Incorporating your small business as a limited liability company (LLC) can be an excellent way to grow your company or take it to the next level. An LLC is a legal business entity that offers its members personal liability protection while providing flexible tax and organizational structure. You can think of an LLC as a hybrid entity since it combines the best features of a corporation and a general partnership.
Like a corporation, an LLC protects its members from personal responsibility for the company's debts or liabilities. At the same time, its simplicity, organizational flexibility and tax efficiency are core features of a general partnership and sole proprietorship. However, despite its overwhelming benefits and popularity, LLC has some disadvantages, so you must consider your business's current needs and how that might change over time before choosing an LLC or other business structures.
How Does an LLC Work?
LLCs are creations of state laws, so the rules and regulations guiding their formation or operation and the inherent benefits vary from state to state. Owners of an LLC are generally referred to as members, which depending on the state, may include individuals, corporations, trusts, foreigners or foreign entities and other LLCs. The majority of states do not restrict ownership.
People who manage the operations of an LLC are referred to as managers. Members can also serve as managers, especially if the LLC comprises only one or two members. However, having members dictate the obligation with their signature can jeopardize the business in a more prominent LLC. So it makes more sense to have a specific manager in charge. While the requirement for an LLC differs among states, there are many similarities.
For instance, all LLCs must have a minimum of one member. To form an LLC, members first need to choose a name and then file articles of organization with the state, along with a fee. The articles of organization establish members' liabilities, rights, duties, powers and other obligations. The names and addresses of the members, the name of the LLC's registered agent and the business statement of purpose are documented in the article. Additional paperwork and fees are submitted at the federal level to obtain your employee identification number (EIN).
What Types of Businesses Should Form an LLC?
Businesses of all sizes and entrepreneurs from diverse industries can legally incorporate as or form an LLC. So whether you're a personal trainer, a web or software developer, a real estate agent, a marijuana entrepreneur or a caterer, you can register or form an LLC in your preferred state. Some states permit licensed professionals to establish a professional LLC or (PLLC), which covers professions that require licensing by the state government.
Candidates for PLLCs include physicians, pharmacists, engineers, dentists, architects, attorneys and accountants. Depending on your home state or preferred state of incorporation, a PLLC is worth considering if you're a licensed professional in the specified categories. There are exceptions in businesses that can form an LLC in line with federal regulations. For instance, financial companies like banks, credit unions, insurance agencies and financial trust companies cannot incorporate as LLCs. Nonprofit organizations are also not allowed to form an LLC in some states.
What Can an LLC Do That Other Business Structures Can’t?
Compared to other business entities, LLC offers various outstanding features. For instance, unlike sole proprietors and general partnerships, LLC members enjoy limited liability protections, meaning they're not personally responsible for the company's debt or legal liability if the company fails or gets sued. While shareholders in a corporation enjoy limited liability protection, they have to deal with double taxation, one at a corporate level and another at personal income levels when they receive dividends.
In comparison, LLCs are taxed as pass-through entities by default, meaning that the business profits and losses are passed through the member's personal tax returns, making for high flexibility. This flexibility further extends to ownership and management. An LLC can have one or an unlimited number of members. Members or a designated manager often manage them. In contrast, general corporations require a specific number of members and are managed by a board of directors.
Furthermore, there's no requirement for formal meetings, and formation or operational bureaucracies are highly minimized, making it a cost and time-efficient business entity compared to others.
Considerations When Forming a Limited Liability Company
To tap into the key benefits of an LLC and avoid potential challenges, you must understand how LLCs operate and the requisite legal obligation that must be met during the formation. Some of the things you need to consider include meeting specific guidelines when creating your company name, allocating special agents, state laws, fees, tax and compliance requirements.
Although operating agreements are not mandatory in most states, when forming a multi-member LLC, consider drafting an operating agreement. The reason is that it is an essential controlling document of the business equivalent to bylaws and can be a vital document to present to lenders. It clarifies the power of the manager, how decisions are made via member voting, how and when a distribution is to be made, capital contributions, new members' admission and the business dissolution.
Taxes and Compliance
By default, LLCs do not pay business income tax since profit and losses are pass-through to members. However, other taxes may apply depending on the state. For instance, a Delaware LLC is subject to a gross receipt and franchise tax. A Wyoming LLC is subject to the 4% sales tax and 1% general tax imposed by counties. Compliance requirements are mostly the same across states. To keep your company operational, you must have a registered agent who may serve as the manager, file your tax returns when due, renew the requisite operating license or permit, file your annual report and ensure your business and personal accounts are separate. Suppose you incorporate in a state other than your home state. In that case, you must also register the company in your state as a foreign LLC (filing charges and taxes apply).
