Forming an LLC
Starting a business is an exciting journey for entrepreneurs. Choosing the right business structure is crucial for success for small-business owners. This guide dives into limited liability companies (LLCs).
Small businesses are often set up as 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. This means the owners are not personally liable for 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 on forming and managing LLCs. This article outlines the process for starting an LLC in most states.
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What Is a Limited Liability Company (LLC)?
An LLC, or limited liability company, is a business structure that combines elements of a C corporation with a general partnership. Unlike other structures, an LLC gives its owners of the LLC, known as members, protection from personal liability for business debts. This means that if the business owes money, the personal assets of its members, like their homes and cars, are usually safe.
For tax purposes, the Internal Revenue Service (IRS) doesn't treat an LLC as a separate tax entity. Instead, profits and losses pass through to members' individual tax returns.
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 IRS. That means the company is not taxed. Any income it earns passes through to the owners. The owners include that income on their personal tax returns. LLCs can face taxes as a single-member or multimember LLC. Unlike a sole proprietorship, where the business owner's Social Security number and tax ID are the same, an LLC requires a separate tax ID. This setup can simplify self-employment taxes and business transactions.
- Organizational Flexibility: Most states have default rules that apply to LLCs, requiring owners and managers to follow business formalities like 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.
What Are the Disadvantages of Forming an LLC?
LLCs offer many benefits. But there are also drawbacks to consider. LLCs often face more administrative paperwork and record-keeping than sole proprietorships or partnerships. They might also encounter varying startup and annual fees depending on the state. This can be burdensome for some small businesses. Unlike corporations, LLCs have a limited life in many states. This means the LLC might dissolve if a member departs or dies.
The LLC structure provides protection from personal liability. However, this protection is not absolute. LLC members may still be personally responsible in certain situations. Regarding raising capital, LLCs can find it more challenging to secure outside investors or obtain bank loans than traditional corporations.
How To Form an LLC
To form an LLC, start by organizing the basics of your business. First, choose a unique name that reflects your business's essence. Your LLC's name is your trade name. Ensure the name includes "LLC" or "limited liability company" within the name, depending on your state laws.
Each state has its specific requirements for creating an LLC. Each state also requires its own filing fees and has different requirements for which legal documents they need to register your LLC. Familiarize yourself with these filing requirements so your new business complies.
State agencies must approve the business name. They can also reject the business name if another registered business already uses it. You can 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 register with the state.
After selecting a name, file the necessary paperwork with your state. This is often referred to as the certificate of formation or articles of organization. For a step-by-step guide on creating an LLC, visit FindLaw's Starting an LLC Checklist.
Filing the Articles of Organization
LLCs form when their organizers file the articles of organization. These are sometimes known as certificates of organization or certificates of formation. You should file articles of organization with the state where the business will be.
These formation documents generally include a description of the rights, duties, and obligations of each owner. These owners are often referred to as members of the LLC. The articles also describe any obligations the LLC has to its owners. It may also provide the physical address of the business to the state.
The articles of organization are generally filed with the state entity charged with registering business organizations, usually the secretary of state. There is typically a filing fee involved with the initial registration and an annual fee.
While some LLCs choose to draft their articles of organization from scratch, many states have easy-to-use forms and templates 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.
Drafting an LLC 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 an 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 nonresidents 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.
What To Do After Registering Your Business
After successfully registering your business, there are vital steps to ensure it runs smoothly. Begin by opening a dedicated business bank account to separate personal and business finances.
You may need an Employer Identification Number (EIN) from the IRS to open this bank account. This number is essentially an ID number for your business. You will also need this number to file federal income and employment tax returns. Even though the LLC itself is not taxed on its income, you must file an annual Form 1065 (U.S. Return of Partnership Income) informational return.
Acquire any required business licenses or permits specific to your industry or locality to operate legally. Protect your venture by considering business insurance based on potential risks associated with your field. Set up a reliable accounting system or hire an accountant to manage your finances and ensure you're prepared for tax season.
Finally, establish a strong online presence with a business website. Buy a unique domain name and engage in marketing strategies to attract customers and grow your brand.
Some 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 need 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
Need More Help? Get Legal Help
LLC formation 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 you receive the structure's best possible benefits.
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