When to Form an LLC: Everything You Need to Know
It may be time to form an LLC if your business needs greater liability protection and to separate your personal and business assets.3 min read
It may be time to form an LLC if your business currently operates as a sole proprietorship or partnership and you needs greater liability protection to separate your personal and business assets. Consider all the benefits and challenges before you take the first step to make sure you understand the requirements and all of your options. Not every business is ready to make the leap to an LLC.
What Is an LLC?
LLC stands for limited liability company. Similar to a corporation, this is a business structure that was created in the 1970s to provide small business owners more personal protection from liability than a sole proprietorship or partnership without the hefty paperwork and management requirements of a corporation.
Limited liability means that if an LLC owes debts, files bankruptcy, or loses a lawsuit, then the company's assets stand good for what is owed, but the owner's personal assets do not. In most situations, an entity trying to collect a business debt from an LLC cannot go after the personal money or property of the business owner. All members of a company benefit from this protection. This is different than a limited liability partnership or LLP, which only protects certain partners.
Some exceptions to the limited liability concept do exist. If the owner of an LLC engages in negligence or illegal activity, they may lose the liability protection. Also, if you enter into a lease or a loan from a bank, you may have to sign a personal guarantee waiving your right to the protection of your personal assets in order to get the deal to go through.
Taxes and the LLC Structure
- Income in an LLC is treated as a pass-through for tax purposes. Profits and losses of the LLC are reported on Schedule C as part of the owner's individual tax return. No return is filed on the business itself.
- Whereas a corporation is an entity in and of itself in the tax code, an LLC is not.
- If you are a single-owner LLC with no partners, taxes are very easy to handle, one reason why many entrepreneurs choose this business structure.
- If your LLC has more than one member, you have to file a 1065 partnership return, and each one files a K-1 to show profits, credits, and losses.
- With an LLC, you can choose to be taxed like an S-corporation or a C-corporation. Carefully evaluate the options to see which is better for your situation.
Benefits of an LLC
- While an LLC does share some features of a corporation, an LLC is easier to manage.
- Paperwork requirements are less, and operations are less formal than in a corporation.
- An LLC has more tax options as well.
- Because of the pass-through tax structure, business losses can reduce your taxable income.
- An LLC can be part of living trust for tax and estate planning purposes. Sometimes it's actually cheaper to create a trust than an LLC. Trusts are complicated tools, so you want the advice of a knowledgeable attorney if you're trying to establish one.
Disadvantages of an LLC
- Profits in an are subject to self-employment taxes since they flow through to the individual. This done on IRS Form Schedule SE.
- If your business is seeking to raise money, especially from venture capitalists, the LLC structure makes it more difficult to do that. Offering stock options is harder to do in an LLC, and there is no Board of Directors to oversee the finances. Venture capital firms have tax-exempt investors who are sometimes put off by the pass-through structure of profits. A C-corporation is likely a better option if your company needs to raise money.
How to Form an LLC
In most states, the requirements to set up an LLC are the filing of the articles of organization, pay the fees, and meet whatever annual filing requirements exist. Most of this process can be completed online. While it's not required, it's a good idea to lay out an operating agreement if you have partners in your business. This document lays out the details of how the company is governed, who gets paid what and when, how decisions are made, and so on. It allows for more efficient management and operations.
When you're trying to determine whether your business is ready for an LLC structure, do some research on how often companies in your field get sued. Evaluate competitors and see which structure they use for comparison.
If you need help with forming an LLC, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.