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Should I Form an LLC for My Business Activity?
[Prefer to listen? You can find a podcast version of this article here: E174: Should I Form an LLC for My Business Activity?]
There are many paths to generating income. Often the W-2 route makes sense and a career path as an employee can pay off and help create wealth. Others pursue entrepreneurship and generate an income by starting a business or through consulting work as an independent contractor.
Some people do both!
When you’re starting a business or providing a service through a non-employee route, you may be wondering how to structure your business activity. You’ve probably heard of different types of businesses such as:
- Sole proprietorship
The Limited Liability Company, or “LLC” is a very common type of business structure, and for good reason. It tends to be convenient and easy to establish and comes with some benefits to the owner.
So how do you decide if you should form an LLC?
What is an LLC?
LLC stands for "Limited Liability Company." It is a type of business structure that combines the benefits of a partnership or sole proprietorship with the protection of personal assets that comes with incorporation.
In an LLC, the business is a separate legal entity from its owners, known as "members." This means that the LLC can enter into contracts, own property, and conduct business in its own name, just like a corporation. However, the members are typically not personally liable for the LLC's debts and liabilities as long as certain rules and guidelines are followed.
LLCs are a popular choice for small businesses and startups because they are relatively simple and inexpensive to set up and maintain, while still providing the benefits of liability protection and flexibility.
The United States first made it possible to form a Limited Liability Company (LLC) in 1977, when the state of Wyoming enacted the first LLC statute. Other states began to adopt similar statutes in the following years, with Florida, Delaware, and California being among the early adopters.
By the early 1990s, all 50 states had LLC statutes, and the popularity of the LLC as a business structure began to grow rapidly. Today, the LLC is one of the most common forms of business organization in the United States, particularly for small and medium-sized businesses.
What are the advantages of an LLC?
So why form an LLC? What are the benefits?
There are several advantages to forming a Limited Liability Company (LLC):
- Limited liability: One of the primary benefits of forming an LLC is that it provides “limited liability” protection for its members (owners). This means that the personal assets of the owner is generally protected from the debts and liabilities of the business. If the LLC is sued or goes bankrupt, the owner's personal assets are not typically at risk.
- Tax flexibility: LLCs offer flexibility in how they are taxed. By default, an LLC is taxed as a pass-through entity, which means that the profits and losses of the business are passed through to the owner and reported on their personal tax returns. However, LLCs can also choose to be taxed as a corporation if it makes financial sense for the business.
- Easy to form and maintain: LLCs are relatively easy and inexpensive to set up and maintain compared to other business structures, such as corporations. They generally have fewer formal requirements and less paperwork.
- Management flexibility: LLCs offer flexibility in management, allowing members to choose whether to manage the business themselves or hire a separate management team.
- Improved credibility: Forming an LLC can improve the credibility of a business, as it signals to customers, suppliers, and investors that the business is a legitimate and established entity.
- Transferability: Ownership in an LLC is transferable through the sale of membership interests, making it easier for owners to exit the business if they choose to do so.
Overall, the advantages of forming an LLC make it a popular choice for small businesses and entrepreneurs who want liability protection, tax flexibility, and management flexibility in an easy-to-maintain business structure.
In contrast, a sole proprietorship offers no such liability protection. The sole proprietorship is the default entity type if no business entity is formed which means the owner’s personal assets (house, bank accounts, etc.) can be exposed in the event of a lawsuit.
While the other points are benefits of an LLC, the liability protection alone is often reason enough for many people to establish this entity for their business.
In fact, many attorneys recommend setting up an LLC as soon as you start your business so that you have liability protection from the start.
What are the disadvantages of an LLC?
While LLCs can be very beneficial when starting a business, it’s not necessarily ideal for 100% of situations. Some business owners choose to remain a sole proprietorship.
A single member LLC (meaning “single owner”) and a sole proprietorship are two different business structures with their own advantages and disadvantages. Here are some disadvantages of a single member LLC as opposed to a sole proprietorship:
- Slightly Increased Complexity: A single member LLC is a more complex business structure than a sole proprietorship. It requires more paperwork and legal formalities to be followed. For example, you need to file Articles of Organization with the state to create an LLC, and you may need to maintain an operating agreement.
- Slightly Higher Costs: There are additional costs associated with setting up and maintaining an LLC, such as filing fees and annual fees. In contrast, a sole proprietorship is a simpler structure that does not require formal registration or ongoing fees.
- More Formalities: A single member LLC is required to follow more formalities than a sole proprietorship. For example, you need to hold annual meetings and keep minutes of these meetings.
- Limited Tax Flexibility: A single member LLC is taxed as a separate entity from its owner, which means that the owner cannot use personal tax deductions for the LLC's expenses. In contrast, a sole proprietorship is not taxed as a separate entity, which allows the owner to use personal tax deductions for the business's expenses.
It's important to note that the advantages and disadvantages of each business structure can depend on your specific situation and goals (which we will discuss shortly). As always, consulting with a legal or financial professional can help you make an informed decision so keep that in mind when comparing the pros the cons.
How do I form an LLC?
