How to Form an LLC
One of the first decisions a business owner makes is the structure of the company. There are several different types of business entities, one of which is an LLC, which is an abbreviation for limited liability company. But, what is an LLC? How does it operate? How is it registered with the state?
To help entrepreneurs understand the ins and outs of an LLC, this guide provides an excellent introduction to this kind of business entity and answers frequently asked questions.
What is an LLC?
An LLC, or limited liability company, is a type of business entity that offers limited liability protection to the owner. As the name suggests, personal liability is provided in the event of a lawsuit or financial crisis. Personal assets like the owner’s home, bank accounts, and car are kept separate from business assets, so if the company is sued or falls into bankruptcy these assets are safeguarded.
The extent of liability protection does vary by state, so it’s a good idea to speak with a lawyer in your area to make sure you understand what is and isn’t covered.
To the IRS, an LLC is considered a pass-through tax entity, which means the LLC itself doesn’t pay federal taxes. Instead, they pass-through to the owner. Taxes are paid on the owner’s share of the profits or personal income gained from the company.
Why form an LLC?
There are many advantages for a small business to form an LLC. This kind of business structure offers the following benefits:
Limited liability protection
As mentioned, an LLC offers a layer of protection for your personal assets. Essentially, it keeps personal assets and business assets separate, which is crucial if the company has financial trouble or is sued.
Lax record keeping
Compared to other business structures, like a corporation, for example, an LLC isn’t required to keep or submit much paperwork to state or federal officials. Unlike other entities, an LLC doesn’t have to hold meetings and keep notes, which keeps paperwork to a minimum.
Your LLC is only taxed once, as opposed to a corporation, for example, which is taxed twice. An LLC has pass-through taxation, which means the company itself isn’t taxed. The owner pays taxes on his or her profits, but that’s all. Avoiding double taxation is often considered one of the biggest perks to LLC formation.
An LLC can have an unlimited number of owners and isn’t required to have a board of directors or officers. The management structure of an LLC is flexible and can be altered to suit the business; a luxury that’s not given to all business entities.
Lax profit sharing
LLC owners can decide how to share profits. Other entities must distribute profits equally based on the amount of shares held in the company. If two LLC owners want to do a 60/40 split of the profits because one owner handles more tasks than the other, that’s fine. Flexible profit sharing is yet another benefit for business owners.
LLC compared to other types of businesses
Ready to make your startup ideas a reality? If so, one of the first things you must decide is what kind of business structure the company will take. The type of business selected can impact many things like taxes, compensation, and roles of internal management. To better understand the different types of businesses, here’s how other structures compare to an LLC:
LLC vs. Sole Proprietorship
A sole proprietorship is one of the easiest business structures to set up and maintain. This kind of entity isn’t registered with the state, so there’s no paperwork to submit or annual reports to consistently file. No filing fees are paid either.
Setting up an LLC must be done through the state with certain paperwork required and filing fees paid. While there is more paperwork to file with the state, an LLC provides personal liability protection, which means personal and business assets are separated. If the business racks up debt or is sued, the owner’s personal assets aren’t used to rescue the business.
LLC vs. S Corp
It’s common for people to hear LLC and S corporation mentioned together. An LLC is a type of business while S corp is a type of tax classification. In other words, an owner can form an LLC and choose to file taxes as an S corp. This works best primarily when business owners are company employees. S corp owners/employees pay themselves a wage and pay taxes on it. Additional profits are doled out as distributions and aren’t subject to Medicare and social security taxes.
An LLC owner that doesn’t opt to file taxes as an S corp is considered self-employed and pays taxes on the entire share of company profits through personal tax returns.
LLC vs. Corp
An LLC and corporation are different in both its ownership abilities and taxation. In an LLC, one or more members can own the company. In a corporation, shareholders own the company.
A corporation is considered a separate legal entity, so it can collect its own income. As a result, a corporation must pay taxes and the owner must pay taxes, which is referred to as double taxation. While paying more in taxes isn’t ideal, corporations do have perks. Corporations can deduct 100% of their business expenses, for example, which could be a big win for some companies. It’s best to speak with an accountant to understand how this choice will impact your new business and finances.
