So, you’ve decided to start a business, congratulations!! Owning a business can be extremely personally rewarding and a great way to contribute to your family’s finances. But, after the initial excitement wears off, it can start to feel overwhelming as you think about all the things you now have to do to make your business “legal”. One of the first questions people often ask themselves is what type of entity they need for their business. An LLC is a popular choice for small businesses. This article will cover what an LLC is, what the benefits are, how it’s taxed and things to be aware of while running your business, so you can make the best decision for your business.
What is an LLC?
LLC stands for limited liability company. When you set up an LLC, it is a separate entity from you. Owners of an LLC are called “members” and can be formed with one or more members (generally, a business can also be a member). An LLC is kind of a blend between sole proprietor/partnership and a corporation. LLC is similar to a sole proprietor or partnership, in that the profits “pass through” to the individual(s) and are taxed at the individual level. And, it’s similar to a corporation in that the members (what the owners of an LLC are called) have limited liability.
Limited liability means, generally, that individual members are not responsible for the debts, claims, or losses incurred by the company. This can provide great protection for your personal assets in case something goes wrong in your business. As a sole proprietor, if your “business” gets sued or has to file bankruptcy, your personal assets (home, bank accounts, personal property, etc.) are at risk.
What are the benefits of an LLC?
The biggest benefit of an LLC is the liability protection it offers. Sometimes, it’s hard to see what potential liability your company may have in the future, but things can, and do, sometimes go wrong. By forming an LLC you’re protecting your personal assets (subject to the section Beware! below). However, you can still be liable for your own personal negligence or wrongdoing even if you have an LLC. If you personally guarantee a loan for the LLC, you will still be personally liable for that loan.
Having an LLC can make your business seem more legit than if you were operating in your own name. If you plan to get a loan, most banks want to see that you have a business entity set up and are not just operating in your own name. (Side note: if you plan to have investors, most prefer to invest in corporations-not LLCs).
What are the disadvantages of an LLC?
- Though it is easy to form an LLC, it is a more involved process than operating as a sole proprietor.
- If you want to have investors, many of them will not invest in LLCs, so that can be a disadvantage if that’s something you’re thinking about.
- Since an LLC is a separate entity, there are certain expenses and formal requirements. For example, there is a fee to form an LLC, and most, if not all, states require an annual report to be filed with an additional (usually lower) fee each year. We’ll discuss below the need to maintain formalities with your business to preserve the liability protection offered with an LLC.
- The liability protection offered with an LLC does not protect against losses suffered with your business from fire, flood, etc., so you should still look into insurance for losses you may suffer outside of legal liability.
- There are certain types of businesses that can’t operate as an LLC, such as banks and insurance companies. In some states, professionals such as doctors and lawyers are prohibited from operating as an LLC.
How is an LLC taxed?
LLCs may also have tax benefits. LLCs are not seen as a separate entity for federal tax purposes (although it may be in your state, be sure to check your state requirements), so they have the flexibility to choose how they want to be taxed. You can choose to be taxed as a sole proprietor/partnership or taxed as a corporation. You may have heard about the concept of “double taxation” for corporations. This means that the company is taxed at the corporate level, then the shareholders are taxed at the individual level for money they receive from the company. With an LLC (taxed as sole proprietor/partnership), money made from the business is taxed to the individual member receiving the money, so it’s only taxed once. A knowledgeable tax accountant can advise what the best choice is for your particular situation.
Do I need an attorney?
Generally speaking, forming an LLC is a fairly easy process and an attorney is not required. If you have specific questions, you should seek advice from an attorney licensed to practice in your state. The more members you have or the more complicated your business is, the more likely you are to need to consult an attorney.
How do I form an LLC?
LLCs are formed at the state level. In many states, you can even form an LLC online through the Secretary of State’s office (or other office). There is a nominal filing fee. In Kentucky, the fee is $40, but this will vary greatly by state. If you aren’t able to file online, generally you can print a form out for filing with your state.
- Step 1: Choose a name. Your state should have a database where you can search to see if the name you want is available. Generally, you have to add an ending to the business name that shows it’s an LLC, such as LLC, L.L.C, Limited Liability Company. It’s a good idea to do a Google search for your business name to see what else it out there that may not show up in your state’s database. It’s also a good idea to run a search through the Trademark office to make sure you don’t run into problems in the future.
- Step 2: File the paperwork. Most states have online filing now and it’s a fairly easy process. The initial documents are generally called the “Articles of Organization” and this will be what officially creates your business. In many states, this is filed through the Secretary of State’s office, but research where to file in your individual state. In my research, I found that some states have an additional requirement of publishing notice of your intent to create an LLC. You will want to look into this in your state, specifically if you live in Arizona, Nebraska and New York.
- Step 3: Check what other licenses or permits you may need to run your business and register for tax accounts. Sometimes, this is connected with the Secretary of State’s office and after filing your Articles of Organization you will be prompted to register your tax accounts. It is up to you to make sure you have looked into what licenses might be required and that you have properly registered with your local tax agencies.
- Step 4: Create an Operating Agreement. In most states, this is really an optional step (and not filed with the State) but highly recommended. An Operating Agreement is essentially a contract stating how the business will be run. Most states have default rules if you don’t have an Operating Agreement and you should research what the default rules are in your state. If you are running the business with another member, you really need to have an Operating Agreement. This will cover what happens if there is a dispute between the members. You may wonder why you need an Operating Agreement if you are a single member LLC, but we’ll cover that in the Beware! section below.
- Step 5: Obtain an EIN. An EIN is an Employer Identification Number. You can apply for one through the IRS, and there is even a place to do this online. If you apply for an EIN, go here. There are copies that will charge you for obtaining an EIN, but it’s really simple, so not something you need to pay for. You will likely have to have an EIN to open a bank account.
There are some things you need to keep in mind if you decide to start an LLC. Since your LLC is offering liability protection, it is imperative that you run the business as its own separate entity. When you’re a single member LLC, it can feel like you don’t have to observe the formalities since you obviously won’t have disputes with yourself. However, there’s a concept in the law called “piercing the corporate veil”. Basically this means that the company was just an extension of yourself and not really a separate entity. If you get sued, and the other party can show the corporate veil was pierced, you essentially lose all liability protection you had from forming the business. Don’t let this scare you though. By maintaining certain formalities in your business, you can generally avoid this. For example, don’t commingle funds—keep all business and personal account separate, don’t pay for personal expenses with your business account and vice versa, draft an Operating Agreement
Starting a new business venture can be an exciting, yet scary endeavor. In this article, we looked at what an LLC is and how to form one, as well as the ins and outs of running an LLC. Use this information to make the best decision for YOU going forward. If you decide an LLC is not right for you at this time, you can almost always make the change in the future. Don’t worry-you’ve got this!!
Disclaimer: This site, and all information contained herein or through communication with me, is intended as legal information only. I am an attorney, but I am not your attorney, so nothing on this site, nor any communication with me, shall create an attorney-client relationship. I am not liable for damages or losses based on any action taken, or inaction, based on the information contained on this site. All areas of the law are fact specific and there is no substitute for legal advice from an attorney licensed in your jurisdiction who is familiar with the specific facts and circumstances of your situation.