Limited liability companies (or LLCs, for short) are a popular choice among first-time business owners because they formalize a new venture and give them greater credibility with consumers. Entrepreneurs also appreciate the limited liability protection, management flexibility, and tax advantages that an LLC offers.
So, if you’re thinking of forming an LLC for your venture, too, keep reading to learn more.
What is an LLC?
A limited liability company is one way a business can be structured. It combines elements of a sole proprietorship or partnership with those of a corporation, giving small business owners the best of both worlds.
First-time business owners typically choose an LLC over a sole proprietorship or a partnership because it offers limited liability protection. This liability protection shields LLC owners (or members, as they’re typically referred to) from being personally liable for the company’s debts and obligations. If the business is unable to repay its debts, creditors can’t go after the business owner’s personal assets to recoup their losses.
Since an LLC is treated as a separate legal entity from its owner, the company is responsible for its financial obligations.
How does an LLC work?
The laws governing how an LLC operates vary from state to state, but most states have minimal restrictions on who can own one of these businesses.
Some states require LLC owners to be at least 18 years of age—or whatever the age of consent is in the state—to become a member. But aside from that, almost anyone can become a member—including corporations, foreign individuals, foreign entities, and even other LLCs.
Members of an LLC can run the business themselves or hire managers to handle the day-to-day activities on their behalf (more on this in the following sections). This flexibility in management structure allows members to determine their level of involvement in the LLC’s operations.
Common types of LLCs
Single-member LLC
If an LLC has only one owner, the business is known as a single-member LLC and is treated as a disregarded entity for tax purposes. A business treated as a disregarded entity doesn’t file a separate federal income tax return. Instead, the owner reports the business’s income, expenses, and profits on Schedule C and files it with their personal tax return (Form 1040).
Multi-member LLC
Similarly, a multi-member LLC is an LLC with multiple owners. This structure is ideal for businesses with multiple owners because it allows members to share in the LLC’s ownership, profits, and losses. Multi-member LLCs also provide liability protection for each owner of the business.
The Internal Revenue Service (IRS) treats an LLC with multiple owners as a partnership, unless it elects to be taxed as a corporation (more on this later). When an LLC is taxed as a partnership, its members must file an information return on the company’s behalf (Form 1065) in addition to reporting their share of the LLC’s income taxes on their personal tax return, using Schedule K-1.
Multi-member LLCs can be member-managed or manager-managed, as explained below.
Member-managed LLC
As the term implies, a member-managed LLC is simply an LLC that’s managed by its members. Owners have direct and equal input in the company’s decision-making process, ensuring that decisions are made collectively. Member-managed LLCs are ideal for smaller businesses with owners who wish to be actively involved in the day-to-day management of the company.
Manager-managed LLC
Limited liability companies that aren’t managed by their members, on the other hand, are known as manager-managed LLCs. Members don’t participate in the company’s day-to-day operations, similar to the shareholders of a corporation, and hire managers to run the company on their behalf. You’ll often see this organizational structure used with larger companies and LLCs with passive investors.
How are LLCs taxed?
Compared to other business entities, limited liability companies can elect to be taxed in various ways.
One significant benefit offered by LLCs is the ability to pass business profits and losses through to their owners. This tax election, known as pass-through taxation, ensures that the company’s income is only taxed once. Any income received by the LLC “passes through” to its owners and is reported on their personal income tax returns, so the owners pay taxes on the business’s income themselves.
However, keep in mind that business owners who opt for pass-through taxation may also be responsible for paying self-employment taxes each year in addition to income tax on the LLC’s profits.
Alternatively, LLCs can be taxed as a C corporation (C corp) or an S corporation (S corp). These companies are typically subject to double taxation—business profits are first taxed at the corporate level, and then shareholder distributions are taxed at the personal income tax rate. In return, LLCs taxed as corporations have access to tax breaks and write-offs that aren’t available with pass-through taxation.
