What is an LLC?: A Guide to Limited Liability Companies
If you’re deciding whether or not an LLC is the right business entity for your small business, you’ve come to the right place. This blog post is a one-stop shop for all things LLC, including a deep dive into what an LLC is, the advantages and disadvantages of forming an LLC, how to start an LLC, and more good stuff that will help you make an informed decision about starting a limited liability company. Let’s get into it!
What is an LLC?
LLC stands for “limited liability company,” which is a type of business structure that gives you the legal and financial protection of a corporation and the tax benefits of a sole proprietorship. LLCs give you the (get ready for the obligatory Hannah Montanah reference) beeeest of both worlds…🎶 Ahem. LLCs give you the best of both worlds, which is what makes them such a popular choice for small business owners.
Is an LLC right for you?
Okay, limited liability companies sound cool and all, but are they right for you and your business? There are many good reasons to consider starting an LLC or converting your sole proprietorship into an LLC. Wherever you are in your business owner journey, an LLC might be right for you if:
- You need or want extra protection from legal or financial issues
- You’re the only owner of your business
- Your business has multiple members (FYI, LLC owners are more commonly referred to as “members”)
- You want the flexibility to have as many members as you want
- You want an easy way to make your business more credible, without all the paperwork and regulations
Different states have different rules and regulations for LLCs (not to mention different benefits!), so make sure you do your research on a local level, too.
A Wave Advisor can help you determine the best structure for your business based on your specific needs. Get coached with Wave Advisors.
Advantages of an LLC
Speaking of benefits, let’s get into all the perks that make LLCs such a popular choice for small business owners. If you’re in a rush, here’s the TL;DR on the advantages of LLCs:
- Limited liability
- Pass-through taxation
- Tax options
- Business loan access
Now, grab a muffin and/or a large caffeinated beverage, we’re getting into the nitty-gritty.
Limited liability protection
An LLC protects you and any other members from being personally responsible for any lawsuits or debts incurred by your business. For example, your personal bank accounts and assets can’t be touched by anyone suing your LLC.
With pass-through taxation, the profits (and losses) from your business “pass through” your business’s tax return to your personal tax return, so they’re taxed only once at your personal tax rate (as opposed to twice, as is the case with C-corporations). Another benefit of pass-through taxation is the simplicity, which makes tax time a little easier.
There are very few restrictions on the way LLCs manage their members and managers. You can have as many or as few members as you want, and you can decide how much responsibility each member has.
LLCs can choose between three different ways to pay income tax: as a sole proprietorship, a partnership, or a corporation (either as a C-corp or an S-corp). There is no single, specific “LLC tax,” so you have the power to choose which method is most cost-effective for you.
Business loan access
LLCs build credit faster and, in turn, can access loans quicker. Now that’s what we call a perk. ;)
LLCs are fairly easy to form and maintain, especially compared to corporations. There’s also less dreaded paperwork involved.
LLCs are viewed as a more formal and reputable business structure compared to sole proprietorships or partnerships. Seeing “LLC” as part of your business name can give your customers that extra sense of security.
Disadvantages of an LLC
It’s only fair that we now cover the disadvantages of LLCs so you can make the best decision for you and your business. Here are some possible downsides you’ll need to consider:
LLCs are usually pricier to establish compared to a sole proprietorship. LLCs need to pay a fee in order to form, plus annual state fees and taxes in most states.
Harder to find investors
The flexibility and simplicity of LLCs can also be a thorn in your side; investors may feel less confident about this business structure, and therefore less confident about investing. Additionally, most investors prefer corporations over LLCs because they can own shares of the company.
Problems with ownership
Compared to a corporation, it can be harder for LLCs to transfer ownership. Additionally, even if there are multiple owners, one owner has the power to disband the entire company (yikes).
Different Types of LLCs
Did you know not every LLC is the same? There are four different types of LLCs you should be aware of.
A domestic LLC is an LLC that does business in the same state it was formed in. For example, if you formed your LLC in Florida and still do business in Florida, your LLC is a domestic LLC.
A foreign LLC is an LLC that formed in one state, but then moved to or set up shop in another state. For instance, if you formed your LLC in Florida and then opened a physical location in Ohio, your LLC would need to form as a “foreign LLC” in Ohio.
If you are a licensed professional (think lawyer, doctor, accountant, etc.) providing professional services, then your LLC is a professional LLC. In order to form one, you’ll need the proper licenses to practice.
In a series LLC, there is one “parent” LLC, with an unlimited number of “child” businesses (these are the “series”). The series are all totally separate from the parent and from each other (they each have their own bank account and everything), but have the limited liability protection of the parent company. Note: not every state allows series LLCs, so do your research on a local level, too.
Okay, example time. Let’s say you own a successful Japanese restaurant, and you want to open up new ventures. You could create an LLC for a bento stand, an LLC for a Japanese grocery store, and an LLC for a cafe specializing in matcha. These three new LLCs are still technically the same company, but they are individually protected from liabilities. So if, for example, the bento stand isn’t as successful as anticipated and incurs debt, your other LLCs will not be affected. Or if your grocery store gets sued, your other LLCs wouldn’t be held liable.
How are LLCs taxed?
As they say, there are only two things that are certain in life—death and taxes—and unfortunately LLCs can't help you avoid either (they aren't miracle workers!). But they do give you some flexibility on how to be taxed. If you are the only member of your LLC (meaning you have a “single-member” company), you’ll be taxed as a sole proprietorship. Your LLC doesn’t pay taxes, and you’ll report all the profits (and losses) on your tax return.
