Last Updated on September 27, 2023 by Ewen Finser
It is not easy to form and run a business. Entrepreneurs face a lot of challenges, and this explains why most of them fail.
According to the US Bureau of Labor Statistics, about 20% of small businesses in the United States die within the first year. Within five years, almost 50% fail, with only a third surviving after ten years.
While there are no guarantees that your business will be a hit, strive to create the best conditions for it to thrive. One critical decision that will go a long way to determine your business’s success or failure is the legal structure you pick for it.
Business owners typically must pick between a Sole Proprietorship, Limited Liability Company, or Corporation, with a few variations of the three. The business structure defines your day-to-day operations, how much you pay in taxes, and what degree your assets are at risk.
This piece will single the Limited Liability Company and explain how to form one while highlighting valuable information about this structure.
Overview of an LLC
A Limited Liability Company is a business structure that protects owners from the company’s debts while giving them the benefit of flow-through taxation.
To better understand this structure, let us bring the others into the picture for easier comparison.
Is the simplest business structure and the owner has complete control over everything. The owner and business are essentially a single entity. You are automatically considered a sole proprietor if you run a business but do not register as any other structure.
Sole proprietorships are not separate business entities, and you will be held liable for the debts and obligations of the business. However, they can get a trading name to operate under if the owner does not want to use their name for the company. This structure is perfect for low-risk businesses and people who want to try out ideas before setting up a formal business.
Are a slight upgrade from Sole Proprietorships, and they allow two or more people to run a business. The two types are limited partnerships and limited liability partnerships.
Limited partnerships have one partner with unlimited liability, with the others having limited liability. Limited liability partnerships give every member limited liability from debts arising from the partnerships.
This structure is ideal for businesses with multiple owners who wish to try out ideas before going formal.
Is a large business that is a separate legal entity. Corporations can be taxed, sued, make a profit and enter into contracts. They offer the best protection against liabilities to their owners but cost a lot more to form. They also need more paperwork and must follow multiple operational processes to remain compliant.
They pay taxes on profits, and in some instances, can be taxed when paying out dividends. They are insulated against owner action, and a shareholder can quickly sell their stake to a new entity without affecting the day-to-day business operations.
Corporations are ideal for medium or high-risk businesses that want to raise money or those that want to go public and eventually be sold.
A Limited Liability Company
Is a hybrid between a Sole Proprietorship and a Corporation, as it offers the best of both worlds. They protect you from personal liability and offer a way to avoid paying corporate taxes at the profit level. If you choose this tax direction, members of the LLC will be seen to be self-employed and will pay taxes at their income level.
Owners in an LLC have a lot of power to dictate the business’s day-to-day operations, and disputes among owners can lead to the dissolution of the company. LLCs are perfect for medium and high-risk businesses where owners want their assets protected but still want to pay a lower tax than they would do had they formed a corporation.
Advantages of an LLC
1. Limited Personal Liability
Essentially, an LLC is a separate legal entity from its owners and can enter into contracts, sue, be sued, and be held responsible for its obligations.
This is arguably the highlight feature and benefit of LLCs. Owners are safe from the business debts and liabilities, a key feature since other members might act in negligence and leave you in trouble. If the company runs into losses, you will lose the money invested, but personal assets won’t be used to recover business debts.
2. Easy to Form
LLCs are simpler to form compared to corporations. While corporations offer limited liability, they are subject to more regulations regarding their operations, paperwork, and tax procedures. They are complicated to form, and small businesses owners might not be well prepared to do all that.
On the other hand, LLCs do not have to hold annual meetings, keep extensive records or report their accounts. The process of forming an LLC is digitized in many states. Within a few steps, as we will highlight below, one should comfortably have a fully running company approved by the secretary of state within a few days.
3. Tax Benefits
LLCs enjoy the perks of a Corporation and Sole Proprietorship when it comes to tax matters. This is a sensitive feature since it determines how much the business pays to the government every year. LLCs do not have a bespoke tax classification but can adopt any of two options.
The IRS classifies LLCs as sole proprietorships or partnerships by default, which means owners pay taxes at a personal income level. This is called pass-through taxation, where the business does not pay any corporate taxes. In the other scenario, owners can classify it as a corporation where they pay tax at the corporate level. This flexibility is a good advantage since owners can assess the implication of each scenario and pick on the best one for their situation.