If you want your LLC to be taxed as a corporation, you’ll need to change its tax classification with the IRS. To classify your LLC as a C corporation, file Form 8832. To have your LLC taxed as an S corporation instead, file Form 2553.
Benefits of forming an LLC
Limited liability protection
As mentioned earlier, limited liability protection prevents LLC members from being held personally responsible for the company’s financial obligations. So if the business gets sued or goes bankrupt, creditors can’t go after the personal assets of its owners.
However, keep in mind that if an LLC fails to meet its legal and compliance requirements, doesn’t conduct itself as a separate entity from its owners, or commits fraud, members may lose their personal liability protection. Creditors will then have free rein to seize the owners’ personal assets to fulfill the company’s debts.
Versatile tax classification
Business owners can change their LLC’s tax classification to reap the most benefits for themselves and the company. By default, LLCs are treated as disregarded entities for tax purposes. LLC members pay taxes on the company’s income through their personal tax returns, ensuring that the business income is taxed only once.
However, LLCs can also be taxed as a C corporation or S corporation if their members elect to do so. This opens up benefits that aren’t generally available to LLCs that are classified as disregarded entities.
Fewer compliance requirements than corporations
Limited liability companies are easier to set up than corporations, while still providing members with the limited liability protection that incorporation offers.
Once an LLC is up and running, it also has fewer compliance formalities and requirements to maintain compared to its corporate counterparts. For instance, corporations are required to have a board of directors and hold annual shareholder meetings, while LLCs aren’t.
Since an LLC has fewer record-keeping and administrative responsibilities than a corporation does, its members can dedicate more time and resources to growing the business. For many prospective business owners, this makes an LLC the ideal choice.
Flexible membership
States place very few restrictions on who can become a member of a limited liability company. Membership is open to individuals, other LLCs, corporations, trusts, as well as foreign individuals and entities. There are no limits on the number of members an LLC can have.
Disadvantages of forming your business as an LLC
Although there are a few drawbacks to forming your business as an LLC, the benefits typically outweigh any downsides for first-time business owners.
Cost
A limited liability company generally costs more to form than, say, a sole proprietorship or general partnership. Prospective LLC members can expect to pay a one-time formation fee plus an annual fee. States charge anywhere from $35 to $500 for formation fees, while annual filing fees range from $7 to $800 (although a handful of states don’t charge yearly filing fees at all).
LLCs may also be subject to state franchise taxes. These taxes are levied for the privilege of conducting business within the state’s jurisdiction. Franchise taxes are paid annually, and the amount varies by state.
More compliance requirements than disregarded entities
An LLC typically has more compliance obligations than a sole proprietorship or general partnership. For example, business owners are required to keep their business and personal finances separate. They must also appoint a registered agent for their business, file annual reports, and pay annual filing fees to the Secretary of State’s office.
In comparison, most sole proprietors don’t need to file formal business formation documents or apply for a federal employer identification number (EIN). Partnerships may need to register with their state and file annual information returns, but have few legal requirements beyond that.
Complications with transferring ownership
Changing ownership is more complex with a limited liability company than it is with a corporation, which can make things difficult if you plan to sell your business in the future.
Unless the LLC’s operating agreement states otherwise, all current members must agree to any changes in ownership percentages or the addition of new members. If a member dies or leaves the business, some states require the remaining members to dissolve the LLC and refile the paperwork to reestablish the company. As you might imagine, this can dramatically slow down the company’s operations and overall success.
In comparison, a corporation continues to exist even if its ownership changes.
How to form an LLC
1. Choose the state where you’ll form your LLC
Business owners can form a limited liability company in any state, even if they don’t live or plan on doing business there. Some seasoned entrepreneurs register their LLC in Delaware or Nevada to take advantage of their business-friendly tax laws and other benefits.
However, most new business owners form their LLCs in the state where they plan to do business to reduce their administrative responsibilities.
