Disclaimer: The following information is provided for educational purposes only and in no way constitutes legal, tax, or financial advice.
Have you been wondering what an LLC is and whether it’s the right move for your business?
No doubt, you’ve heard the term ‘limited liability company’ before when it comes to business. At first glance, the term can sound overwhelming. But when you drill down to the specifics, understanding what an LLC is and how it could benefit your business is nowhere near as complicated as you may think at first.
It’s essential to understand what a limited liability company is and what it can offer you if you own a business.
Maybe you’ve been thinking about starting your own business for a while but are not sure how to get started. Or, perhaps you’re currently operating as a sole proprietor or a partnership, and are ready to take the next step.
Many well-meaning people will advise you to at least think about starting a limited liability company, or LLC.
Whether you’re a total beginner, know a little about LLCs, or want to know more about the benefits of becoming a limited liability company, you’ve come to the right place.
If you’re ready to find out more about limited liability companies, let’s delve right in.
In laymen’s terms, a limited liability company, or LLC, is like a combination of a corporation and a sole proprietorship or partnership. At a high level, it combines the limited liability protection of a corporation with the pass-through tax status of a sole proprietorship or partnership.
In a sole proprietorship or general partnership, if something goes wrong, and your business gets sued by a customer, a vendor, or a creditor and they win, you’ll be personally liable for the debts of your business. That means your personal assets (for example, your personal savings account) are at risk.
As you can imagine, this situation can have terrible consequences. And it’s a situation that is so often overlooked by business owners who operate as sole proprietors or in a partnership.
Many people nonchalantly go about their business, thinking ‘it’ll be fine’ or ‘it’ll never happen to me.’ But then, if something happens, and a large sum of money is owed, all of a sudden, their personal assets are all at risk of being used to pay the debts.
That, for any business owner, is an incredibly frightening and stressful situation.
This is where limited liability protection can be a huge lifesaver for you. Unlike the sole proprietorship or partnership, an LLC is a separate entity from its owners. And as a separate entity, it separates your business assets from your personal assets, and offers you ‘limited liability.’ That means that if something goes wrong, only the LLC’s assets are at risk. This means that you can sleep safely at night, knowing that your personal assets are not at risk.
However, you still need to proceed with caution. There are exceptions to limited liability protection that you need to know. For example, if you don’t treat the LLC as a separate legal entity but rather like your personal account, or if the LLC in underfunded and doesn’t have business insurance, you run the risk of being personally liable for the LLC’s debts. Drawing a very clear line between what are personal expenses and business expenses is essential.
When you own a sole proprietorship or a general partnership, the sole proprietorship or partnership doesn’t pay taxes. Instead, the taxes are paid by the sole proprietor or respective partner in a partnership. That means the revenue, expenses, and income all get reported on your personal tax filings, and taxes get paid at the personal tax rate rather than the corporate tax rate.
Unlike sole proprietorships and general partnerships, C-Corporations file their own tax reports and pay tax at the corporate tax rate. Then, when they distribute dividends to the shareholder, shareholders get taxed on their personal tax returns.
Very simply, a limited liability company, or LLC, is a magic combination of the two concepts we have just looked at. First, an LLC gives you limited liability protection, so that your personal assets at not at risk, only the company’s assets. And second, the pass-through tax treatment means you are not subject to double taxation the way a C-Corporation is.
By default, the LLC has pass-through tax status. For single-member LLCs, taxation works similarly to a sole proprietorship’s taxation system. And for multi-member LLCs, taxation works similarly to a partnership’s taxation system.
However, you’re not bound to those rules. With an LLC, if you wish to do so, you can also choose for it to be taxed like an S-Corporation or C-Corporation. It’s good to know that, further down the line, if your business grows and it makes sense to be taxed as a corporation, you will have that option.
Let’s move on to LLC ownership. If you, or you and a number of other people, own an LLC, you are, quite simply, called members. And the equity in the LLC is called membership interests.
Membership interests, however, do not refer to just one class. An LLC can have different classes of membership interests (similarly to how the corporation has common stock and preferred stock).
Now that we have a good understanding of what an LLC is, what at a high-level it can do for you, and why you would choose to form an LLC, let’s take a look at both the advantages and disadvantages of your business being an LLC.
As we discussed previously, knowing your personal assets are protected, in case of a lawsuit or debts needing to be repaid, can be a lifesaver further down the line.
Operating an LLC, if it seems fit for your business at the time, can save you a huge amount of time and money compared to operating a corporation. The corporation generally requires a lot more paperwork and corporate formalities than an LLC does.
If the LLC has one owner/member, the default rule is that it will be taxed as a sole proprietorship. If the LLC has two or more owners/members, it will be taxed as a partnership. Again, you’ll save a great deal of money and time on paperwork, not having to file corporation tax.
While this can provide more freedom, it also provides less certainty, depending on the type of business you’re operating.
If your future plans involve raising venture capital, investors are not going to be interested if they see your company is an LLC. This is worth thinking long and hard about because, if you’re on the fence about raising venture capital and you end up deciding it is right for your business, forming an LLC rather than a Corporation will be a complication when raising venture capital. Investors will ask you to convert your LLC to a Corporation. Sometimes converting to a Corporation is a mere formality, and other times it can be a very complicated and expensive lesson!
Although the paperwork is far less daunting and complicated than that of an S-Corporation or C-Corporation, it does require more know-how than that of a sole proprietorship or partnership. You will likely need to hire a lawyer, an accountant, or tax professional, to help you form and operate the LLC.
We’ve covered all the basics and plenty of ground when it comes to a limited liability company. But now, there’s one question left to answer. And it’s the most important question: Is an LLC right for you?
To put it simply, LLC can be the right entity for you if:
1 – You want the limited liability protection
2 – You do not plan to raise venture capital
3 – You want to be subject to less paperwork and corporate formalities than those of a Corporation
And there you have it. Those three letters that you see so often, LLC, actually refer to an entity that is very straightforward. With everything we’ve looked at, you should now have a better understanding of a limited liability company, or LLC, and whether it is the right choice for your business.
Before we wrap up all things LLC, here are some additional points to take into consideration:
As mentioned above, an LLC is not the right entity to form if you’re looking to raise venture capital. If you wish to raise venture capital, it’s usually best to form a Delaware Corporation.
Some states, such as Texas, do not allow certain professionals (e.g., doctors, attorneys) to form LLCs. However, they will allow the professionals to form other entities such as a Professional Limited Liability Company (PLLC) or a Limited Liability Partnership (LLP).
Thank you for reading, and best of luck in whatever you decide is best for your business moving forward.
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