4. Owner and Management Flexibility
LLCs offer some degree of flexibility on two fronts. In ownership, Corporations have restrictions, for instance, S Corps that limit ownership to only 100 shareholders. This is done to prevent them from misusing the pass-through taxation associated with this type of corporation. On the flipside, LLCs offer pass-through taxation with no limit on the number of owners or their profiles.
On matters management, corporations have a rigid management structure that should consist of a board of directors and employees who oversee the company’s day-to-day running. The shareholders who own the company should also meet annually to elect directors. LLCs can either be owner-run or manager-run, depending on how the members decide.
In an owner-run LLC, the owners oversee the day-to-day business, whereas, in a manager-run, they employ a manager to handle these operations.
5. Profit Flexibility
The owners of an LLC can decide how they want to share profits. This is unlike Corporations that must distribute profits according to the number and type of shares owners hold. For LLCs, members might have an equal stake in the business, but one gets a higher profit share because they are actively involved in day-to-day operations. Alternatively, one might get more profits because they invested more in the business.
An LLC is a flexible business structure that owners can tweak to suit their needs from the advantages. This is a significant benefit for small businesses that need the legroom to wriggle around and play around with different strategies to find what is best for them.
Disadvantages of an LLC
1. Ownership Transfer Limitations
It is not easy to transfer ownership of an LLC. There is no standard procedure to manage the transfer of ownership, compared to a corporation which is straightforward. In the latter, owners have many shares in the business valued at a certain amount, and they can quickly sell these shares and leave the company without affecting operations. Exceptions to these are specified in the shareholder agreement, but they are not common.
With LLCs, members must agree to add a new member or follow the procedures stated in their operating agreement. If the owners did not outline the steps to resolve this, it could lead to the dissolution of the LLC.
2. Capital Limitations
Raising capital for an LLC is challenging since the structure does not allow for issuing stocks or bonds like corporations. This limits the business to the individual contributions of the members to run and scale operations. Small businesses that start need a lot of money before they turn profits and might require huge capital to scale. All these limitations can stunt the growth of an LLC and make it hard for the business to get to the next level.
3. Variations in LLC Rules
LLCs are governed by the state, whose rules vary. This is hard for LLCs that plan to grow and operate across the states, as some rules might be unfavorable. If you plan to operate across all states, you need to study all the various regulations and find a way of having a single business that somehow manages to comply with all the rules.
4. Upholding the Corporate Veil
An LLC offers limited liability, but this can be breached if they do not keep the corporate veil. Anyone can pierce this veil if the court rules that the LLC is not entirely separate from the owner or if you acted negligently as the owner. In such situations, creditors will get the green light to go after your assets. If you fail to do this, creditors will use personal assets to pay the business liabilities.
How to Form an LLC
All states have their procedures of forming an LLC, but they are not all that different from the baseline we will highlight below. Read on;
1. Choose a Name
You might have this figured out already, but the state requires you to choose a name that meets specific requirements.
In addition, understand that the name you pick for the business affects the marketing and brand aspects, so make a wise choice.
The law states that your LLC name does not have to be the same as any other legal registered entity in that state. You can confirm this by conducting a “name search” on your Secretary of State’s website to ascertain if the name you want to use is available.
Most states let you reserve a name for some time, say 60 days, but this does not automatically guarantee you will use the name for your LLC. It simply keeps other people from using the name as you proceed to form the company.
A few rules to consider when naming your LLC are;
- The name must include the words “limited liability company” or the abbreviation LLC on it. A few variations of these two are allowed.
- It must not have terms that refer to other business legal entities like corporations or incorporated.
- It cannot refer to specialized services like insurance, banking, and law. Such practices have to be run under a Professional LLC.
If you plan to do business using a separate name and do not want to form an LLC, consider filing for a DBA. It gives you the room to sell a different product or service under a unique brand name using the same LLC. It also helps to rebrand the business if your LLC name no longer fits the purpose, but you do not want to form an entirely new company.
2. Pick a Registered Agent
All LLCs must have a registered agent. This is an entity that receives legal documentation on behalf of the business. They must have a physical address in the state where the LLC is registered in.
But why pay an entity to receive official mail when you can do it?
Registered agents offer other key benefits, as they help you to maintain corporate compliance. You could list your address and receive official mail, but most of the communication from the authorities require reactions that are time-bound.
Failing to meet these timeframes can jeopardize the business. A registered agent is a gatekeeper for companies, as they help them resolve issues within the stipulated time.
