Should I Form an LLC? Your Questions Answered

A limited liability company (LLC) is a business structure created by state law. Each state has slightly different requirements and methods for forming an LLC, but the general benefits and drawbacks of an LLC are the same throughout the country. Whether you should form an LLC for your business will vary based on the unique circumstances of your business and personal situation. Reviewing the basics about an LLC as well as the pros and cons, will help you make an informed decision about whether forming an LLC is the right option for you.

The Basics of an LLC

Before reviewing the benefits and drawbacks of creating an LLC, it is a good idea to have a foundational understanding of what an LLC is. Understanding how it works will also help you decide whether creating an LLC will suit your situation.

Who Owns an LLC?

An LLC’s owners are called “members.” Each member holds a percentage of ownership of the company. Owners can also be individuals, partnerships, other LLCs, and corporations. Even foreign entities can be LLC members in many situations. Most states do not restrict who can be a member of an LLC.

Many LLCs have just one member. No specific number of members is required, but single-member LLCs might have different tax treatment under federal and state tax laws.

Tax Treatment for LLCs

An LLC can be treated as either a corporation or a “pass-through entity.” A pass-through entity is still a separate legal entity, but it is treated like it is an individual (or partnership if there is more than one member) for tax purposes. The main benefit of this type of tax treatment is that it allows the LLC owners to use their own tax rates for the LLC’s income. This can result in tax savings for many LLC owners, especially if the LLC is a single-member LLC.

How Is an LLC Different from a Corporation?

Like an LLC, a corporation is also a separate legal entity. Stockholders own corporations. Corporations can also be publicly traded or closely held. In a closely held corporation, the owners are individuals who function a lot like LLC members. They have voting rights and can sometimes make management decisions, depending on the structure of the corporation.

Perhaps the biggest difference between a corporation and an LLC is the ongoing requirements to maintain the legal structure. Corporations will often have more requirements within a specific state, such as annual fees and reporting requirements. Corporations often have to have at least an annual meeting (with minutes to show what occurred in the meeting) as well. Many states do not have these stringent reporting requirements for LLCs.

The Benefits of Forming an LLC

Creating an LLC has many benefits. However, some of these positive aspects will be more important to some LLC owners compared to others.

Asset Protection

An LLC is a separate legal entity. That means that it can sue and be sued. It can also incur debt and have its own liabilities. As the LLC owner, you are generally not personally liable for the LLCs debts and other obligations. Instead, if a creditor or other third party sues the LLC, the most they can receive is from the assets of the LLC. As long as the LLC is maintained properly, any liability will not reach the individual owners’ assets.

Pass-Through Taxation

Pass-through taxation can result in huge tax savings for LLCs. C-corporations have their own unique tax rate. That means that the corporation pays tax, and the owners of the corporation must also pay tax on whatever income they receive from the corporation. This double taxation effect can be very expensive for individual owners. Structuring your tax status can be a complicated tasks to deal with, so it’s highly recommended to consult a CPA or reach out to an online tax service to help you understand all the possible consequences.

LLCs can choose to be taxed as a corporation, but most choose to be taxed as a pass-through entity. Pass-through entities have the same tax rate as the individual owner. The result avoids double taxation, and the tax rates are sometimes lower. Pass-through entities also occasionally qualify for tax rate deductions and reductions that corporations may not receive.

Simple Maintenance Requirements

An LLC is a popular form of business because it provides all of the benefits of having a separate entity without a lot of hassle. The maintenance requirements for an LLC are not as expensive as a corporation. Filing fees are often lower, and ongoing documentation and meeting requirements are not as strict.

Flexibility in Ownership and Management

An LLC does not have any minimum or maximum number of owners. There are few requirements on who can and cannot be a member, and members have much more flexibility in determining what ownership means. For example, each member could have a separate percentage of ownership, and their rights and responsibilities within the company can vary quite a bit. Even income and cost-sharing can vary. Flexibility for owners is often considered one of the best benefits of creating an LLC.

LLC members can also choose how active they want to be in the management of the day-to-day operations. Many LLCs choose to have a management team or individual manager so other members can take a more inactive role in the management and function more as investors. LLC managers also do not have to be members of the LLC to have a management role.

Credibility

Creating any type of business entity adds an air of credibility to the business venture. Compared to a sole proprietorship or general partnership, having an LLC with a business name and business bank account can benefit owners by attracting new clients and customers as well as investors and financing.

Drawbacks to Creating an LLC

While LLCs are extremely useful, there are some downsides to using this type of business entity as well. Just like the benefits, the shortcomings of an LLC may not be as important to some as they are to others. For most companies, the benefits of creating an LLC will far outweigh the disadvantages.

Formation Requirements and Cost

To create an LLC, you need to follow state requirements. These requirements vary by location, but they will usually require a relatively simple form that sets out the very basic information of the LLC, such as the name of the company and contact information for the owners.

Filing to create an LLC will require certain fees or registration costs. Many states also require annual or biannual fees and reports as well. Failure to follow these requirements can lead to administrative dissolution of the LLC, which undermines all of the benefits of creating the LLC in the first place.

If your company operates in more than one state, it will likely need to register to do business in that state. However, these registration requirements are not the same as formation. Instead, registering to do business in another state will usually require a simple form and a nominal registration fee. The company would likely need to go through this registration process regardless of what kind of business structure it may be.

Ownership Transfer and Investment Challenges

LLCs are owned by members. That ownership has value, but transferring or selling those interests can be difficult. Unlike holding corporate stock, membership units in an LLC can be very difficult to value. Many LLCs restrict how membership units can be transferred and how they must be valued.

Membership units can also be hard to sell as well. In some states, if there is no language about how to transfer LLC membership units, the LLC may need to be dissolved if any member wants to sell or transfer their ownership rights.

Because of how LLC ownership is created, it can be difficult to attract investors. Investors might not be willing to become members because transferring the membership rights when they want to sell their investment might be difficult. If a company wants to attract outside investors (including angel investors), using a corporation that can issue stock might be a better option.

How to Create an LLC

Creating an LLC is actually very straightforward in most states. Many states require a relatively simple filing that provides very basic information about the LLC, including:

• Name
• Listing of the initial members
• The purpose of the LLC
• Contact information for the registered agent

Individuals who want to create an LLC can work through this process in a few ways. You can review the laws in your state and create your own documentation to form the LLC. Most states have the requirements for formation set out in their codes and laws, and some states even have very basic forms that you can use to create an LLC.

Many online resources are available to help you start an LLC as well. Companies offer forms and tools that may be very useful to start the formation process. These online resources often also have templates to use for creating membership agreements and other governing forms for your LLC.

Lastly, an attorney licensed in the state where you want to start your LLC can help with formation as well. While using an attorney is often the most expensive option, it also ensures that your filings comply with the laws in your area. In addition, an attorney can provide specific advice for maintaining your LLC and help with other governance documents that might affect your specific type of business.

Putting It All Together: Is Creating an LLC Right for You?

LLCs are very helpful legal structures that can benefit a wide variety of business owners. They have unique attributes that allow them to provide an array of advantages with very few disadvantages. LLC formation is relatively simple, and an LLC is one of the easiest business structures to maintain. However, if you are looking to add outside investors, an LLC might not be the best choice. Consider your overall goals and member needs before creating an LLC.