If you live in California, for example, but register your LLC in Nevada, you’ll still need to register in California to conduct business in the state. Registering your business in multiple states increases your formation and upkeep costs, which is typically not ideal for first-time business owners.
2. Pick your business name
Business owners must choose a unique name that isn’t used by any other company in the state where they’ll register.
So to avoid this, do a business name search on the Secretary of State’s website to see if your preferred name is already used in your state. If you’re starting an online business or plan to expand operations nationwide, consider checking to see if companies in other states are using your business name as well. You may also want to conduct a trademark search on the US Patent and Trademark Office’s website to ensure your business name hasn’t been trademarked.
Each state also has its own set of LLC naming requirements, so make sure that your business abides by those guidelines. Otherwise, you may have to change your LLC’s name.
3. Find a registered agent
Next, you’ll need to choose a registered agent for your business so you can include their information in your operating agreement.
A registered agent, also sometimes referred to as an agent for service of process, receives legal and tax correspondence—such as IRS notices and subpoenas—on behalf of a company to ensure it complies with state regulations. Although the owner or manager of a business can act as its registered agent, it’s generally better for an LLC to work with a company offering registered agent services instead.
A registered agent must have a physical address (not a P.O. box) in the state where the company does business so they can promptly receive the company’s mail and any time-sensitive correspondence during business hours. The name and address of an LLC’s registered agent also become part of the public record. So, if you’re a solopreneur working from your living room, for example, you may want to avoid making your home address publicly available.
4. Write your LLC operating agreement
An operating agreement is a contract that outlines the operational structure of a limited liability company. An LLC’s members typically draft this document during their first meeting and retain it for internal reference.
Almost every state requires an LLC to have at least a verbal agreement, although a written one is highly recommended, especially for LLCs with multiple owners. By outlining exactly how the business should be run, an operating agreement ensures that all LLC members understand their financial, legal, and managerial rights and responsibilities. A clear and well-defined agreement also helps reduce conflict by specifying exactly how members will share ownership, labor, and profits among themselves.
Your operating agreement should generally include information on the following:
The LLC’s structure and essential business functions
How the company’s members, managers, and officers conduct business
Who is responsible for what tasks
What vote is required to approve certain transactions
How members will split distributions, profits, and losses
How to add or remove members
How to dissolve the business
Consider having a business attorney review your agreement before all of your members sign it to ensure you’re not missing any critical details.
5. File articles of organization with the state
For your LLC to exist legally, you’ll need to file business formation documents with the Secretary of State’s office in the state you want to form your company in. This document, known as the articles of organization, is also referred to as a certificate of organization or certificate of formation.
An LLC’s articles of organization outline basic information about the business. Although the details differ between states, this document generally includes the following:
Name and principal location of the business
Names and addresses of the LLC’s members
Whether the LLC will be member-managed or manager-managed
Names of the LLC’s managers
Name and physical address of the LLC’s registered agent
The registered agent’s consent to act in this role (in some states)
Statement of purpose for the business
Some states also require business owners to publish a notice, typically in a local newspaper, informing the public about the formation of their LLC. Once the newspaper publishes your notice, you’ll need to file a certificate of publication with your state.
Filing forms, as well as detailed instructions and requirements for filing your articles of organization, are available from the department that handles business filings in your state. When you submit your articles of organization, you also pay a filing fee, which varies by state.
Once your business formation documents are approved, the state will provide you with a certificate or confirmation document that serves as legal proof that your LLC exists and is permitted to operate in the state. You’ll need this document to complete the setup of your new business.
6. Apply for an EIN and your business licenses or permits
Now, you’ll need to apply with the IRS for your EIN. Your LLC will use this identification number to open a business bank account, file business tax returns, hire employees, and more.
To apply for an EIN, complete and file Form SS-4 with the IRS.
Depending on your LLC’s purpose, industry, and business activities, you may also need to apply for specific licenses or permits to do business in the jurisdictions you operate in. For example, if your company sells taxable goods or services, you must apply for a tax identification number with your state to collect sales tax. And if you plan on hiring employees, you’ll also register with the state labor department to file and pay employment taxes.