Advantages of Forming an LLC
Thanks to its inherent benefits, an LLC is overwhelmingly popular as a business entity. A few of the advantages follow.
Limited Liability Protection
In line with its name, an LLC allows small business owners and entrepreneurs to separate and protect their personal assets (homes, cars, real estate properties and personal savings) from business debt and liabilities. Personal liability protection is the cornerstone of a properly formed and managed LLC. This aspect of an LLC ensures that only the business assets are exposed to risk when the company fails or in a judgment against the company.
Flexible Management Structure
An LLC offers the most flexible regulatory, organizational and management structure. It can be formed by one person (single-member LLC) or an unlimited number of people (multi-member LLCs). Members can handle the day-to-day running or management of the business or vote to choose a manager. The registered agent can also be the manager, especially non-resident and foreign-owned LLCs. Most states allow in-person and online filing, which makes for flexibility and minimizes organizational bureaucracy, saving the business time and money.
Tax Benefits
If no tax election is made, single-member LLCs are, by default, taxed as sole proprietorships, and multi-member LLCs are taxed as general partnerships. However, by default, none of these entities pay taxes on business income. The reason is that the shares of profit and losses from the business are passed through to the members and are reported on their individual tax returns — pass-through taxation. However, members can elect to be taxed as a C-Corp or S-Corp to enjoy certain tax benefits. These flexible tax options make LLCs highly appealing.
Disadvantages of Forming an LLC
Despite its inherent benefits, LLCs have certain disadvantages. A few of these follow.
More Expensive to Set Up and Maintain
The cost of setting up and maintaining an LLC can be discouraging, especially for small business owners. Applicable fees vary from state to state and include filing, maintenance, registered agent and annual reporting fees. The filing fees may range from $100 for states like Wyoming to about $3,000 for states like Tennessee (depending on the number of members). The annual reporting license tax ranges from $60 in Wyoming to about $800 in California.
In addition, you'll have to pay some yearly fees to the registered agent, which, depending on the state, can range from $25 to $100 annually. These fees can add up quickly, making LLCs unappealing to small businesses. It gets costlier when you're filing in a state other than your home state because you must file the company again as a foreign LLC and pay applicable fees and even taxes, meaning double fees.
May be Subject to Double Taxation
LLC owners are subject to self-employment tax. As a member, you could be both the employer and employee. Besides the double fees resulting from filing a foreign LLC, you may also be subject to a tax required by the state where you are foreign-qualified or your home state. For instance, inventory and VAT may apply in your incorporation state. At the same time, franchise and gross receipts tax may apply to your home state. Again, different states have different annual reporting taxes. And when you get caught up in the mix, you'll have to pay or file your taxes per the state tax laws.
Less Prestigious than Corporations
Regardless of the numerous perks of an LLC, a general corporation remains a more robust and prestigious business entity. Unlike a corporation, an LLC is not internationally known since it is a U.S. state creation, so doing business internationally can be problematic. Raising capital can be challenging since owners can't issue shares or stocks to woo investors or do an IPO. Most investors will prefer to invest in corporations.
Turbocharge Your Small Business by Incorporating it as an LLC
Thanks to its tax efficiency, personal liability protection and flexible organizational and management structure, an LLC remains one of the most popular and beneficial business entities in the U.S.
Suppose you're a small business owner looking to save operational costs via taxation, minimize organizational bureaucracy and maximize operational efficiency. In that case, an LLC can be the perfect recipe for success. However, it also has disadvantages, so you must conduct adequate research, especially regarding state rules and compliance guidelines, to better decide if LLC or other entities will fit your company's short- and long-term goals.
Frequently Asked Questions
Do LLCs get tax refunds?
No. However, suppose an LLC elects C-Corp status for tax purposes by filing Form 8832 and makes quarterly estimated payments above its annual tax liability. In that case, it can receive a tax refund.
What is the benefit of having an LLC?
LLC offers numerous benefits, including personal liability protection, flexible or efficient tax options and simple organizational and management structure.
Can I write off my car with an LLC?
Yes, if you keep relevant paperwork detailing the amount you spent and the car’s business use. An LLC doesn’t significantly alter the process of deducting expenses such as a car lease.