Starting a business comes with a lot of decisions. One of the big ones is which type of business entity to form. A limited liability company (LLC) is one option, but it’s not the only one.
There are several business entity types to choose from, and it’s a good idea to explore them before selecting the one that’s right for you. Fortunately, this handy guide wraps up all the information you need.
What Is an LLC?
An LLC is a popular business structure for startup companies due to its many benefits. An LLC provides personal liability protection, for example, so that your assets are not at risk if your business is sued or cannot pay its debts.
Also, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
You have other options to choose from that come with different factors.
If you’ve started your online business without forming a business entity, you’re, by default operating as a sole proprietorship, assuming you’re the only business owner. Sole proprietorships do not require registration with the state.
In the case of a sole proprietorship, the business’s income passes through to the owner, just like in an LLC, and income is reported on the owner’s tax return on Schedule C. However, the key difference is that a sole proprietorship does not provide the owner with personal liability protection.
If you’re a sole proprietor, you and the business are legally considered the same. This means that if your business has debt or is sued, you’re personally liable for the obligations of the business. This puts your assets, including your home, at risk.
If you’re going into business with another person or persons, you can form a partnership. A general partnership is a business in which two or more people share ownership, profits, and liability. Just like a sole proprietorship, a general partnership does not require registration with the state.
A partnership agreement should clearly define business ownership and how profits are distributed. In addition, it’s a good idea to have an attorney draft or review the agreement to ensure all partners’ rights are protected.
General partnerships do not provide personal liability protection for the partners. So again, if your business has debt or is sued, the partners will be personally liable for the obligations of the business.
Partnerships are also pass-through entities, so profits and losses of the business are passed through to the partners, who report their income on their tax returns. Therefore, the partnership agreement should specify how profits and losses are divided.
A corporation is a bit more complex, with more formal requirements. For example, a board of directors must implement the company’s business plan.
Shareholders rather than members own a corporation. The ownership is in the form of shares of common stock. Shareholders have ownership of the company but no financial obligations, though they share in the profits.
Unlike an LLC, a corporation pays taxes on profits. However, shareholders also pay taxes on the dividends they receive, often called double taxation.
Benefits of an LLC
Let’s discuss the specific benefits of an LLC.
1. Simplicity of Administration
LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complicated.
In an LLC, the members do not have to answer to anyone. Instead, they fully control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power.
3. Limited Personal Liability
In LLCs and corporations, owners are considered separate entities from the business, so they offer personal liability protection. For a sole proprietorship, if an owner guarantees a bank loan, which is common, they’re liable for that debt. Hence, the owner is personally responsible for all obligations of the business.
LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
For corporations, the business income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions.
However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
5. Profit Sharing Flexibility
No matter the entity type, most businesses split profits based on owners’ capital contributions. Corporations pay dividends based on the ownership percentage of the shareholders.
With an LLC, on the other hand, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.
If you have a sole proprietorship, your name is the legal business name legally. However, an LLC allows you to choose your business name, lending greater legitimacy.
LLCs are only one business entity option, but entrepreneurs prefer them for many reasons. It’s much simpler to form and manage than a corporation, and you have liability protection and flexibility regarding management, taxes, and profit sharing.
If you’re unsure whether an LLC is right for you, consult an attorney and tax advisor. It’s best to take your time and choose the option that gives your business the best chance of success.