One of the most common forms of corporate structure is the Limited Liability Company (LLC).
As we’ve already covered, if you’re aching to get your business started and don’t need much liability or potential tax optimization, the sole proprietorship is your best bet.
But if there is going to be more than one person owning the business, you want to ensure that you’re not held liable, and can take advantage of certain business friendly taxes, the LLC might be the next best step for you.
Read on to learn the advantages and disadvantages of an LLC.
We've also built a handy guide outlining how owners get paid as an LLC, sole proprietor, or LLC member. Download it for free here.
Forming an LLC
Forming a Limited Liability Company requires a formal process, which is why so many individuals avoid it. Further, there can be considerable cost in setting up an LLC. In New York City, the filing fee and the mandatory newspaper publishing can cost upwards of $1,500 to close to $2,000. However, long-term, the tax benefits can very much outweigh the initial cost that will come to someone setting up an LLC.
All 50 states have a version of the LLC, but they each have slightly different requirements for forming one.
Step 1: Get A Name
The first step to forming an LLC is to determine the name of the business. You’ll want to do research on the names because if there is already an LLC in the state with the name you want, you won’t be able to register it. Your business name will, most likely, have to include either Limited Liability Company, Limited Company, LLC, L.L.C, Ltd. Liability Company or some other variation. Finally, there might be some rules in your state that you can’t include certain words in the name, such as Bank or City.
Step 2: File Away
With the name squared away, the next step is to file your LLC’s Articles of Organization. Some states refer to this as a “Certificate of Organization” or “Certificate of Formation.” Whatever the name, the goal of the document is the same: to give the basic information on the LLC. This includes the name, the address, and in many cases, the name of all the members of the LLC.
You’ll submit your business name and the Articles of Organization to your Secretary of State’s LLC division along with the name of your registered agent. Since an LLC is comprised of multiple members, there needs to be one who will receive any legal documents. If I am sued, I receive the document; if an LLC is sued, someone needs to receive the document. The registered agent does this.
There will also be a fee associated with your filing. In many states, the filing is $100. However, in other states, the cost be higher. California is the most expensive state because it charges a filing fee and then an additional $800 tax every year for holding an LLC.
Step 3: Report It
The publication requirement when forming an LLC is highly dependent on what state you’re in. In essence, to become an official LLC, you need to tell your local area that you are, in fact, operating as a Limited Liability Company.
That way that the government has deemed this suitable is through the publishing of notices in newspapers. Typically, you publish several times over multiple weeks so that the maximum number of people can read the statement that you are now in business. This can’t be an advertisement, though. In New York City, for example, this can cost upwards of $2,000. Mail an “Affidavit of Publication” to your LLC filing office and you’re good to go.
Creating an LLC Operating Agreement
While it is not required for the formation of your business from a legal perspective, it is very important to have an LLC Operating Agreement. In essence, this is the member’s way of getting down on paper how the business will be handled, who owns how much, and other rules. Some important things to include in your operating agreement are:
- Who the members are
- How the profits and losses will be distributed
- What the LLC management team will be
- Each member’s percentage of the LLC
- Any money that the members put into the business
- What happens if a member wants to sell his/her share or dies?
- The voting powers of each members and how votes will be held
The operating agreement will also lay out what kind of business you are going to be conducting. It’s an agreement among the members of the LLC that defines what the business is, how the business is run, where it is run, who owns what, and how many things will get done. In essence, it is the Who, What, Where, When, Why, and How of your LLC.
Taxes for an LLC can be very straight forward, but depending on how the business is treated, can start to get a little more complicated. If you are operating a single-owner LLC, you must file your taxes the same way you would as a Sole Proprietor. This means submitting the Form 1040, Schedule C, Schedule C-EZ, Schedule SE, and 1040-ES. Even if you decide you want to leave half the money in the business for future expansion, you’ll still have to pay personal income tax on it.
If you are operating as a multi-owner LLC, each member pays their own income taxes based on the distributive share of their profits/losses.
There are only two forms that an LLC has to manage, from a tax perspective. The first is Form 1065, which shows how much money the organization make, what its costs were, what each member of the LLC was paid, and other costs and revenues. In essence, this tells the IRS how much it should expect from all members of the LLC. The members should also be provided with a K-1. This breaks down any profits and losses that they are entitled to from the LLC so they can fill it in on their personal tax forms.
There is a way around having the individual pay taxes on their profits/losses. By filing a Form 8832, known as an Entity Classification Election, the members tell the IRS that they want to be treated like a corporation. This is beneficial because the income tax for corporations on the first $75,000 is lower than the income tax rates.
There are other benefits such as stock options, stock ownerships plans, and other benefits that corporate LLCs can offer that non-corporate ones can’t.
One thing to remember as a member of an LLC: as an owner, you are still considered self-employed. That means that your profits at the end of the year are not taxed throughout the year like an employee’s income is taxed. Therefore, you need to pay estimated taxes in April, June, September, and January of the following year to ensure that you pay the IRS enough.
Advantages of LLC
There are certainly advantages to running an LLC, especially when compared to a corporation and a self proprietorship.
The primary advantages are that taxes are a little more straightforward than a corporation because the LLC is treated as a “pass-through” entity.
That means that the corporation and the owners are not both taxed; instead, it’s either/or. If the business makes $100,000 in profit, the owners pay taxes on that. Whereas with a corporation, the corporation must first pay taxes and then when the owners receive their compensation, they must also pay taxes.
Another benefit is the ability to use the cash method of accounting. With a corporation, the IRS says that you are liable to pay taxes when they are earned irrespective of if you’ve received that income. With an LLC and the cash method, you only pay taxes on money that is in your hand.
Finally, all employees and members are protected from liability. The LLC is sued and all the LLC’s assets can be seized, but the individual members are safe from lawsuit.
Disadvantages of LLC
There are also disadvantages from a tax perspective.
Unlike corporations, the profits earned from an LLC are subject to Social Security and Medicare. For a large business, where the owners are paid over $117,000, this isn’t a problem because that is the cap on Social Security and Medicare. But if you were to take a $40,000 salary and then an additional $40,000 in profit, you would be paying over $6,000 more in taxes on the $40,000 in profits.
Members must recognize profits immediately. That means that if the business makes money, you have to receive the money immediately and pay taxes. A C-Corporation, on the other hand, does not have to distribute dividends to its owners immediately.
Is an LLC Right for Me?
There are a couple of questions to ask yourself when you are looking to set up a Limited Liability Company.
- Do I need to raise money? Because there is a corporate structure now, some investors might be willing to invest in the formation of the business. However, most investors still want more guarantees such as a C-Corporation.
- Are there employees involved? Added liability is important when you are dealing with employees. You don’t want to be held responsible for something they do.
- Do I generate enough for tax benefits? If you are generating significant amounts of money, an LLC might help you save on the first $75,000 of corporate income tax. Further, once you’re over $117,000 in total income earned, the rest won’t have Medicare and Social Security taxes.
It is always advisable to talk an accountant about setting up an LLC because they may think you need more or less corporate structure. That being said, whatever you choose to do, Justworks can work with you. If you are hiring employees, the platform can process payroll and ensure that all tax documents are submitted.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.