How to form an LLC
Forming an LLC isn’t difficult, but there are a series of things that must be done to set one up. To officially launch an LLC, here are the steps to take:
1. Pick a name
Every company needs a name. Do you have one in mind? Whether you settled on a name years ago or are still weighing your options, there are several rules to be aware of. For starters, the business name must have “LLC” or “Limited Liability Company” in the title.
Second, most state laws won’t allow two businesses to have the same name. Most states require business names to be “distinguishable from one another” so even similar names are often rejected. Most states let prospective business owners conduct a business name search to check availability of a certain name. Usually these search-based sites can be found on the secretary of state’s website.
Owners can usually pay a small fee to reserve an LLC name for 90-120 days. For owners who don’t plan to register their LLC immediately with the state, this is a good option to preserve the name until you’re ready to file.
2. File Articles of Organization
To start an LLC, the company owner must file an official formation document, usually called Articles of Organization. (Some states call it Certificate of Organization or Certificate of Formation). Most states allow owners to file the document online or download and mail it in.
Expect to pay a filing fee as well. The fee ranges from $50 in Arizona to $500 in Massachusetts. The proper paperwork and filing fee amount can be found on the secretary of state website.
The Articles of Organization ask for the company name and address, the registered agent’s name and address, a list of managing members, and a brief description of the business. The owner must digitally sign the document, if it’s filed online, and pay the fee with a credit card.
Once submitted, expect it to take 2-7 days for the state to approve the document. Approval marks the official start of an LLC.
3. Pick a registered agent
As mentioned, Articles of Organization ask the owner to list a registered agent. A registered agent is a person or company that accepts official documents for a company. For instance, a registered agent could receive tax documents, filing updates from the secretary of state’s office, or legal documents.
Most states require a registered agent to be either an adult or a professional registered agent service with a physical address. Since some documents must be delivered in-person or even signed for, a P.O. box cannot be used.
A registered agent service charges an annual fee to accept important documents and notifies the company owner when items arrive. Some services offer additional assistance with compliance documents, like filing annual reports for an additional charge.
4. Create an operating agreement
With Articles of Organization filed, small business owners should move next to an operating agreement. An operating agreement explains how a business is run and should include the company’s hierarchy, an explanation of how decisions are made, and a summary of day-to-day operations. The document should also provide financial direction, explaining how profits and losses are managed.
States don’t require owners to file an LLC operating agreement, however, business experts strongly advise owners to create the document before opening to the public. The document can answer questions and solve potential feuds in the future.
If you aren’t sure how to write an operating agreement, you can speak with an attorney or search for a downloadable template online.
5. Obtain an EIN
Most businesses need an EIN, or an employer identification number, to function. This nine-digit number is issued by the IRS and required for many financial transactions including paying taxes, hiring employees, or applying for a bank loan.
Obtaining an EIN is simple to do. Visit the IRS website, fill out a quick form, and the number is instantly provided at the end of the session. A company EIN is unique to your company. Think of it as a social security number, but for businesses.
6. Inquire about state licenses and insurance
Depending on your business, it likely needs one or several licenses to operate. Each state is different in its requirements. Check with state and local officials to see which business licenses are required.
In addition, it’s a good idea to research insurance. While setting up an LLC does provide limited liability protection, insurance can provide further asset protection. You might consider property insurance to protect the building or property that houses your company and vehicle insurance for company-owned cars. There are even policies that are geared towards home-based businesses. An insurance agent can provide specific advice for your company.
7. File an annual report
Most states require LLCs to file an annual report with the state. The report is meant to keep state officials informed about your business and points of contact. Should the state need to reach business owners to deliver notices or updates, the report provides that contact information.
The report takes seconds to file online and is often completed just like the Articles of Organization. For owners who would rather not handle this kind of chore, registered agent services can often file these documents for you. It’s an additional fee, but owners rest easy knowing that the document is handled yearly.
Failure to submit an annual report, and its associated filing fee, can cause problems for an LLC. Some states charge late fees if it’s not filed on time and will dissolve a business if it’s not turned in.