Just Select Your State to Begin!
What is an LLC & What Does it Do?
An LLC is not a corporation; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. They do not need to be organized for profit.
Has characteristics of a corporation and a partnership or sole proprietorship (depending on how many owners there are).
Limited Liability: which basically means that should any serious legal issues arise and your company gets sued, they are suing a corporate entity – not the flesh and blood owners or investors of said company. If the LLC ends up in debt to creditors, the creditor cannot legally come after a member’s personal assets. So they are not liable beyond what they’ve already invested.
Pass-through income taxation: income is not taxed at the corporate level, only the individual owners’ level. The profits are passed directly through the business to the owners and are taxed on the owners’ individual income tax returns. Losses are also passed-through to owners, but the total deductible amount available is limited to the original investment amount.
LLCs don’t have the formalities of corporations to maintain, which adds to its flexibility. Owners get to decide how their LLC is governed through an operating agreement.
One of the most prevalent forms of business in the US.
LLC Operating Agreement: most states do not dictate detailed governance and protective provisions for the members of an LLC. Most states do not require them. Usually includes percentage of interests, allocation of profits and losses, member rights and responsibilities and other critical provisions.
The federal government doesn’t tax the actual LLC, but some states do, or may, depending on a number of stipulations.
LLC Tax Forms
- Partnership income/loss report IRS Form 1065
- IRS Form K-1 reports members distributive share of income/loss.
- IRS Form 8832 if the LLC wants to be taxed as a corporation.
- C corporation: taxation of the entity’s income prior to any dividends or distributions to the members and then taxation of the dividends or distributions once received as income by the members)
- S corporation: entity level income and loss passed through to the members (self-employment tax savings). Limited number of stockholders all must be U.S. citizens
What are the Advantages of Forming an LLC?
Well for starters, corporations are taxed twice, once at the corporate entity level and again when distributed to shareholders thus more tax savings often result if a business formed as an LLC rather a corporation.
- Flexible when it comes to how you want to be taxed – sole proprietor, partnership, s/c corporation.
- LLCs may deduct normal business expenses, including salaries, before they allocate income to owners/members.
- Can form one anywhere you want, or in any state, and it’s somewhat easier to register than with a corporation.
- Can have unlimited number of members and there are no citizenship restrictions.
- Protection from personal liability for business decisions or actions of the LLC. Member personal assets are exempt. But keep in mind the word “limited” doesn’t mean comprehensive protection from all wrongdoings or the bad choices of your employees – owners and/or corporate shareholders can lose this protection by acting illegally, unethically, or irresponsibly.
- Personally, and directly injure someone.
- Personally, guarantees a bank loan or a business debt on which the LLC defaults.
- Fails to deposit taxes withheld from employees’ wages.
- Intentionally does something fraudulent, illegal, or reckless that causes hard to the company or to someone else, or,
- Treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity. IF the members do not treat it like a separate business entity (aside from them just working for themselves as individuals), courts may find that the LLC doesn’t really exist.
- Act fairly and legally: do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders.
- Fund your LLC adequately: invest enough cash in the business so that your LLC can meet foreseeable expenses and liabilities.
- Keep LLC and personal business separate: get a federal EIN, open up a business-only checking account, and keep personal finances out of your LLC accounting books.
- Create an operating agreement – a formal written operating agreement/contract lends credibility to separate existence.
- Startup costs are going to be lower because there’s a bit less paperwork to do and keep track of.
- Free to dispense with profits in any way you see fit, within the bounds of overarching state/federal laws of course.
How about the Disadvantages?
Pass-through income can make for a confusing tax situation, depending on the complexity of company operations. Furthermore, sometimes pass-through income is not actually distributed to shareholders leaving the owners with a tax burden but no cash with which to pay it.
- Technically, it’s not as easy to gain investment funding as an LLC because more formal corporations headed towards IPO status are a safer bet.
- In tons of jurisdictions LLCs pay the state a franchise tax for the benefit of limited liability – can be based on revenue, profits, or an amount based on the number of owners or the amount of capital employed in the state, or some combination – or a flat fee like in Delaware.
- Renewal fees tend to be a bit higher as well.
- Because there isn’t a board of directors or officers, management may not be clearly stated.
- Internationally most taxing countries and jurisdictions do not recognize LLCs. – who ACTUALLY has the authority to enter into a contract on behalf of the company?
- Most are member managed, where members are responsible for an equal share.
- Then there’s manager management where one or more people are designated to take responsibility and can thenvote on management decisions and act as agents of the LLC.
- In most states if a member leaves, then the LLC is dissolved and the other members must fulfill any remaining business obligations, pay off all debts, divide any assets and profits among themselves and then whether they want to form a new LLC to continue.
- Can be prevented through terms and provisions in your LLC operating agreement.
