If you are starting a consulting business, you’re probably in the process of determining which type of business entity to form. It’s an important decision that will affect your taxes, your personal liability, and your business registration requirements. An LLC is one option, and you should know its advantages and disadvantages so you can make the right decision for you and your business.
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.
Benefits of Forming an LLC for a Consulting Business
An LLC is simple to form for your consulting 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 consulting 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.
Limited Personal Liability
Unlike a sole proprietorship, an LLC is considered a legal entity that is separate from you, as the owner. 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 for your consulting business. 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.
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 from your consulting business 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 was 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 to be beneficial for the company.
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 the shareholders. In an LLC, in the operating agreement, the owners can specify any profit-sharing plan that they choose. One owner can take a percentage 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 consulting 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 more as a more established company, as opposed to a one-person show.
Disadvantages of Forming an LLC for a Consulting Business
While the disadvantages of an LLC are few, they should be considered.
Forming an LLC for a consulting business involves more paperwork than a sole proprietorship and fees must be paid to register the business. To form a sole proprietorship, you need to do nothing but start doing consulting. However, depending on your location and type of business, you may need certain licenses and permits. If you want to do business under a name other than your own, you need to register that name as a DBA with your state. Forming a sole proprietorship is the least expensive and easiest type of business entity to form.
To form an LLC for your consulting business, you need to file articles of organization with your state. 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.
When you have an LLC for your consulting business, you will need to keep your personal and business assets separate, including your bank accounts. If you commingle your business and personal assets, you could risk your personal liability protection. If you have a sole proprietorship, this is not an issue.
Potential limited growth
If you plan to grow your consulting company by attracting investors, you may run into an issue because LLCs are not as appealing to investors as corporations. Corporations can issue stock while LLCs cannot, so it’s more difficult to sell an LLC. However, you can always change your business structure in the future if necessary.
How to Form an LLC for a Consulting Business
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, 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 consulting 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 consulting 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 for your consulting business’s LLC is not usually required but is highly recommended. 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 for your consulting business. 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 consulting 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.
9. 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.
An LLC has many benefits, making it a great choice for many startup companies, including consulting companies. As a consultant, you often give advice on your areas of expertise. If your guidance has negative consequences for your clients, they may, unfortunately, take legal action. With an LLC your personal assets will not be at risk. An LLC also gives you a lot of flexibility in terms of management, as well as tax advantages. If you’re in doubt, consult with an attorney so you make the right decision for you and your consulting company.