If you’re launching a business while working, you need to set up a formal business structure after consulting with an attorney, of course). I’ve explained the number one reason why you must take that step here.
Owning a business isn’t just about setting up any business structure at random. There is no one-sized fits all approach to this decision. What’s best for your entrepreneur friends may not be what’s best for you. Start educating yourself on the differences between the various business entities and when you’re ready, see an attorney to help you select an entity that’s a fit for not only where you are now, but your expansion plans as well.
I wanted to give you a jumpstart by explaining the key characteristics of a Limited Liability Company (LLC). I see lots of creative entrepreneurs setting up Limited Liability Companies on their own and it’s important to understand what it actually means for you to own one.
But first, remember that as a sole proprietor you are doing business as you – the individual. Legally, this means your personal business is mixed up in the business-business. If something happens there is no liability protection for your personal assets.
Limited Liability Company (LLC)
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.).
An LLC tends to be really flexible when 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.
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 with LLCs, from a tax perspective, is that you can decide how you want the LLC to be taxed. For example, it can be taxed as a C Corp or S Corp and take advantage of those benefits. As your business grows, there will be different benefits of choosing a tax structure other than the default.
For example, with an LLC, let’s say you have a lot of cash in your business account at the year end. You’ll pay taxes on that full amount. With a c corporate 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.
LLCs tend to have very low administrative requirements in most states. 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). 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. I can be cynical, but my personal thought is states want to cash in because LLCs tend to be a favorite in small business world. However, you don’t want to base your decision solely on cost – research the filing fees in your state, attorney’s fees to handle your formation, and the annual report fee. Prepare a budget so you’re not hit with any surprises when it’s time to move forward.
One important tidbit I’ll share that Google won’t tell you… your business structure is a living, breathing thing.
For instance, I shared that LLCs can be taxed in different ways– maybe you’ve started off being taxed as a sole proprietor but you’re now earning massive cash and have a nice profit account. A S Corp or C Corp may be a better tax option at that point. Or, 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 assess where you’re at and determine whether the structure you’ve chosen is still ideal.