Who is an LLC Typically Right for?
- Firstly, those who can afford basic liability business insurance if the nature of the business calls for it, for example when working directly with the public or in situations where someone could get physically harmed. The extra layers of protection for both the LLC and its members. However, this insurance doesn’t cover your LLC if you fall behind and can’t pay your bills.
- Can’t typically be involved with banking trust, and insurance, and some professional like architects, accountants, doctors, and licensed healthcare workers.
- Normally three reasons for a self-employed person to create an LLC:
- Limited liability coverage
- Ability to be taxed as an S-corp or a partnership – flow-through entity
- The ability to take a pay check and have taxes withheld throughout the year. So you create an LLC and become its employee, collecting a pay check which makes tax time a bit easier – the paycheck being deductible for the LLC. People pay the LLC and this money is deposited into the LLCs bank account vs. personal accounts.
- Brands that believe they can benefit from the additional credibility of an LLC distinction and title, as well as those that want to register and project their brand name.
When is the Ideal Time to Form an LLC?
In terms of income thresholds, there really are none. Basically, once you or your partner or someone involved starts worrying about losing their personal assets, then the limited liability of an LLC can offer some protection.
Or, lets say income shoots up and you want to form the LLC before tax time, or the end of the year, consider the length of time it will take to fill out/file the paperwork, pay the fees, get an EIN, get processed, etc.
So you’re interested in learning how to form an LLC, brilliant! They’re the most common form of business entity in America for two very good reasons, both of which we’ll dive into below along with the many other advantages and disadvantages.
First, an LLC isn’t a corporation because you aren’t required to maintain a board of directors, elect officers, or take part in any of the other corporate formalities. However, an LLC does have one corporate characteristic, which is where we’ll begin.
When you form an LLC you’re creating a separate business entity under the law in most jurisdictions. So, now it’s “the company” that can get sued and fall into debt not founders, members, or investors whose personal assets become somewhat protected – they’re no longer liable beyond the money they’ve already put into the company.
However, it’s “limited” liability, not a free ticket. There are restrictions:
- If founders or employees personally and directly injure another person.
- Trying to guarantee lines of credit or business debt with the intention of defaulting.
- Failing to deposit tax money that’s been withheld from employee wages.
- Intentionally taking fraudulent, illegal, or reckless actions that causes harm to the LLC.
- Failing to adequately treat the LLC as a separate and legal business entity.
Before we get into the other major aspect of LLCs, which is how they’re taxed, let’s talk a little about that last point because you’d be shocked to find out how many LLCs lose their limited liability status from the IRS and in court because a judge felt the LLC really didn’t exist.
If you and your members follow the four basic guidelines below, your LLC has a very high chance of keeping its limited liability status over the long haul and in court should an issue arise.
- Transparency: Be fair, ethical, and responsible, and don’t conceal or misrepresent the state of your LLC to the state, federal government, creditors and vendors.
- Funding: There should be enough inbound cashflow/capital to keep the LLC afloat rather than just racking up huge amounts of debt to cover expenses.
- Distinction: The LLC’s financials should in NO WAY mix with personal income of founders or members – get an EIN, set up an official bank account, and keep the data separate.
- Management: While not mandatory, it’s HIGHLY recommended you have an “Operating Agreement”, which is a formally written and signed contractual agreement on finances, management, responsibilities, etc. Without one your LLC is subject to default state/federal rules which may not be as beneficial. And, with no Operating Agreement you’re failing to leverage the flexibility LLCs were created for!
Pretty straightforward guidelines across the board. That being said, let’s move on now to the second big strong point of LLCs which is what’s called pass-through taxation.
Pass-Through Taxation means the LLC itself isn’t taxed by the Federal Government as a separate entity (some states do though!), instead, taxation and profits/losses pass through the LLC to the members who report these financials on their individual income tax returns.
While you can have an unlimited number of members and there are no citizenship restrictions, the IRS will treat your company as though it’s a sole proprietorship (single-owner LLC) or partnership (multi-owner LLC).
- Single-Owner: The LLC itself pays no taxes and doesn’t have to file, only the owner/founder.
- Multi-Owner: Each member/owner pays taxes in accordance to their “distributed share” of the profits/losses as stated on their personal income tax returns. Shares should be stated clearly in the LLC operating agreement (contract).
In some circumstances, pass-through is preferable because individuals will be taxed less than a corporation which is double-taxed. Or, in other words, once on the corporate level and then again when profits are distributed to shareholders.
However, there are also plenty of circumstances where an LLC will switch to a corporation to leverage the other benefits (stock options, tax incentives, etc.), and the corporate income tax rates may be better than individual. This is where consulting with a tax attorney or qualified accountant comes in handy.