3. File Articles of Organization
This is the form you fill to show that you have formed the LLC legally. It is called the Certificate of Organization in Massachusetts and Pennsylvania or the Certificate of Formation in Delaware, New Hampshire, New Jersey, Washington, and Mississippi. On successful filing, your Limited Liability Company will be formed.
Today, most states have converted this document to an online form that anyone can quickly fill. However, you can draft it, include all the required information, and send it via mail if you do not want to use the digital process.
The Articles of Organization contains the following details;
- A statement identifying which state law you will form the LLC
- The effective date for the new LLC
- Name of the business
- Main business location
- Name and address of the owner responsible for filing the articles of organization
- Name and address of the registered agent
- Statement of purpose for most states
- How long the LLC will exist
- Authorized signatures of the organizer
The Secretary of State will go through this information and reject or approve your request to form the LLC.
Ensure all the information included is accurate, as any inconsistency can lead to rejection and force you to restart the process all over again.
Be careful with the name, as it is a common reason for rejection during this process. You will have to pay a small fee stipulated by the state to complete the filing process.
4. Create an Operating Agreement
An Operating Agreement is not mandatory in most states but a critical part of any LLC. It is a contract between the owners of the LLC outlining details about the organization’s structure, ownership, and management. It simply defines how you will conduct the day-to-day business of the company. You can get templates online, but the more members include in the agreement, the better it is for the business.
States requiring LLCs to have an operating agreement are California, Missouri, Maine, Delaware, and New York.
An Operating Agreement comes in handy during disagreements. According to the LLC laws, you cannot forcefully evict an owner, and if they disagree with the others, it could force everyone to dissolve the LLC. With a clause covering such a scenario documented in the Operating Agreement, members can always find ways to avert disagreement and deal with members who might want out amicably without compromising the integrity of the LLC.
If you have no Operating Agreement, the state’s default LLC rules apply, and they are not the best. They are generalized and not made to adhere to the individual interests of the business owners. As a result, an Operating Agreement is the best way to tweak the workings of the business to meet the needs and requirements of the business owners.
Key aspects to include in an LLC’s Operating Agreement include;
- Profit distribution criteria
- The LLC’s management structure
- Roles and responsibilities of the members
- Criteria for decision making
- How to handle members who want out
- How to handle dissolution
This list is not conclusive and always forecasts both the good and bad scenarios to help draft a definitive Operating Agreement that will give owners a smooth ride.
5. Get Compliance
Clearance with the Secretary of State is not enough as you need to comply with other regulatory requirements before an LLC is fully operational.
First, get an Employer Identification Number. This is mandatory if the LLC has more than one member.
An EIN is an identifier that helps the IRS tax your business. You can obtain it by completing an online application on the IRS website.
Note that an LLC should be fully registered and approved before getting an EIN.
An EIN gives you a couple of benefits, for instance;
- Protects your corporate veil
- You do not have to use your SSN, which keeps it safe from identity scammers
- Banks need it when opening an account
- Lenders prefer to give credit to businesses with one
Secondly, you must get all the business licenses for your niche. They depend on the type of business you are running and your location. All LLCs have their local and state business licenses specifications and always check with all agencies to prove that you have all the licenses.
6. File Annual Reports
Some states require LLCs to file annual reports that provide updated information about the business, such as the name and address, registered agent, and owners. Filing this report is not complicated as all states have their requirements when doing so.
Always find out whether you need to file this report, as it depends on the state you form your LLC in. If it is a requirement, find out when it is due and ensure you complete it in good time. Most states have digitized the process, and the form is available online.
How Much Does It Cost to Form an LLC?
The cost of forming an LLC depends on the initial amount required to start one and the ongoing costs to keep it running. They vary widely depending on the state, and always check with your specific one to get the correct costs.
You must pay an amount to reserve the name you want to use for the LLC as you get the other paperwork done. Depending on the method you will use to reserve the name, you might be required to pay some amount, which won’t exceed $100.
Most LLCs are required to have a registered agent. Costs vary depending on the agent you select and the services you enlist them for. Many entities offer these services at a small fee, and you will have to pay them some amount for them to allow you to list them as your designated agent. Prices for hiring a registered agent generally range between $75 and $150 per annum.
