If you’re starting an LLC, the business entity formation process is one of the first and most important hurdles. This step can be terribly complex ...
When Should a Business Become an LLC?
Written by: Martin Eckler
Martin Eckler is the in-house legal advisor for and a commercial attorney with over 20 years of experience in commercial law and business strategy.
Published on February 15, 2022
Updated on June 21, 2023
If you’re a sole proprietor, you may be thinking about forming a limited liability company (LLC) because your business is growing. There is no magic time or income level at which it’s best to form an LLC, because anytime is a good time to form an LLC — if it’s right for your business.
Benefits and Drawbacks of a Sole Proprietorship
Sole proprietorships are uncomplicated and inexpensive. No registration or registration fees are required, and there are no annual reporting requirements. Taxes are simple because you simply report your taxes on your personal tax return.
However, if you have any risk of liability in your business, you have no personal liability protection with a sole proprietorship. If your type of business is low risk and you have no debt for the business, it may not matter. But if there is a chance that your business could be sued, being a sole proprietor is risky. If you’re sued, your personal assets are fair game because you and the business are the same.
For example, if you have a remodeling business, and someone is not satisfied with your work or is injured because of your work, the client could sue you as a sole proprietor. If they win, your personal assets, including your home, could be at risk. If you have an LLC, that is not the case.
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
Forming an LLC, no matter when you decide it’s the right time, offers many benefits.
An LLC is simple to form, 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 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, the owner. Just as in a corporation, your personal assets are protected because you’re 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’re asked to personally guarantee a business loan, you’re 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 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 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.
If you form an LLC for no other reason than to have personal liability protection, it’s worth the time and cost. You do not want to put your personal assets at risk. In business, the unexpected can happen, and having an LLC can protect you and your assets. Of course, it’s a good idea to consult with an attorney about what’s best for your business.
When Should a Business Become an LLC?
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