There is no one-size-fits-all approach to selecting a business entity and what’s best for your friends may not be what’s best for you. This post explains the key characteristics of a Limited Liability Company (LLC) because it’s a popular option among creative entrepreneurs.
As a sole proprietor you are doing business as you, the individual. Legally, this means that your personal business is mixed up with your actual business. If something goes awry there is no liability protection for your personal assets. A Limited Liability Company gives you liability protection for your personal assets. If something goes wrong in the business then it’s handled with the business assets (and not your house, car, etc.).
One of the standout features of LLCs is that they are flexible for structuring business partnerships. For example, you can contribute 60% of the financial investment in the business, and your business partner, 40%. But, that doesn’t automatically mean you own 60% of the business. Maybe she put in more sweat equity than you, so you two decide that she’ll own 60% of the business. LLCs allow that type of flexibility. The flip side is that while you can get creative with structure you need to be really cautious about capturing everything in the LLC’s operating agreement or else the default rules of your state will kick in.
By default, LLCs are taxed the same as sole proprietorships (if there’s one owner) and partnerships (if there are multiple owners) – you report taxes on your personal return in lieu of a separate filing. Also, LLCs are considered pass-through entities for tax purposes meaning that you pay taxes on your profit from the business and not a “corporate tax” on the entity. A huge advantage is that they are also flexible in how they can be structured for tax purposes. For example, LLCs can be taxed as a C Corp or an S Corp. As your business grows, there will be different benefits of choosing a tax structure other than the default.
For example, let’s say that you have an LLC and you land with a lot of cash in your business account at the end of the year. You’ll pay taxes on that full amount. With a C Corp tax structure you can keep some of this cash designated as “retained earnings” and benefit from a lower tax bracket. This is really useful if your business is saving cash to fund a large asset or building up a hefty savings account. You’ll still pay the corporate tax plus your actual earnings (legally, called dividends). Here is an excellent article from Entrepreneur breaking down the five tax differences between LLCs and corporations.
In most states, LLCs have few administrative requirements. You’ll be required to file the initial formation documents (typically a Certificate of Formation or Articles of Organization) and from there you’ll need to submit an annual report (each year obviously). Also, you’ll need to keep your business records at a designated place (i.e. the principal place of business). That’s typically it.
Don’t be surprised if it costs more in your state to set up an LLC than it does a Corporation. Research the filing fees in your state, attorney’s fees to handle your formation and the annual report fee. Plan a budget so you’re not hit with any surprises when it’s time to move forward. In other words, prepare yourself but please don’t make such an important decision for your business based solely on cost.
Your business structure will evolve as your business evolves.
Maybe you’ve decided to formally bring a spouse into the LLC — you’ll need to have a new operating agreement prepared because your single member agreement will no longer fit the bill. As you grow, it’s important to continue to assess where you’re at and determine whether the current iteration of your business structure is still ideal. An attorney and accountant who are trusted advisors for your business will help you make critical decisions along the way.
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