The process for forming an LLC (Limited Liability Company) can vary slightly from state to state, but generally, here are the steps you can take to form an LLC:
- Choose a name for your LLC: Your LLC's name must be unique and not already in use by another business in your state. You can check the availability of your desired name by searching the state's business name database.
- File Articles of Organization: This is a legal document that you file with your state's LLC filing office. It typically includes your LLC's name, address, and the names of its members (which is just you if you are the only owner).
- Appoint a registered agent: A registered agent is a person or entity that is designated to receive legal and tax documents on behalf of the LLC. This can be you or a professional registered agent service.
- Draft an operating agreement: An operating agreement is a legal document that outlines the internal rules and structure of your LLC, including management, ownership, and profit-sharing. This is not always necessary and if you are the only owner, many states will allow you to skip this.
- Obtain any necessary licenses and permits: Depending on your business and location, you may need to obtain certain licenses and permits to operate your LLC legally.
- Obtain an EIN: An EIN (Employer Identification Number) is a tax identification number issued by the IRS. You'll need an EIN to open a bank account, file taxes, and hire employees.
- File annual reports and pay any fees: Most states require LLCs to file an annual report and pay a fee to maintain their status.
There are also online services that can help you with this process and make it easier through a streamlined experience. Some examples include:
No affiliation or endorsement is implied with any of these services. They are simply examples.
Of course, it can be a good idea to work with an attorney to form your LLC. If your business is fairly simple you may be fine doing it yourself. But if you are uncomfortable with the process or have more complex needs, consulting with a qualified attorney licensed in your state can be a good way to make sure you are doing it correctly.
Also, see our podcast for a more in-depth episode on "How to Start an LLC."
What does it cost to form an LLC?
The costs to form an LLC will vary depending on circumstances and your state. If you are doing it yourself through your state’s website, the cost will only be the filing fees determined by your state. Some states are fairly inexpensive and can be as low as $100 while others can be as high as $800 (such as California).
If you are using an online service, the fees charged will be in addition to your state’s LLC filing fees. Pricing for online service will vary but can be anywhere from $50 to a few hundred dollars.
If you are working with an attorney, you might expect to pay $800 or more depending on the state and the complexity of your needs (this is in addition to your state’s filing fees).
Most states require LLCs to file an annual report, which includes updated business and contact information. The fee for this report is usually between $50 and $300.
What’s the difference between LLC, Sole Proprietorship, and S-corp?
As discussed earlier, LLCs can offer some advantages over the sole proprietorship model, including liability protection.
You may have also heard of a type of business called an S corporation and might be wondering what the difference is and if you should be concerned about it.
An S corp is taxed differently than an LLC and has some differences when it comes to operation and structure. Often it can make sense to move to an S corp status once certain income levels are reached because of the potential tax savings.
The good news is that you don’t have to decide today. Many business owners are not aware of this but an S corp is not an actual business entity – it is a tax election. This means that you can form an LLC as you start out, and then update your tax election to S corp status if and when it makes sense.
For this reason, many business owners start as an LLC and then elect S corp tax status later, which involves some paperwork with the IRS. Be sure to consult a tax professional when doing this.
How to Decide if an LLC is Right for You
So ultimately, the question is: should I form an LLC? Here are some things to think about when deciding.
First, what type of business is this, and what sort of liability protection do you feel is important? If you are operating a small home-based business selling holiday wreaths, an LLC may be overkill. There is likely not a high need for liability protection because there is a low probability that you will get sued over selling crafts or that you will operate a business that goes into significant debt.
The main protection of an LLC deals with any liabilities or debts that the business incurs. In most situations, you are safe from having your personal assets seized in order to pay any debts that your business takes out and cannot repay unless you have put up a personal guarantee when you took out the loan.
Another main area of personal protection is through any liability that occurs from wrongdoing the employees, co-owners or business performs. If the business is sued and found liable, then your personal assets will remain protected, as long as you personally did not have any involvement.
An LLC can also help protect you from liability from accidents related to your business, such as someone slipping and falling at your office.
However, an LLC may not project from all liability, especially if you commit any wrongdoing or negligence yourself. For example, if you commit tax fraud or intermingle your personal finances and that of the business, you and your personal assets will be held accountable.
It’s important to evaluate the risk of your business activity. What is the potential that you could be exposed to liability? The higher the risk, the more an LLC might make sense so you can limit that liability.
Another factor to consider is your plans for growth. Is this a simple side hustle that will be limited to you doing the work part-time? Do you ever plan to hire employees?
If it’s never going to grow beyond you, and it will stay small, a sole proprietorship may be just fine. However, if you can envision a time when you grow your business and hire team members, an LLC is going to be a better route.
When moving from a sole proprietorship to an LLC, you will typically need to get a new EIN, new bank account, and possibly update other elements of the business which can be a bit of a pain. Because of this, if you have any plans for growth then forming an LLC from the start can be a great way to avoid the hassle of updating everything later.
Finally, what about credibility? Is it important to be seen as professional and legitimate by your customers or clients? If so, having the “LLC” after your business name can add credibility to your image.
In general, a sole proprietorship can be an adequate business structure for those running simple, low-risk businesses. However, many businesses and self-employed individuals can benefit from the protections, flexibility, and credibility of an LLC, which is why it is one of the most popular business structures for entrepreneurs.