Should I Form an LLC for Consulting?

When starting a consulting business, one of your first major decisions is choosing which business entity to form. One popular choice is a limited liability company (LLC), but is it right for you and your business?  

To help you make an informed decision, this handy guide lays out all you need to know.

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. 

What Are My Other Options

Sole Proprietorship

If you’ve started your consulting business already without forming a business entity, you’re, by default operating as a sole proprietorship if you’re the only 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.

The key difference between an LLC and a sole proprietorship 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. 

Thus, if the 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. 

Corporation

A corporation is a bit more complex, with additional requirements. First, it must have a board of directors, which is responsible for the implementation of 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.

2. Control

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 both structures offer personal liability protection. However, in a few instances, owners do have personal liability. For example, if an owner personally guarantees a bank loan, which is expected, they’re liable for that debt. 

In a sole proprietorship, on the other hand, as mentioned above, the business owner and the business are legally the same, so the owner is personally responsible for all obligations of the business.

4. Taxes

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

Most businesses split profits based on owners’ capital contributions, no matter which entity type. 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 whatever profit-sharing plan they choose. As a result, one member can take a greater share than their interest while others take less. This may be based on the fact that one member is more involved in day-to-day operations.

6. Credibility

If you have a sole proprietorship, your name is the legal business name. However, an LLC allows you to choose your business name, lending greater legitimacy. 

In Closing

Entrepreneurs often choose to form an LLC because of the many benefits. It’s much simpler to form and manage than a corporation and offers liability protection and flexibility on management, taxes, and profit sharing. 

If you’re still 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.