The short answer to the question is no, you don’t have to form a limited liability company (LLC) to start a business. You can form another type of business entity, such as a corporation, or run your business as a sole proprietorship, but there are some factors and risks that you need to consider before you decide whether or not an LLC is right for you.
What is an LLC?
An LLC is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes. The LLC itself does not pay taxes. As a “pass-through” entity, income passes through the business to the owner or owners, who report it on their personal tax returns. An LLC is created by filing paperwork with your state, and nominal fees are involved.
An LLC offers its owner or owners, who are called members, considerable flexibility in terms of management. You can choose your management and operational structure and decide how you want to be taxed. Your LLC can have a single member or multiple members, all of whom have personal liability protection, meaning your personal assets are not at risk if you cannot pay business debts or are involved in a lawsuit.
What Are the Other Business Structures?
A sole proprietorship is the simplest type of business entity to have and operate. It is a business with one owner that is not incorporated. If you operate a business and you don’t form another type of business entity, your business is automatically considered a sole proprietorship. There is no paperwork to file. You and the business are the same in a sole proprietorship, therefore you are personally liable for the debts and obligations of the business.
In a sole proprietorship, the business name is your name, unless you register a DBA. “DBA” stands for “doing business as.” Simply put, it’s a name that is registered for a company to do business under that is not it’s legal business name. A DBA name is also sometimes called a fictitious name or a trade name.
A partnership is a business with two or more owners who share the profits and liability of the company. It is possible to have a limited liability partnership, in which one or more owners have some amount of personal liability protection.
A partnership agreement will define the type of partnership, how profits are shared, and what happens when a partner leaves or when a partner can be forcibly removed.
In a partnership, the company is not taxed. Profits are passed through to the partners who report them on their personal tax returns.
A corporation is a legal business entity that is separate from its owners. Corporations, like individuals, can enter into contracts, pay taxes, hire employees, be involved in legal action, loan or borrow money, and own assets. Corporations offer personal liability protection for their shareholders, and shareholders benefit from the profits of the corporation.
A corporation is created when it is incorporated by a single shareholder or group of shareholders who have ownership of the corporation in the form of common stock. A corporation can be for-profit or non-profit. Shareholders pay money for the common stock but have no further financial responsibilities to the company.
A corporation must have a board of directors, which is responsible for implementing and executing the company’s business plan. The board of directors is elected by the shareholders. A corporation pays taxes on its profits, and shareholders pay taxes on their dividends, which is sometimes referred to as “double taxation.”
Risks of Not Registering a Business Entity
If you choose to not form a business entity, you will by default be running your business as a sole proprietorship, which means that you will not have personal liability protection. If your business is sued, your personal assets will be at risk. Also, you cannot use a business name other than your name unless you register a DBA name. “DBA” stands for “doing business as.” Simply put, it’s a name that is registered for a company to do business under that is not its legal business name.
If you don’t register a DBA and use a business name that is not your name, any contracts or transactions that you do under that business name may not be enforceable. You also can’t open a bank account under that business name or accept payments payable to the business name.
If you do elect to run your business as a sole proprietorship, you still need to make sure that you get any required business licenses or permits at the state and local levels. If you do not, your business could be shut down.
Benefits of Forming an LLC
An LLC is simple to form for your business, requiring much less paperwork than a corporation. You only need to file Articles of Organization and have an Operating Agreement to define ownership and roles and responsibilities. There are no annual meeting or reporting requirements, as with a corporation, and you don’t need a board of directors. In some states, however, you do have to file an annual report for an LLC. It’s also less expensive to form an LLC. Corporations and partnerships are best formed with the assistance of an attorney, which is expensive. It is a good idea, however, to have your LLC’s operating agreement reviewed by an attorney. Corporations also pay fees for their required annual filings.
In an LLC, you can be the only owner of your business just like a sole proprietorship so that you have full control of the business. If you have more than one owner, you can structure the management any way you choose with your operating agreement. You don’t have to answer to a board of directors or anyone else. You have more freedom to make decisions than you do in another type of business structure, other than a sole proprietorship.
3. Limited Personal Liability
Unlike a sole proprietorship, an LLC is considered a legal entity that is separate from you, as the owner of your business. Just as in a corporation, your personal assets are protected because you are not personally liable for the company’s debts or legal liabilities. In a sole proprietorship or general partnership, your personal assets such as your home are at risk if there are unpaid debts or legal liabilities. There are some instances in which an LLC owner, however, could have personal risk. For example, if you are asked to personally guarantee a business loan, you are personally liable for the debt.
