All small business owners, especially sole proprietors and partnerships, should consider forming a limited liability company (LLC). No matter how small your enterprise, operating your business as an LLC is an easy and inexpensive way to protect your personal assets from business liabilities while also maintaining favorable income tax treatment. Today, nearly 80% of all companies in the US are small businesses, and roughly 2.4 million of those businesses are organized as LLCs.
What is an LLC?
LLC is an abbreviation for “limited liability company.” It is a business structure that provides owners (owners of an LLC are called “members”) of a business limited liability and pass-through income tax treatment. LLCs take the benefits of incorporating (limited liability for owners) and the benefits of partnerships or sole proprietorships (pass-through taxation of business income), and puts them together in a business form that’s simple to set up and easy to maintain.
Limited Liability for Owners
LLCs limit the owner’s/member’s personal liability for debts owed by the business as well as claims against the business. Generally, if a business owner is operating as a sole proprietor or partnership, and the business cannot pay off its debts or claims against it, the owner may be required to personally pay those debts and claims with his or her personal assets. In a worst case scenario, an unincorporated business owner could lose their car, house or personal savings paying off the debts and claims of the business.
However, business owners operating as an LLC are personally protected from the debts and claims of the business. In most cases, the member only puts at risk the money he or she has invested into the company. The member’s personal assets are protected from claims against the business, i.e. the member’s liability is limited (“limited liability” company). Additionally, in most states, creditors with liens against an LLC cannot pursue the personal assets of the members to repay the business’s debts.
Taxes: Pass-Through Treatment of Business Income
Corporations are subject to what’s commonly referred to as “double taxation”. The corporation’s profits are taxed first as corporate income taxes, and then they are taxed a second time as personal income taxes when the profits are distributed to the owners.
Double taxation exists because corporations are deemed to be a separate legal entity from its owners, and this has both a positive and negative effect. On one hand, the shareholders are protected from the liabilities of the corporation (similar to, but not the same as the LLC’s limited liability discussed above), but on the other hand, the corporation and the shareholders are each required to file separate income tax returns, resulting in the corporate profits being taxed twice.
Fortunately, unlike a corporation, a LLC is not considered a separate legal entity from its members for income tax purposes. The income or losses generated by a LLC are simply reported on the member’s personal income tax returns. There is no separate tax return for the LLC, and the businesses’ profits are considered income of the members. In addition, reporting income (and losses) from a LLC is a simple process, requiring only a Schedule K form to be included with a personal tax return. Most do-it-yourself tax return programs include the ability to create Schedule Ks.
How Do I Form an LLC?
In most states, you can create an LLC by filing “articles of organization” with your state’s filing office. Usually a state’s secretary of state handles LLC creation. Some states will refer to the organizational document as a “certificate of organization” or a “certificate of formation”. A small fee will be due with the filing (usually between $25 and $100).
Most states provide a fill-in-the-blank articles of organization form on their website. This form is where you choose your business name. Business names must be unique, and most states provide a business name look-up service on their website, which can be used to quickly determine if a name is available. Most states require that an LLC must include “LLC” or “Limited Liability Company” in the business name.
The form will also ask for a name and address for a registered agent. This does not have to be an attorney’s office, but must be a reliable contact. All official correspondence is usually sent to the registered agent.
After you’ve completed the form, it should be sent to the proper state office along with the appropriate fee. Once filed, the state will notify you that your LLC is officially formed.
Although not legally required, most business owners will want to prepare an operating agreement when creating an LLC. Operating agreements outline the rights and responsibilities of the owners, as well as the powers and management structure of the LLC. Operating agreements clearly state how the LLC is to be run, and in the case of multiple owners/members, states the ownership interest of each owner/member.
LLC members want to be sure ownership interest is clearly stated. In most cases, profits and losses are divided up based on a member’s ownership interest. For example, unless the operating agreement says otherwise, if a LLC has four owners, each owning a 25% interest in the company, and the company makes $10,000 profit, each member is entitled to $2,500 (losses are divided up in the same manner).
If an operating agreement is not created, the LLC laws of your state will govern the inner workings of your LLC.
Establish a Business Checking Account
This is not a legal requirement, but is simply a good business practice. Keeping your business and personal finances separate draws a bright line between the two. This is important for reducing potential risk to your personal assets for debts and claims against the business.
Other Benefits of an LLC
An LLC can be managed by its members or by managers. Managers do not have to be members of the business, which allows LLCs to hire well-qualified individuals from outside the company. This gives members a substantial amount of flexibility when deciding how to operate their business. For example, small day-to-day decisions may be carried out by a manager, while large decisions like taking out a loan, or signing a lease may require approval by all the members. These member and management decision-making powers should be outlined in the operating agreement.
Additionally, setting up and maintaining an LLC is relatively easy and cheap. In general, you only need to complete one form and pay a nominal fee to organize an LLC. Annual state filings usually only require a one or two page form, and the annual filing fees are small, usually being less than $100. In return for the light effort, you protect yourself personally, maintain favorable federal tax treatment, and gain the credibility that comes with being a limited liability company.
Notes on LLCs and Employees
The IRS requires any business that has employees to have an Employer Identification Number (EIN), also referred to as the Federal Employer Identification Number (FEIN), or Federal Tax Identification Number. EIN’s are a nine-digit number assigned to businesses for tax purposes.
Members of an LLC have two options when it comes to how its employees are treated for federal income tax purposes. By default, the IRS treats LLCs the same as partnerships. Alternatively, members can elect to have their LLC treated as an S corporation.
If your LLC is taxed as a partnership, all of its employees are considered to be self-employed, which means those employees are personally responsible for paying Social Security and Medicare taxes (collectively known as self-employment taxes). The amount of self-employment taxes due is based on the business’s total net earnings.
If your LLC is taxed as an S-corp, you and the other employees pay social security and Medicare taxes only on compensation, not on the whole of the company’s pretax profits.