Certain businesses, such as those in the food service industry, are required to obtain additional permits before they can accept customers. Check with your state and local government authorities for further information.
7. Open a business bank account
Once you have your EIN, you can open a business bank account for your new LLC. This will help you keep your business and personal finances separate, thus helping to maintain the limited liability protection that your LLC provides.
You’ll need to provide details about your LLC and its members when you apply for a bank account. This information includes:
Owner names and contact information
Business name
Business formation date
Business type
Business EIN
Business formation documents
8. Register your LLC with other states (if needed)
If your LLC will be doing business in states other than the one in which it was formed, you may need to register the company in those states through a process known as foreign qualification.
States have different criteria to determine whether a company needs to foreign qualify to do business within their jurisdictions. Some of the most common ones include whether the company:
Has a physical location in the state
Has employees in the state
Accepts orders in the state
Must collect sales tax in the state
If you meet the state’s requirements for foreign qualification, you’ll typically file an application for authority with that state’s Secretary of State office. You must also have a registered agent with a physical address in the new state.
Because each state has its own requirements for foreign qualification, you should consult with a business attorney to determine whether your LLC meets the criteria.
9. File an annual report with your state every year
To keep your LLC active, most states require you to file an annual report and pay any associated filing fees to the Secretary of State department every year. In addition to helping keep your business compliant with state law, fulfilling this obligation also enables you to maintain your limited liability protection.
Annual reports share basic information about your LLC, as well as details on the company’s:
Registered agent
Current business locations
Changes to current members and managers
Business activities in the state during the year
Financial information for the current year
Annual report filing requirements vary by state, so check with your state for the most up-to-date information. Keep in mind that you’ll need to file with your formation state as well as any other states you’ve registered your LLC with.
How is an LLC different from other business entity types?
The business structure you choose will give you access to different benefits, but it also means you’ll be subject to certain drawbacks as well. The best one for your new venture will ultimately depend on your business goals and needs.
LLC vs. corporations
Corporations and LLCs provide their owners with limited liability protection, and they must file certain state documents upon formation and every year afterward to maintain compliance—but that’s where the similarities end.
Corporations may be subject to double taxation, while LLCs can elect to be taxed as a C corp, an S corp, a sole proprietorship, or a partnership. This flexibility enables the owners of an LLC to opt for pass-through taxation if desired.
Corporations also have more legal and compliance requirements to meet, in exchange for greater tax benefits and more flexibility with issuing stock than LLCs.
LLC versus sole proprietorship and partnership
Unlike sole proprietorships, which are considered disregarded entities and not separate from their business owners, both partnerships and limited liability companies are seen as separate legal entities from their owners.
Businesses structured as sole proprietorships and partnerships offer no liability protection for their owners, and creditors can pursue the owner’s personal assets to satisfy business debts. In comparison, an LLC gives members limited liability protection as long as the company meets its compliance obligations.
Is an LLC the best choice for my business?
If you’re a business owner looking to level up your venture from a sole proprietorship or a partnership, a limited liability company may be the right choice for you.
You’ve already established the viability of your business idea, created processes and workflows to support you, and are now ready to expand your operations. So, establishing your business as an LLC can help assure customers that your business is legitimate, and also provide you with additional benefits that your current business structure doesn’t offer.
However, if you plan to attract investors to your venture, you may want to consider structuring your business as a C corporation or S corporation instead, as LLCs have investment restrictions that corporations don’t.
Ultimately, whether an LLC is right for you depends on what your business needs now and what your future goals are. For further guidance, consult with your business attorney and tax professional.
And, if you do decide to form an LLC, consider using Gusto’s HR software to manage your operations with ease and help you save hours on administrative tasks so you can get back to growing your business. Create a free account today to see how the platform can help streamline your business.
