Advantages of LLCs (Limited Liability Companies)
When I formed my first Limited Liability Company (LLC), I had a lot of questions.
- Is an LLC the right business structure for me?
- Will it provide the best tax benefits and ease of operation?
- Does it really keep my personal assets separate from the business?
As it turns out, in my case the answer was a clear “Yes” across the board. Here are 3 major reasons why I chose to form an LLC instead of something else*:
1. LLCs are easier to form, register, and operate than Corporations.
From a big picture perspective, LLCs are just plain easier to setup and operate than corporations. Speaking from personal experience, it was very fast for me and my business partner to prepare and file the requisite formation documents for our business, and there are only minimum requirements for ongoing formalities (meetings, minutes, etc.).
This was ideal since we live in two different countries and two different time zones apart, and would find it burdensome to introduce unnecessary red tape into our business model. Our online commerce company, Collaboration Enterprises LLC, a Texas Limited Liability Company doing business as ThinkPlanLaunch was born in less than a week once we started the process.
You can view our certificate of formation here if you’re interested in what it looks like once the Secretary of State stamps it: http://bit.ly/1y1jpRP
In addition to being easy to form, LLCs are also quite flexible in their operational structure. We had great freedom to specify profit sharing percentages, ownership and control matters, management structure, and more in our LLC operating agreement.
We also had (and have) the ability to elect one of many taxation regimes with the IRS, which we elected to let pass-through and be taxed as personal income by default (more on this below). Last but not least, there is no requirement for officers or a board of directors in an LLC like in a corporation.
2. Choosing an LLC protects your personal assets whereas being a Sole Proprietor leaves you exposed.
You might be wondering, “What if I’m just a one-man or -woman show… do I really need to file all the paperwork to register an LLC? Why not just stay a Sole Proprietor?”
The truth of the matter is yes, you can be a sole proprietor if you’d like (for anyone very new to the business world, note that you are a sole proprietor by default if you transact business as an individual in the absence of a legal entity being formed).
In fact, there are quite a few scenarios where I would advocate being a sole proprietor: when starting a side project, for example, or any business where your general liability or likelihood of encountering legal issues is low.
To provide a case in point, one business that provides a small passive income stream to me each month is Creative Edge Music, a music/audio engineering website I originally launched in 2012.
In this business, I am comfortable remaining a sole proprietor and see no point in forming an LLC – yet. This is not to say there are not many websites or blogs that would benefit from having a legal entity formed, but in my case there is currently very little liability concern due to the nature of this business.
Now here’s the other side of the coin. Namely, if you elect to stay a sole proprietor in your business, you should be prepared to give up the legal protections that a registered business entity provides – specifically, protection of your personal assets and property from liability.
What this translates into in the real world is simple: if sh*t ever hits the fan, you’re more likely (as an individual) to keep your house and personal possessions (and not lose them to liquidation/seizure) in the event your business incurs a substantial liability that it cannot afford to pay.
You may still incur personal liability if the justice system deems it fit (usually this will only occur in situations where there’s some funny business going on) or if you personally guarantee a bank loan, for example.
It is still better in many cases to have the additional liability protection that a formal business entity provides, and an LLC is an efficient and cost-effective way of securing such protection. Simply put, you’ll be shielded from certain financial and legal threats that you are not shielded from as a sole proprietor.
3. Taxes in an LLC pass through to its Members as personal income by default, plus you aren’t subject to double-taxation like Corporations.
Yes, that’s right. The default tax structure for an LLC is so simple, it doesn’t involve much else than claiming your distribution payouts on your personal income tax return. The method differs slightly depending on whether or not you are a single-member LLC or a multiple-member LLC, though.
If you own a single-member LLC, the IRS treats you like a sole proprietor by default and you’ll simply need to file Form 1040 Schedule C (and in some cases Schedules E or F) along with your personal income tax return. Frankly, this is about as simple as it gets if you are in fact a one-man or -woman show.
If you’re a member of an LLC with two or more members, the IRS treats the business like a partnership by default and you will need to file Form 1065 – U.S. Return of Partnership Income for the LLC along with Schedule K-1 (Form 1065) to list the pro-rata share of distributions, deductions, and credits for each member.
Did you know that in either case, an LLC can also elect to be taxed as a corporation? Once every 60 months, you are allowed to submit Form 8832 – Entity Classification Election in order to reclassify your LLC’s tax status if you’d like, including an election to be taxed as a corporation – or, reverting back to disregarded entity status (as an individual) or partnership status (in a multiple-member LLC).
Note that your tax status upon formation does not count as an “instance” of classification for purposes of the 60 months, so anytime after formation you can file this form. If you do, though, then you must wait a full 60 months before changing the LLC’s tax status again. More information about this can be found on the IRS website here.
One reason most LLC members choose not to be taxed as a corporation, however, is because sole proprietors and partnerships are not subject to double-taxation like corporations.
Should you elect to form a corporation, or choose to have your LLC taxed as one, the profits of your business will actually to taxed twice. First, at the corporate level, since the IRS considers the corporation to be a completely separate entity from its shareholders (owners). Second, at the personal level (shareholder level) for any dividend distributions made to payout profit to those shareholders.
This isn’t necessarily all bad, because unlike a sole proprietor or partnership tax structure, only the profits are taxed at the level of the Corporation – and this is after you deduct a reasonable salary for yourself and pay business expenses. But you are still looking at paying tax two times – once at the corporate level on profits, and then again on all of your individual dividend earnings as a shareholder/owner via income tax.
For the same amount of earnings, then, it is often the case you will retain a few extra dollars as an LLC being taxed as a sole proprietorship or partnership, since the business profits are not taxed at the corporate level before passing through to you and being subjected to income tax.
The decision to adopt a corporation tax structure, then, is a strategic decision that goes beyond the scope of this article. Due to the double-taxation and additional complexity, you will often need a clear-cut reason that pushes you in that direction. Such reasons might include living in CA, MA, or DC, where the formation of an LLC requires two or more members (although you could always form your one-man or -woman LLC in another state, such as Deleware – more on this in another article); current or future goals of attracting investors for your business; and/or a desire to provide employee incentives such as stock options.
Without such compelling reasons to form a corporation, however, an LLC remains a fabulous option for new entrepreneurs regardless of business partnership.
As you can see, an LLC is a great corporate structure for both individual entrepreneurs and partnership arrangements. Featuring simple formation procedures, a maximum of flexibility in the tax department, and a minimum of time-intensive operating requirements, the LLC is increasingly common in the modern business world.
Finally, when you create your LLC remember that you’ll need to designate a Registered Agent on your application to the Secretary of State. This is not optional and you will not be able to complete your LLC formation without one being designated – although with that said, you can often be your own registered agent. The registered agent accepts service of legal process and other official state documents on behalf of the business, and is generally expected to be available to receive such documents during standard business hours.
*Disclaimer: I can’t provide legal advice – so ask a licensed attorney or accountant if you need clarification or help when choosing a legal form for your business or electing a tax structure. Nothing from this article should be constructed as business, tax, or legal advice of any form and is strictly my personal opinion.