If there are multiple members (meaning you have a “multi-member” company), you can choose if you’re taxed as a partnership or a corporation. If the LLC is treated as a partnership, LLCs don’t pay taxes—members will pay taxes on their income tax returns, similar to single-member companies that are taxed as sole proprietorships.
If you opt to be taxed as a C-corp, your LLC will need to pay the 21% federal tax rate. Treating your LLC as a corporation may be beneficial if you plan on keeping a larger amount of profits in your LLC.
When it comes to state taxes, the amount you can expect to pay will depend on your location and how much money your business is bringing in. Here are some of the state taxes you should have on your radar:
- Sales tax: Sales tax must be collected on the sale of any goods and services.
- Franchise tax: This is basically an annual fee, unrelated to how much money you make. Franchise tax is either paid annually as a flat-rate fee or as a percentage.
- Unemployment tax and income withholding tax: If you have employees, you will withhold these taxes from their income.
How do you start an LLC?: 5 easy steps
We’ve covered the “what,” so now let’s get into the “how.” Here are the five main steps to prepare for when starting an LLC:
- Name your business: The first step to bringing your business dreams to life is choosing a name. Your business name needs to be unique (i.e., it can’t be the same as any other businesses in your state), and there may be some state-specific naming rules you’ll have to follow.
- Get a registered agent: A registered agent is a person or an entity that will receive legal documents on behalf of your business.
- Draft an operating agreement: An operating agreement is a legal document that explains the structure and ownership of your business, including who the members are and what their responsibilities are.
- File articles of organization: In order to officially register your LLC, you’ll need to file the articles of organization. You need to include basic information about your business, including its name and purpose, and the information of your registered agent.
- Get an EIN: An EIN is an Employer Identification number, which is used by the IRS to identify your business so it can tax it properly. You can apply for free through the IRS.
Now that we’ve gone over the basics, let’s answer everything you’ve ever wanted to know about LLCs but have been too afraid to ask (we know you’ve been waiting years for this moment!).
What's the difference between an LLC and a corporation?
Remember what we said about LLCs being the best of both worlds? LLCs have things in common with corporations, but they aren’t the same thing. Just so we’re on the same page, let’s define what a corporation is first. A corporation is a business entity that is totally separate from its owners. This means both LLCs and corporations have liability protection.
Corporations have stricter rules and regulations than LLCs (for example, they need to have a board of directors that meets on a regular basis), so they’re, generally speaking, more complicated to run. However, corporations will find it easier to get funding compared to an LLC, as we’ve mentioned before.
What's the difference between an LLC and a sole proprietorship?
Same thing here: LLCs have some things in common with sole proprietorships, but they are fundamentally different. A sole proprietorship is a business entity that is owned by only one person; it’s not possible to add any more owners.
This means there is no limited liability: You and your business aren’t separate, so you as the business owner are personally liable for debts and lawsuits. In an LLC, members are not personally responsible for the liabilities of the business. Additionally, sole proprietorships are usually simpler and cheaper to form, but it may be easier for LLCs to get funding.
How much does it cost to form an LLC?
There is no exact price for forming an LLC; the cost will vary, especially depending on what state you’re in. The average cost to form an LLC in the US is $132 USD as of 2022, with filing fees ranging from $40 to $500 and annual fees ranging from $0 to $500.
How long does it take to form an LLC?
It typically takes seven to ten business days to form an LLC after you submit your formation documents to your state. If you want to speed up the process, your state might let you pay a fee for same-day or expedited LLC formation.
Do I need a lawyer to form an LLC?
Nope, you’re not required to use a lawyer to form an LLC! You can form an LLC by yourself, or get the help of a lawyer. The choice is yours.
Do I need insurance to form an LLC?
Even though LLCs protect your personal assets, your LLC’s assets aren’t immune to liabilities. So, yes, insurance that protects your business assets is a pretty good idea.
How do you pay yourself from your LLC?
Don’t forget about paying yourself for all your hard work! How you pay yourself depends on whether your LLC is a single-member LLC or a multi-member LLC.
When you pay yourself from a single-member LLC, you do so by making an “owner’s draw,” which lets the IRS know the income from your LLC is staying in the company and going into your personal bank account.
Now, let’s cover what the deal is with multi-member LLCs. So, how you get paid depends on whether your LLC decides to treat itself as a partnership or a corporation. In a partnership LLC, members also pay themselves through draws, but will be taxed differently than a single-member LLC. In a corporate LLC, members are considered employees and must be paid a reasonable salary.
Regardless, it is very important to keep your personal finances and your business finances separate.
Wrapping Up with LLCs
Now that you’re informed about all the ins and outs of LLCs, it’s up to you to decide if it’s the right business entity for you. Here’s a brief recap of everything we covered:
- A limited liability company is a cross between a corporation and a sole proprietorship, giving you the flexibility to decide how you are taxed.
- LLCs can be taxed as sole proprietorships, partnerships, or corporations.
- LLCs are a popular choice for small businesses owners because they allow for pass-through taxation and protect personal assets from liabilities.
- LLCs are more complex and expensive to form compared to sole proprietorships, and may have more troubling finding investors compared to corporations.
- Generally speaking, LLCs are fairly easy to form. After deciding on a name for your business, all you need to do is get a registered agent, draft an operating agreement, file articles of organization, and get an EIN.
Once your business is off the ground, Wave will be with you every step of the way. We’re a one-stop money management software built for small business owners like you. From getting your first customer to hiring and paying your first employee, Wave grows with you.
A Wave Advisor can help answer questions specific to your business.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.