4. Tax Advantages
An LLC is considered a “pass-through” entity, meaning income passes through the business to the owners for tax purposes. The LLC is not a taxable entity, so all income is reported on the tax return of the owner or owners and taxed at their personal income tax rate. In the case of corporations, the corporation is taxed as well as the dividends shareholders receive, which is sometimes referred to as double taxation. LLC owners also may be eligible for the 20% pass-through deduction that’s part of the Tax Cuts and Jobs Act, meaning they can deduct up to 20% of business income. An LLC, however, can choose to be taxed as a corporation or partnership if it is deemed beneficial for the company.
5. Profit-Sharing Flexibility
Most businesses split profits based on the capital contributions of owners. In a partnership, profits are generally divided equally. Corporations pay dividends based on the ownership percentage of shareholders. In an LLC, the owners can specify in the operating agreement any profit-sharing plan they choose. One owner can take a share of profits greater than their ownership interest, while other owners take less. This may be done in a case in which one owner is more involved in the operations of the business than others.
An LLC for your business has the advantage of having more credibility to customers and vendors than a sole proprietorship. As a matter of perception, people tend to see an LLC as a more established company, as opposed to a one-person show.
How to Form an LLC
1. Choose Your State
The first step is to choose the state in which you plan to do business. LLC processes and requirements vary by state, so visit your state’s website for details. Generally, you can form your LLC with an online application. If you plan to have physical locations in more than one state for your business, you will need to register a foreign LLC in the states where you will do business other than your home state.
2. Choose Your LLC Name
Your business name is extremely important. It should reflect the brand you plan to build, tell customers what you do, and be memorable. Once you’ve chosen a name, you’ll need to make sure that it’s not already taken. You can do a search on your state’s website, and on other state websites if you are doing business in more than one state. You should also check the US Patent and Trademark Office to make sure the name hasn’t been trademarked.
3. Choose a Registered Agent
A registered agent is the person or company that sends and receives legal documents on behalf of your business’s LLC. The registered agent can be a member of the LLC, or you can choose a third party such as an attorney, or a company that offers registered agent services. Most states require you to have a registered agent. The agent must be a resident of the state where you do business, or a corporation authorized to do business in your state.
4. Determine Your Management Structure
There are two types of management structures:
- A Member-Managed LLC is managed by the members of the LLC. This is usually chosen by smaller LLCs with few members who will be involved in various management roles.
- A Manager-Managed LLC is managed by people who are not members of the LLC and are employees of the business. This structure is often used when an LLC is larger and has multiple members.
5. File Articles of Organization
The articles of organization is the form you file to create your LLC. These forms vary by state but can generally be filed online. You’ll need to fill out the LLC name, the name and address of the registered agent, the names of the LLC owners, and in some states, the way the LLC will be managed. Fees are generally around $100.
6. Draft an Operating Agreement
An operating agreement is not usually required but is highly recommended for your business. The operating agreement should clearly define the following:
- The percentage of each member’s interests in the LLC
- How profits and losses will be allocated to each member
- Each member’s rights and responsibilities
- The management structure and management roles of members
- The voting rights of each member
- Rules for meetings and voting
- What happens when a member sells their interest, becomes disabled, or dies
It’s a good idea to have an attorney’s help when creating your operating agreement so that you can be sure you’re covering all bases to protect all members and avoid future issues.
7. Apply for Business Licenses
It’s important to make sure you’re in compliance with all laws at the local, state, and federal levels. It’s likely, depending on your location and type of business, that you’ll need business licenses and permits. Do some research to determine which licenses you need. At the very least you’ll need a sales tax permit to sell products and collect sales tax.
8. Obtain an EIN
EIN stands for Employer Identification Number and is like a social security number for your business, allowing the IRS to identify your business easily. It is also known as a Federal Tax Identification Number (FTIN), or sometimes for corporations a Tax Identification Number (TIN). An EIN is required if your LLC has more than one member, if you plan to hire employees, or if you choose to have your LLC taxed as a corporation. The application is free and can be found on the IRS website. The application is form SS-4, and it can be mailed to the IRS or submitted electronically, and once your information on the application has been validated, the EIN is assigned immediately.
After LLC Formation
File Annual Reports
Your state may require you to file annual reports for your LLC, which may involve a fee. Check your state for requirements.
You don’t have to form an LLC to start a business, but an LLC has many benefits that make it worth serious consideration. Running a business as a sole proprietorship is simple, but it does not offer liability protection and puts your personal assets including your home at risk.
If you’re still not sure if an LLC is right for you, it’s recommended that you consult with an attorney and tax advisor for guidance.