If you’re a budding entrepreneur with a great business idea and plan, you may be trying to decide what business entity type to form. A popular choice for many is a limited liability company (LLC) because it offers a host of benefits.
Here you’ll learn the benefits of an LLC so that you can decide if it’s the right choice for you.
Personal Liability Protection
Perhaps the number one reason that many entrepreneurs choose an LLC is the personal liability protection that it offers. Unlike with a sole proprietorship, an LLC and its owners, called members, are considered distinct entities. The LLC can have its own assets and obligations and is solely responsible for those obligations, while the members are not. This means that if the LLC cannot pay its debts or is sued, the members do not have personal liability, therefore, the personal assets of the members are not at risk.
Some exceptions to personal liability protection can occur, however. If you or another member commits fraud or acts recklessly in managing the business, you may be held personally liable.
Additionally, if you personally guarantee a business loan, which is common, you are personally responsible for that debt. If you do apply for a business loan and are asked to personally guarantee it, be sure that you want to take on that risk.
An LLC has very few legal requirements when it comes to management. A corporation, on the other hand, must create corporate bylaws, appoint officers, and elect a board of directors who will have oversight of the company. An LLC does not have those requirements. You simply have to decide if you want your LLC to be member-managed or manager-managed.
In a member-managed LLC, all of the members are active in the management of the business on an ongoing basis. No non-members are appointed as managers.
In a manager-managed LLC, some members may be silent partners while others are appointed as managers. A non-member may or may not also be appointed as an official manager of the LLC.
This does not prevent a member-managed LLC from hiring, for example, a sales manager. That manager will not be an official manager of the LLC with the power to enter contracts for the business, obtain financing, or make key decisions for the business. They will be a middle manager, so to speak.
Some states require that you disclose your management structure and manager names and addresses on your LLC formation documents.
The bottom line is that other than making your management structure choice, you are free to manage the LLC any way that you wish.
LLCs have an advantage over corporations because the LLC itself is not taxed. Corporations are subject to corporate taxes at a federal rate of 21%, and the dividends of the owners, called shareholders, are also taxed. This is commonly referred to as double taxation since some profits are taxed twice.
With an LLC, on the other hand, profits of the business simply pass through to the members to be reported on their personal tax returns and are taxed at their personal income tax rate. However, LLC members are also subject to self-employment taxes at a rate of 15.3%.
But an LLC has the distinction of being able to elect an S-Corp tax status. With an S-Corp, profits are still passed through to members but are not subject to self-employment taxes. Instead, members must be paid a reasonable salary as defined by the IRS before they can take additional distributions. Salaries are, of course, subject to employment taxes, which are essentially the same as self-employment taxes. However, profits above and beyond salaries are not subject to employment or self-employment taxes.
Paying salaries brings payroll expenses, and an S-Corp is subject to corporate requirements and thus is more expensive to manage. This means that for S-Corp status to be beneficial, the saved self-employment taxes must be greater than the additional corporate and payroll expenses.
The decision is best made with the help of a tax advisor, but the uniqueness of an LLC is that you have a choice about your tax status.
Ease of Formation
LLCs are much easier to form than corporations. Forming an LLC requires filing a simple form with the state, while corporation formation documents are more complex. When you form an LLC, however, you also need to create an operating agreement which defines member ownership percentages and much more.
You can check this step-by-step guide to forming an LLC, as well as state-specific LLC formation guides and other LLC tips and information.
Profit Sharing Flexibility
In a corporation, dividends are paid based on the amount of ownership of each shareholder. In an LLC, profits are often shared the same way, based on ownership percentages. However, in an LLC, you can structure profit allocations and distributions any way that you choose. This might occur if one member is more actively involved in the business. Members might decide to allocate a higher share of profits and distributions to this member.
Again, the great thing about an LLC is that you have a choice.
If you operate as a sole proprietorship, you and the business are considered a single entity and your business name must be your name. Having an LLC instead gives you a level of credibility and makes your business seem more “real” to vendors, customers, and potential partners. Perception makes more of a difference than you might think.
Choosing a Business Entity Type
If you’re looking for the simplest, least expensive option, a sole proprietorship is your best bet, since there are few requirements, and no state registration is needed. If you’re starting the business with a partner, a partnership offers similar simplicity. However, with either option you will not have personal liability protection.
If you’re planning to raise investment capital for your business, you might want to choose a corporation. Corporations are more appealing to investors than an LLC because ownership, since it’s in the form of shares, is easier to transfer to the investor in exchange for the capital invested.
If you’re not planning to raise capital, as you can see, an LLC offers many benefits, particularly personal liability protection. You want to, of course, think that your business will go smoothly, but things happen that could put your personal assets at risk if you don’t have the personal liability protection that an LLC offers.
If you decide to choose an LLC, you should read up on the formation process so that all goes smoothly. Alternatively, you could turn to an LLC formation service to help you. They can handle your document filings and offer other services that can be beneficial to your business. If you’re still in doubt about the type of business entity that’s right for you, consult with your attorney and tax advisor.
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