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What is an LLC or Limited Liability Company?
An LLC or limited liability company is a type of legal entity that is formed in order to own and operate a business. The reason LLCs exist is to provide some protection against lawsuits and other legal issues for the actual owner of a company since the LLC makes it so the company is owned by another “entity” that has to deal with and be the focus of lawsuits and other legal issues. They are popular because they provide the same limited liability as a corporation, but are cheaper and easier to form. They also allow for flow-through taxation like partnerships.
What are the benefits of forming your own LLC?
Like I mentioned before, the “limited liability” part of an LLC is from the fact that its owner or owners are typically not personally liable for things like business debts or business-related lawsuits. Because of this, people who sue an LLC are not allowed to collect against personal assets like your personal car, bank account, or home. Everything under the LLC’s name, like a business checking account or other assets owned by it, is fair game to be taken if the LLC is sued though.
Similar to business partnerships, they also provide the benefit of pass-through taxation. This means that the profits or losses the business incurs pass through the business to the owner’s personal tax return. Such profits are taxed at the owner’s personal tax rates. Since they are pass-through entities the owners can qualify for a special pass-through tax deduction that was created by the “Tax Cuts and Jobs Act”. This deduction took effect in 2017 and is supposed to continue through 2025. This is actually an income tax deduction of up to 20% of the net business income earned by the pass-through business.
LLCs are the simplest type of business entity you can form and operate. Unlike a corporation, you don’t need to have officers, directors, board or shareholder meetings, or the other administrative burdens that come with having a corporation. They provide a significant amount of flexibility when it comes to the ownership of a business, management, and taxation. There are no minimum or maximum limits on the number of owners that an LLC can have. Many have only one member but can have five, tens, or hundreds of members.
LLCs can be managed by their members meaning that all of the owners typically share responsibility for the day-to-day running of the business. The managers can be designated members, nonmembers, or a combination of both. They are usually taxed as sole proprietorships or partnerships, but single-member LLCs and multi-member LLCs have the option of choosing to be taxed like a corporation. This is easily accomplished by filing a document called an “election” with the IRS.
They can choose to be taxed as a C corporation or an S corporation. Either way, the owners ordinarily work as employees of the corporations, typically being CEOs, CFOs, or some other C-suite position within the company. With C corporation taxation, the corporation pays taxes on the business profits at the corporate tax rate. The C corporation tax rate is 21%, much lower than that of most individual rates. With S corporation treatment, the LLC remains a pass-through entity, with profits passed through the business to the owners to be taxed at their individual tax rates. But at the same time, such distributions are not subject to Social Security and Medicare taxes.
Image from taxpolicycenter.org
Last, but not least, forming your own LLC to own and run your business helps give you a certain measure of credibility. It reassures customers that yours is a real business and you’ll also have an official business name to use.
What are some of the disadvantages of forming your own LLC?
It generally costs more to form and operate one than to be a sole proprietor or have a partnership. In order to become a sole proprietor all you have to do is go to IRS.gov in order to apply for your own business EIN and register as a sole proprietor which is free and easy to do. However, when you register your business as an LLC you have to pay filing fees to legally establish it.
Although it is not legally required, it is highly desirable for them to adopt a written LLC operating agreement laying out how the LLC will set out the financial and working relations among business owners and between members and managers. Once it is formed, annual fees and taxes will have to be paid to the state. These vary from state to state but can be as high as $800 per year or more for highly profitable ones.
They are also not ideal for business owners who might want to seek outside investment. Particularly if you’re looking for funding from venture capitalists, who normally only fund corporations. Corporations work best for outside investments because when a company is incorporated, stock can be issued in exchange for investors’ money. Outside investors do have the option to invest in LLCs and receive ownership interests, but this is typically a more complicated process than with a corporation.
Another disadvantage they have is that unless they are taxed as a corporation rather than a regular LLC, then you have to pay both regular income taxes as well as self-employment taxes at the same time. If you’re incorporated then you pay less taxes on your income than if you were a regular W-2 employee, but if you are not then you have to pay both regular state and federal income taxes as well as self-employment taxes at the same time. So, even though you have to pay some fees to incorporate your business it’s still better overall to do so because of all the money you can save on taxes you owe.
How to form your own LLC?
Each individual state has its own requirements that you need to meet in order to form your own LLC. A good company that you can use to help you form your own or another type of business entity is LegalZoom.
In order to form your own, the steps that you usually have to take are:
- Deciding on the name for the LLC
- Appointing a registered agent which is someone who is an individual or business entity that agrees to accept legal papers on the LLC’s behalf if it is sued
- File your “Articles of Organization”. This step typically requires you pay a fee and must include the name, the address, the name and address of the LLC’s registered agent, a statement as to whether it will be run by a manager, and the signature of the organizer.
- Prepare an operating agreement
- Obtain a business EIN
- Pay the annual state tax obligations.
Disclaimer: I am not any sort of investment or financial professional giving any sort of legal advice. I’m just some guy trying to teach other people about how they might navigate the financial world.