To summarize the taxation aspect, by default the IRS will treat an LLC as either a sole proprietorship or partnership. Beyond this the LLC can opt to become either a conventional corporation (c-corp) or get a special designation (s-corp).
- C-corporation: separate taxable entity that pays corporate taxes, possibly double.
- S-corporation: gets pass-through taxation, no corporate taxes.
- Partnership income/loss report IRS Form 1065.
- IRS Form K-1 reports members distributive share of income/loss.
- IRS Form 8832 “Entity Classification Election” if the LLC wants to be taxed as a corporation.
- C-corporation: tax return IRS Form 1120.
- S-corporation: Must file IRS For 2553 to become an S-corporation, then submit informational tax return IRS Form 1120S.
The biggest advantage for most entrepreneurs, small teams, and startups who form an LLC is flexibility in terms of taxation and management. Then there’s the personal/asset protection of limited liability. Here’s a handful of the other popular LLC advantages,
- LLCs are allowed to deduct all normal business expenses which include paid salaries BEFORE they distribute any income to members which can help lessen overall tax burdens.
- You can form an LLC anywhere in the U.S., from sea to shining sea, and the registration process can be simpler than with corporate/non-profit entities.
- Startup costs and fees tend to be lower, at least when it comes to the paperwork side of things at the initial founding and over time.
- Members are free to dispense or distribute profits as they see fit, within the bounds of overarching state and federal laws of course.
- Unlike most Corporations, members can distribute profits and ownership interests in creative ways that don't necessarily correspond to capital contributions. For instance, one member might contribute $10,000 cash along with a great business plan and business relationships, and another member might just contribute $90,000 with no intangible contribution, but the the members could agree in the operating agreement that each member is entitled to 50% of the profits and a corresponding 50% membership interest.
Again, the importance of an Operating Agreement can't be over-stated for LLCs with more than one member! They’re what make it possible, in the eyes of the law or in court if you end up in one, to use an LLC for its intended purpose.
Listen, if you aren’t trained in business taxation, or at least LLC-specific taxation, and you don’t have an attorney or qualified accountant…PLEASE think this through! One of the disadvantages is that the tax situation can get confusing fast depending on how complex your company operations/management are.
Here are some other considerations:
- Funding: LLCs can find it more difficult to raise funding because many investors are after corporations or LLCs with lots of funding headed towards an Initial Public Offering (IPO).
- Franchise Tax: Along with typically higher renewal fees, many states levy a franchise tax on LLCs as a sort of fee to pay for the benefits of limited liability. This fee can be based on revenue, profits, the amount of capital employed in the state, a combination, or just be a flat fee like they charge in Delaware.
- Dissolution: In most states your LLC can completely fall apart or dissolve and lose its status if one member decides to quit, thus leaving any financial debts/obligations to remaining members. Only an operating agreement provision can prevent this.
- Non-Corporate: No board of directors or officers means that managing an LLC can be vague (especially with no operating agreement) and this can be challenging.
- Federal Taxes: There are instances where an S-Corporation is a more appropriate pass-through vehicle for tax purposes, especially when the goal is to save on self-employment taxes.
Oh, and another thing, U.S. Limited Liability Companies aren’t recognized by most taxing countries so this could cause some issues if you don’t have a great attorney in place!
To be honest, if your business works directly with the public or is regularly involved in situations where other people and their property could be damaged you should consider limited liability protection. Then, of course if the numbers make sense it could be worth a shot until your platform grows to the point a corporation or some other legal business entity makes sense.
- Can’t typically be involved with a banking trust, insurance, and some professional titles like accountants, doctors, licensed healthcare workers, architects, etc.
- Self-employed folks should also consider the coverage along with the ability to be taxed differently – it’s easier! You turn your product/service into a brand and then become an employee who collects a paycheck.
Beyond these basics, many brands also want to benefit from the additional credibility and distinction that comes along with forming an LLC. So, instead of “Tommie’s Beads” it becomes something more official like “Tommie’s Beads LLC.”
If you’re asking whether there’s an official income threshold where an LLC should be considered, no. It really just comes down to when you as a sole proprietor or together with your founding members feel that it a) makes sense financially, and b) your platform warrants limited liability protection.
Also, let’s say income shoots up and you want to form the LLC before tax time hits, or the end of the year, do consider the length of time it takes to fill out/file forms, pay applicable fees, get an EIN, set up a bank account and get everything processed.
Below are useful references for understanding and getting started:
- Howtostartanllc.com: "What is an LLC?"
- IRS.GOV: "How the IRS Classifies an LLC"
- New York Department of State: "Limited Liability Companies FAQs"
This article on Startup Savant is not a legal document or legal advice. It is for informational purposes only and the information is subject to change over time. For specific questions and concerns regarding how to form an LLC, please consult an accredited attorney or a qualified professional.