The most significant cost of forming an LLC is the amount paid when filing Articles of Organization. Fees for this vary widely, with the lowest being in Kentucky at $40 and the highest in Massachusetts at $500. Generally, most states charge between $50 and $200. These are the fees for regular processing, which takes some time as stipulated by the state. You can opt for expedited processing as specified by the states, which will cost more but get your LLC approved within a shorter time.
Additional costs include those for processing the business licenses and permits required to operate in your niche. The Small Business Administration is a reliable place to check out information about the licenses you need.
Some states, for instance, New York, require you to publish a statement of formation in one or more newspapers operating in the county your LLC is located. This can cost between $40 and $2000 depending on the newspaper you select and the statement’s period in publication.
Another component of the ongoing costs associated with running an LLC is the annual franchise tax imposed in certain states. This is a flat yearly tax that applies to LLCs. It depends on the state; for instance, you will pay $800 per year in California and $250 per year in Delaware.
Some states impose a reporting fee, which is used to maintain the LLC. It increases depending on the number of partners you have. In New York, you will pay a minimum of $325, rising to a maximum of $10,000. Other states charge a lower flat fee, say $30 a year.
How Long Does It Take to Form an LLC?
Your LLC processing time depends on which state you form it in. Typically, it takes between 7 to 10 business days, while others take more extended periods ranging between 4 to 6 weeks. Some states are swift and approve within three days of filing the articles of organization.
Another factor that determines the time it takes to have your LLC approved is the season. The Office of the Secretary of State receives multiple applications during certain times of the year, and if you apply for one at this time, the chances are high it will take longer to get it approved. This explains why they give a range as opposed to a definite timeframe.
Luckily, most states offer an expedited option where you pay more and have your LLC approved within a shorter time. Understand that choosing the expedited option does not guarantee that your LLC will be approved as it will be subjected to the same checks as the others using the regular option.
An example is Arizona which typically has a processing period ranging between 22 and 27 days. If you choose the expedited direction, the turnaround will be between 7 and 12 days at an additional $35. Delaware has multiple expedited processing options for additional fees.
Next-day processing is available for $50, same-day processing is available for $100, two-hour processing at $500- and one-hour processing at $1000.
Unique Scenarios when Forming an LLC
LLCs are not allowed to operate in every niche. You cannot run some professional services under regular LLCs and must form a Professional LLC.
PLLCs are not very different from standard LLCs and are subject to most of the typical LLC requirements. They are only recognized in specific states.
The main difference between PLLCs and normal LLCs is that the professional licensing board must check the owners of the professionals and approve their licenses before the business can run. The licensing board also plays a part in approving the Articles of Organization.
Some states that recognize PLLCs include Arkansas, Arizona, District of Columbia, Colorado, Florida, Idaho, Iowa, Kentucky, Maine, Massachusetts, Minnesota, Michigan, Mississippi, Montana, Oklahoma, North Dakota, Texas, Tennessee, Utah, Vermont, and Washington among others.
A critical difference between LLCs and PLLCs is the liability aspect that is related to malpractice. In a PLLC, owners are shielded from personal liability against business debt and lawsuits and malpractice arising from actions by other owners.
However, they are liable for claims against their actions that resulted in malpractice. As a result, it is prudent for members of a professional LLC to have professional liability insurance.
Frequently Asked Questions
Question: Should I use a lawyer to form an LLC?
Answer: You can choose to use a lawyer, but there is no legal requirement to hire one. Most states allow you to register an LLC on your own if you follow the right processes. A lawyer can come in handy if you are not well versed with the procedures and need some help to get over the line. However, they will charge you a fee and make the total cost of forming an LLC higher.
Question: Do I need a bank account for my LLC?
Answer: Legally, the owners of an LLC are not required by the state LLC statutes or federal tax laws to have a different amount. However, experts highly recommend that you get a separate account first to uphold the corporate veil. Suppose you use a personal bank account for the business. In that case, anyone can contest the company’s independence and say that you are intertwined, something that will make you liable for any business debts.
Question: Can an LLC owner be sued personally?
Answer: LLC owners have limited liability, but this does not guarantee absolute protection. There are multiple situations where an LLC lawsuit can be directed to an individual owner.
Some of the essential things about forming an LLC have been highlighted above. It is a straightforward process, and you can get the company up and running within no time.
Always check with your specific state to find out the particular requirements to make the process easier.
If all the legal stuff about LLCs seems too much for you, consider hiring an agency to help you get through the process.
LLC Formation Guides by State
For some of our specific LLC formation guides with state specific steps, check these guides out: