Why Should I Form an LLC?

Sunday, October 6th

Why Should I Form an LLC?

Are you thinking about starting a new business? While you may initially be caught up in exciting elements of launching a business, such as deciding on a name, you also need to think about the ownership structure for your business. The type of legal entity that you choose will impact everything from taxation to legal protections and more. The primary business structures available are a corporation, an S-corporation a limited liability company, a sole proprietorship and a partnership. Each of these entities has its unique benefits as well as a few drawbacks that you should be aware of. For many small businesses, a limited liability company offers an attractive range of essential benefits. What should you know about this type of business entity?

Understanding What an LLC Is

An LLC, or limited liability company, is a common type of entity that combines some of the benefits of a corporation with other benefits of a partnership. This type of entity generally has a managing member and members. The managing member is responsible for managing the business. There may be more than one managing member. An LLC often has many members as well. These are owners of the entity who are not involved in entity management and operations. There is no limit on the number of members an LLC may have. Keep in mind that managing members and members can be individuals or other business entities.

Tax Advantages of an LLC

From a taxation standpoint, an LLC is a pass-through entity. The entity's profits and losses are accounted for by the individual members and according to their ownership percentage in the entity. There are a few key advantages to this type of taxation strategy. Consider that corporations are required to pay taxes directly to the government at the company level. This complicates tax planning as well as tax prep. It may also lead to a higher overall tax rate in some cases.

Because of the extensive business write-offs permitted by the IRS, there may be some years when a successful and profitable business can record a loss on its tax returns. This loss must be reported on the members' individual tax returns. As a result of the loss, it can reduce the members' individual tax burdens directly. There is a strong financial benefit to doing so in many cases.

Easy Formation and Maintenance

Forming an LLC is a straightforward process. In fact, many people choose to conveniently prepare and file the paperwork online rather than deal with a business lawyer. LLCs are established through a state's Secretary of State department or through another similar division. Because of this, the specific documentation, requirements, and formation fees will vary by state.

After your LLC is established, you will need to follow your state's requirements for LLC maintenance. Maintenance ensures that your LLC remains in good standing for taxation purposes and that it continues to provide the legal protections that you may rely on. These requirements vary considerably, so you should research them independently through your state. For example, some states require the LLC to file a statement of information or annual report. In addition to regular maintenance, you may need to amend the articles of organization to change the ownership structure, the business name and other specifics. These are only some examples of when LLC maintenance may be required.

Personal Liability Protection

With some business entities, some or all of the participants may be held individually liable for the business's activities. For example, if you are a sole proprietor of your business, you may be held personally liable for all of the business's activities. This extends to its financial losses and debts. As a result, an unfortunate business decision made by a sole proprietor could place that individual's personal assets at risk.

In an LLC, the managing members and the members have personal liability protection. This means that your liquid assets, investments, vehicles, real estate and other assets that are owned by you personally cannot be used for the business of debt collection from the business. Your personal assets and your business's finances are separated. Likewise, your personal credit rating may not be negatively impacted if you default on a business debt through your LLC.

Management Flexibility

Another benefit of running your business through an LLC is tied to the entity's management. As mentioned, managing members are the participants who make decisions for the business on a day-to-day basis. Generally, the person or entity that organizes the LLC is at least one of the managing members. However, there may be instances when it is more advantageous for someone else to run the business on a daily basis. For example, the selected person may have more experience or stronger credentials in other ways. Keep in mind that professional managers who are outsiders can also be hired to perform this important function.

When you establish your LLC legally, you will name the members on the paperwork. Each state has its own requirements. Some states require you to specifically name managing members and members. In other states, however, members become managers by default if an explicit statement to the contrary is not made.

What Else You Should Know

While the benefits of running your business through an LLC are profound, there are a few drawbacks that should be carefully considered before you finalize your decision. For example, there are instances when a judge may override the personal liability protection that an LLC provides. This is known as piercing the corporate veil. Your personal assets may be at risk through this action if you do not separate business and personal transactions or in incidents of fraud.

There is a taxation drawback as well. LLCs are required to decide between being taxed as a partnership or an S-corporation. If you choose for your LLC to be taxed as a partnership, all of the members are considered to be self-employed individuals. Therefore, they must pay Medicare and Social Security taxes accordingly. Keep in mind that this is taxation based on their portion of the business's net earnings. If you opt for your business to be taxed as an S-corporation, taxation is based on actual earnings or on the business's pretax profits.

Another crucial drawback to keep in mind is how changes to the entity's membership can affect the LLC. Depending on your state's specific requirements, the dissolution of the LLC may be required in specific circumstances and even if you are not interested in dissolving the entity. For example, some states require dissolution in the event of bankruptcy or if a member leaves the business for any reason. This includes departure because of death and all other reasons. If you intend to keep your business running, you will need to initiate the formation of a new LLC. It is important that you research this aspect of your state's business laws carefully before you form your entity.

Deciding If an LLC Is Right for You

Forming an LLC online is easy to do. You simply choose your business name and a registered agent. Then you prepare and file the articles of organization and take a few additional steps to wrap up the process. However, before you walk through these simple steps, it is important to fully understand all of the benefits and drawbacks associated with running your business through an LLC. Each state has unique nuances to consider, so ensure that you complete your research through the IRS and through your state's Secretary of State or business filings department. When you are ready, consider taking advantage of the easy online process for preparing and filing the LLC paperwork.