered agent, 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, depending on the number of members and other factors.
Step 5: Secure any licenses and permits you need
Step 6: Get an Employer Identification Number from the IRS
The Internal Revenue Service 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 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 7: Announce your newly-formed LLC in a newspaper
It sounds old school, but some states require newly-registered businesses to announce their LLC 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.