Forming an LLC
Small businesses are often set up as limited liability companies (LLCs) because the structure offers many of the benefits of a corporation without subjecting the owners to corporate taxation. LLCs operate as entities that exist separately from their owners, which means the owners are not personally liable for any of the businesses' debts and obligations. Since they are not subject to the federal corporate income tax, LLC owners can avoid double taxation of company profits.
The exemption from federal taxation of corporate income has driven the popularity of LLCs, but they are formed under state law. That means each state has its own rules and regulations regarding the formation and management of LLCs. However, the sections that follow outline the process for starting an LLC in most states.
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What Are the Benefits of an LLC?
There are many benefits to structuring your existing business entity or startup as an LLC rather than a sole proprietorship, partnership, or traditional corporation. Those include:
- Limited owner liability. Since LLCs exist as independent entities, their owners are not liable for the company's debts and obligations. This liability protection is similar to that offered by traditional corporations. It also frees ownership from some of the operational formalities required for corporations. The owners of sole proprietorships and partnerships have unlimited personal liability for all their business's debts.
- Pass-through taxation. Traditionally, one of the biggest reasons business owners avoid organizing as corporations is because, as independent entities, corporations are subject to the corporate tax on their income. Any profits passed to the corporation's owners are taxed a second time as income to them. LLCs allow owners to avoid this so-called "double taxation" by choosing pass-through status with the Internal Revenue Service (IRS). That means the company itself is not taxed, and any income it earns is passed through to the owners, who include that income on their personal tax returns.
- Organizational flexibility. Most states have default rules that apply to LLCs, requiring owners and managers to follow business formalities similar to corporations. Many allow the default rules to be overridden in the company's operating agreement. For example, an LLC's operating agreement can keep owners who are not participating in the company's management from taking an active role in decision-making.
Organizing an LLC
LLCs are formed when their organizers file articles of organization—sometimes known as certificates of organization or certificates of formation—with the state where they are located. These formation documents generally include a description of the rights, duties, and obligations of each owner—often referred to as “members" of the LLC. The articles also describe any obligations the LLC has to its owners.
The articles of organization are generally filed with the state entity charged with registering business organizations, usually a secretary of state. There is typically a filing fee involved with the initial registration as well as an annual fee.
While some LLCs choose to draft their articles of organization from scratch, many states have easy-to-use forms and templates that may be used to register your LLC. These forms may be helpful if your LLC is small and you only have a few owners who are all taking an active role in managing the business.
Finally, most states require that an LLC list a registered agent in their articles of incorporation to receive documents on behalf of the company, including service of process. This registered agent can be an owner or a registered agent service.
Naming an LLC
When you register your company as an LLC, you must include a name for the new business. The LLC's name should be unique and allow customers to identify your business and appear on all legal documents.
The business name must be approved by the state agency that accepts LLC registrations and will be rejected if already used by another registered business. You can usually check to see if another company already uses a name by checking the agency's website.
An LLC can also choose to operate under a name that is different than that of the company. When using an alternative name, the company is "doing business as" the other name or operating under a DBA. In many cases, states will require that DBAs be registered with the state.
Drafting an Operating Agreement
Although your state may not require you to file an operating agreement for your LLC, creating one is still a good idea. The operating agreement for an LLC will set out the rules and regulations for both ownership and operation of the business and help resolve any future disputes involving owners and managers. Generally, operating agreements will include:
- The members' business interest in the LLC
- The rights and responsibilities of the owners and the management structure
- Regulations controlling how the business profits will be shared
- Terms relating to the voting power of the owners
- Rules and regulations that set out how the LLC will be managed
- Rules regarding when meetings will occur and how votes will be taken
- Provisions that will govern situations where an owner leaves LLC by selling their interest, death, or disability
Who Can Form an LLC?
Any individual or business starting out or currently operating can form an LLC in most states. Even people running their business as sole proprietorships can organize as LLCs in all states except Massachusetts. There are usually no residency requirements, and many states don't even require the owners to be 18.
You can even form an LLC with one or more businesses as members, with most states allowing owners that are:
- Other LLCs
- Foreign entities
This lack of ownership restrictions is significant because the other popular pass-through entity used for small businesses, S-corporations (S-corps), place numerous restrictions on who may hold shares in the company. For example, partnerships, corporations, and non-residents may not have shares in an S-corp but can own an LLC.
If you are forming a professional LLC (PLLC), membership is usually restricted to licensed individuals like doctors, dentists, lawyers, and accountants. Additionally, some states don't allow PLLCs.
States require LLCs to file annual reports to keep the information they have on the company current. Filing an annual report is essential to maintain your LLC's protection from owner liability. While the requirements vary from state to state, most require the following information:
- An address for the business as well as contact information for its owners and managers
- The type of business and its operational activities
- A list of those authorized to sign documents on behalf of the company
- Information on the company's registered agent
Employer Identification Number
If you establish your LLC as an independent legal entity, you will need an Employer Identification Number (EIN) from the IRS to file federal income and employment tax returns. Even though the LLC itself is not taxed on its income, it is required to file an annual Form 1065 (U.S. Return of Partnership Income) informational return.
Additionally, an EIN is necessary to open a bank account for the LLC and register to pay sales and employment taxes with the state.
Need Additional Help?
Forming an LLC can be a complex process, and if you fail to follow the required steps in your state, you may not enjoy the protection from personal liability that you are expecting. If you are forming an LLC, it is a good idea to use a reputable business formation service or meet with a local business attorney to ensure that you receive the structure's best possible benefits.
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