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Forming an LLC helps protect your personal assets. It also unlocks the ability for you to open bank accounts, enter into contracts, hire employees, and get business licenses and permits.
Forming a limited liability company (LLC) is an easy and inexpensive way to structure your sole proprietorship or small business. Here's what an LLC will and won't do, and when you should consider forming one.
If you have a business – either a sole proprietorship or partnership – you should seriously consider setting it up within an LLC. It will provide you with similar legal protections to a corporation, but enable you to run your company as a small business.
How an LLC can benefit a small business
Probably the most obvious advantage to forming an LLC is protecting your personal assets by limiting the liability to the resources of the business itself. In most cases, the LLC will protect your personal assets from claims against the business, including lawsuits.
This enables the small business owner—of sole proprietorships and partnerships—to gain the limited liability protection similar to that offered by corporations, but without the cost and complexity that corporations bring. For example, under an LLC, you will not need to file a separate tax return for your business. Your income and expenses will continue to be reported on your individual income tax return, either on Schedule C for sole proprietorships, or on Schedule E for partnerships.
There is also the tax benefit to an LLC. This is particularly true in relation to “C corporations,” which the IRS recognizes as independent entities. Taxes must first be paid on net income to a corporation, before that income is distributed to the owner, where it is taxed again at an individual level. This is what is known as double taxation, which you can avoid entirely with an LLC. (You can also avoid it with a Subchapter S Corporation but that will still involve a complicated set up, as well as ongoing compliance and filing requirements.)
Still another benefit is something of a soft advantage: having “LLC” or “Limited Liability Company” in your business name can make your business seem somehow more official. It implies that the business is registered with the state, and is somehow more substantial as a legal entity.
If you have a small business, either a sole proprietorship or partnership, you should take a serious look at creating an LLC. That will enable you to gain important legal protection for your personal assets, without disturbing the management and income flow of your business.
What is an LLC?
LLC is an abbreviation for limited liability company. It’s a business structure that provides a business with limited liability (similar to a corporation), but the structure is easier to establish and simpler to maintain. It also provides the business with pass-through treatment of income for tax purposes, similar to that of a sole proprietorship or a partnership.
Owner’s limited liability
This is where the term “limited liability” in LLCs comes from. The LLC provides protection to the LLC owners by limiting the owner’s personal liability. Generally, this means that business debts owed by the business, and other claims on the business, including liens and lawsuits, are limited to the assets of the business itself. Those holding such liens against the business cannot pursue the personal assets of the business owner(s) in most states and under most circumstances.
This protection, however, does not extend to illegal acts committed by the owners of the LLC, and can also be lost in the case of certain instances of negligence on the part of the owners.
Pass-through treatment of income taxes
Unlike a corporation, an LLC is not considered to be a distinct entity for income tax purposes. The owner(s) of the LLC report their operating results, including profit or loss, on their personal income tax returns, just as they would as either a sole proprietorship or partnership. No return is filed specifically for the LLC.
Choose a business name
There are two considerations here, the first being to choose a name that doesn’t duplicate that of an existing LLC in your state. Your state will let you know if the name you choose is acceptable.
The second consideration is that your business name must comply with state regulations in regard to LLC names. Generally, this means that “LLC” or “limited liability company” must appear in your business name. There may be other requirements depending upon the state where you are attempting to establish your LLC.
Create an LLC Operating Agreement
This is probably the most complicated part of creating an LLC, but the good news is that the document is not necessarily required to be filed with the state. Still, you should create an operating agreement for your LLC to avoid conflicts later.
Even this document can be relatively simple, and does not necessarily need to be prepared by an attorney (though it’s never a bad idea in the case of an LLC with multiple owners).
The purpose of the operating agreement is to spell out the rights and responsibilities of each owner of the LLC. It is very similar to corporate bylaws or to partnership agreements, which are largely intended to provide a framework to deal with conflicts or with the transfer of ownership between partners, both existing and new.
The operating agreement should provide for owners’ rights and responsibilities, voting power, percentage interests in the business (including division of profits and losses), and the scheduling of owners meetings. A very detailed operating agreement may even include management responsibilities between several owners.
The agreement can be as detailed as you need it to be, but it’s a necessary document if there is potential for any disagreement between owners over either the ownership or management of the LLC.
And don’t be intimidated by the form requirements, either. You can often get them from your state offices, or through a general web search (just make sure they’re specific to your state). Failing all else, you can always check out LegalZoom.com, or one of their competitors, for low cost pro forma legal documents.
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