You’ve got a great business idea and you’re ready to get going.
It can’t be hard, right? Maybe you’ve already been operating “unofficially,” and successfully, for years.
Hold on a minute. The way you form your business will have liability and tax consequences for years to come. It is essential to be intentional about your business structure, especially during the initial formation, so that you can save yourself unnecessary stress and financial investment in the future. While certain factors will change on a state-by-state basis, there are some general factors you should consider.
If you simply open your doors and start charging customers for your services (not recommended!), your loosely formed business structure will likely default to that of a sole proprietor or partnership. Many business owners don’t know that that owners of sole proprietorships and partnerships are fully liable for the legal and financial obligations of their business, while those who own corporations are not held individually accountable for business debts. a lot of small business owners shrink away from forming a corporation because the process of setting one up can be daunting, is more costly up front, and requires a number of ongoing formalities.
Evaluating Your Business Options
For a lot of business owners, the sole proprietorship business form feels too small while the corporation business form is too large. You need to find a structure that is somewhere in the middle. That’s what makes the third option, the Limited Liability Company (LLC), a great option.
The LLC provides a flexible option that sits between a general business form like the sole proprietorship and the larger corporation form. An LLC can be made up of an individual, a partnership, multiple individuals, or a corporation.
In addition to the limited liability and the flexible tax options, the LLC is an attractive option to many business owners because it usually doesn’t need to comply with many of the legal formalities that govern corporations such as annual reports, director meetings, and shareholder requirements.
For these reasons and more, it’s one of the most widely used business forms for small businesses.
Benefits of a Limited Liability Company (LLC)
The cardinal benefit of the LLC entity structure is that the owner(s) benefits from the shield the LLC provides against individual responsibility for business debts as owners of incorporated businesses. Forming an LLC takes about the same effort and cost as properly setting up a sole proprietorship or partnership while simultaneously providing the owner(s) with the same level of protection as a corporate business structure.
To create an LLC, you must file articles of organization with the state you transact business in and pay appropriate filing fees. When an LLC is formed, the owner(s) should adopt an operating agreement, which makes sure the LLC is appropriately governed.
LLCs must follow most of the business requirements a corporation also follows, which includes holding business accounts separate from personal accounts, as well as maintaining company records and required licensing. State laws determine record-keeping and licensing requirements (and any annual fees!). To maintain limited liability, all requirements must continuously be met. If you do not maintain all requirements, you may still be held personally liable for business debts and liabilities, giving creditors access to your personal assets. This is called “piercing the corporate [or LLC] veil.” The liability limit of LLCs provides a significant incentive for individuals in partnerships or sole proprietorships. With limited liability, in the off chance your small business LLC goes bankrupt, creditors would be limited to the business assets instead of your personal assets. With an LLC in place to serve as a shield against personal liability, a lawsuit or other financial liability may clean out your business assets, but your family home will be safe if the LLC is maintained properly. This protection can be lost, though, if the business owners act irresponsibly, illegally, or unethically in certain cases. These acts must be proved in a court of law or an out-of-court settlement.
For many businesses, especially small businesses, the benefits and flexibility make it a better choice than other business forms.
Death and Taxes
One of the greatest advantages of the LLC business form is that they can elect how they will be taxed. The default taxation for an LLC depends on how it’s structured. Most of the time, the base group form decides the default taxation. In other words, if an individual forms an LLC, it’s taxed as a sole proprietorship. If a partnership forms an LLC, it’s taxed as a partnership. For our purposes, let’s assume it’s just you running your small business so you are the sole member of your new LLC. As a sole member LLC, you can decide whether it’s better for you to follow the IRS default and file your small business taxes as a “disregarded entity” or elect to be taxed as a corporation. A disregarded entity means that the business is treated like a sole proprietorship for tax reporting purposes and income is passed through to the individual tax return on Schedule C. If you choose corporate taxation, your small business will be taxed at a lower corporate rate for the first $75,000 of income.
Another tax advantage of the LLC form is that it allows the owner to set up both retirement funds and life insurance policies with greater contribution limits. This means you can set aside money for your future and your family.
Regardless of whether you choose for your business to be taxed as a sole proprietorship or a corporation, both approaches can have big tax advantages, depending on how much income you plan to take and how much you plan to reinvest into your business.
You may enjoy additional tax benefits by paying yourself from your LLC by paycheck. By setting up the LLC taxed as a corporation, you may then pay yourself from the company through payroll and avoid self-employment taxes. The company will still be responsible for a portion of the tax bill, so you will want to make sure your LLC budgets for that payment each reporting period.
Because everyone’s situation is different, you should consult with a CPA or other tax professional to drill down into your financials. This will help ensure you fully understand which option is best for you.
No matter how you choose to tax your small business, don’t forget that business expenses can be deducted. Most importantly, you can deduct the cost of forming your LLC. Get into the habit of hanging on to all your receipts. Invest in a scanner to organize them electronically (and don’t forget to keep the receipt for your scanner purchase)!
Are family and friends telling you to create your LLC in Delaware or Nevada?
Delaware and Nevada are considered prime states for incorporation and you might be tempted to consider creating your LLC in one of these states, particularly if you are electing to be taxed as a corporation. After all, Delaware offers some of the most developed, flexible and pro-business statutes in the country. Nevada has also become a popular choice thanks to its low filing fees and the absense of state corporate income, franchise and personal income taxes. If your small business is a sole member LLC, incorporate in the state where your business has a physical presence. Otherwise, you’ll be dealing with many hassles and fees for operating out-of-state, including difficulty opening a business bank account, appointing a mandatory registered agent in the state of incorporation, and required fees for operating as a ‘foreign entity’ in your own state.
Is an LLC the right choice for my business?
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Ready to start (or fix up) your small business?
You’ve already mastered the art of running a small business. That’s the hardest part. Now you’re ready to set up your business for success by establishing it as an LLC.
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