If you are the sole proprietor of your small business, and – heaven forbid – your business gets sued or must file for bankruptcy, are your personal assets, such as your house or your car, at risk? If this question keeps you up at night, now may be the time to consider converting your business into a limited liability company (LLC). 

An LLC literally does what its name implies – limits your personal liability in the event that creditors or the IRS comes after your company, plus it simplifies taxes. It is a relatively new type of business entity that provides the legal protections of a corporation with fewer tax and financial hurdles. You can form an LLC for nearly any business. 

What is an LLC?

An LLC gives your business its own legal identity. It is a legal status granted to a business that relieves owners of personal responsibility for the company’s debts and liabilities and establishes the business as an official legal entity. In a sole proprietorship, you must file your business’ net income or losses on your personal balance sheet. This makes you personally liable if your company is sued or must file for bankruptcy. In such a case, creditors or the government can – and most likely will – come after your personal assets such as your home, car and personal bank accounts. 

Take note, however, that you can still be sued personally with an LLC, depending on the circumstances. For example, if you’re a masseuse and you accidentally hurt a customer’s back, that customer can still sue you personally. You should still consider taking out a business insurance policy for this reason. 

Unlike a sole proprietorship, you and your business would be separate under a LLC. Once you’ve established your business as a LLC, you can open a checking and savings account in the name of your business. Also, LLCs can be taxed as either a sole proprietorship or as an LLC, and can take on business partners or be a single member LLC.

What are the Benefits of an LLC?

There are distinct advantages and disadvantages to converting to a LLC as opposed to a sole proprietorship. The first advantage is that single member LLCs are typically taxed as sole proprietorships, and the tax liability passes through to the owner’s personal tax return (hence the term, “pass-through” business). 

Second, since a single member LLC is treated as a pass-through business, that means that the single member can still qualify for the 20% qualified business income tax deduction, created by the 2018 Tax Cuts and Jobs Act, and yet, as previously mentioned, enjoy limited personal liability from lawsuits filed against the business and bankruptcy. You can choose to be taxed either once or twice (both as a corporation and a sole proprietor) – whichever option minimizes taxes. 

While an LLC itself doesn’t pay taxes, co-owned LLCs (LLCs that have more than one owner) must file the U.S. Return of Partnership Income  Form 1065 with the IRS each year. Each partner in the LLC must file this form separately, which the IRS reviews to make sure each LLC partner correctly reports their income. Single members must fill out form 1040 Schedule C with the IRS that will report your operating results, including profits or losses. You also have the flexibility to be taxed as a corporation, which, in some cases, can mean even more tax savings. You should speak with your accountant to determine which is best for tax reasons. 

Third is that you don’t have to deal with the red tape and bureaucracy of an S or a C corporation. For example, in an LLC, you don’t have to form a board of directors or have attorneys make sure you are in compliance with federal securities regulations and keep track of board meetings. 

Potential Drawbacks

The biggest drawbacks of an LLC is that you cannot sell shares of your company or go public – the company is solely owned by you and/or your members. You also will not be recognized globally, which means that if you operate or gain sales in another country, you may be taxed as a corporation. 

Other potential disadvantages are that LLCs differ from corporations in that they do not have specific roles, such as directors, managers, etc., which could lead to confusion as to who among the members is in charge. Additionally, in some states, LLCs may legally cease to exist if a member drops out. 

Forming an LLC

There are distinctive steps to forming or converting your existing business into an LLC, but the first thing you may want to do before doing so is to hire an attorney that is familiar with the laws in your state, because each state has different rules and fees when it comes to creating an LLC. Regardless of the state you are in, the basic process is:

Choose a Name for Your LLC

This sounds very straightforward, but the advantage of choosing a name for your LLC is that it will be unique to your business, as no other business will be able to use your name. Most states require your business’ name to end in LLC, and in most states you can reserve your name for 6-12 months for a small fee. Some states, such as New York, will not allow you to use certain words in your LLC’s name, such as “bank,” “Academy” or “Assurance.”

File Articles of Organization

Articles of organization is a document that outlines the initial statements required to form an LLC. Some states, such as New Hampshire and New Jersey, call them “Certificate of Formation.” While creating such a document sounds complicated, most states do make it easy – a form is available on the websites of most states’ Secretary of State that is typically simple to fill out. These forms will require you to name the members of your LLC, the physical address of your company and how it will be managed. All states charge a small fee, usually around $100, to file this document. 

Choose a Registered Agent

Every state requires an LLC to have a registered agent – an individual or company that agrees to accept legal papers on behalf of the LLC in the event that it is sued. The registered agent must have a physical address in the state in which the LLC is registered, and most states, such as California, provide a list of commercial registered agents that will act as an agent for an annual fee. In most states, an LLC member can also act as a the registered agent. You may want to hire an attorney to advise in choosing an agent.

Create an LLC Operating Agreement

Some states – but not most – require that you file an operating agreement. This is an internal document establishing how your LLC will be managed. While most states do not require one, you should create one in the event that one of the LLC’s members takes legal action against the LLC. You should work with an attorney when creating an operating agreement. Additionally, if you do not have an operating agreement, your state may dictate how your LLC operates. 

Comply with Your States’ Tax and Regulatory Requirements

This will require several steps that you should do in consultation with your attorney and/or accountant. 

• First, you must create an Employer Identification Number (EIN) with the IRS if your LLC has more than one member. If the only managing member is you, you can elect to have your business taxed as a corporation rather than a sole proprietorship. As previously mentioned, your business will be able to keep its pass-through status in the event that you do. 

• Second, you will need a business license depending on what type of business you are running. Depending on the specific rules of your local and state governments, you may even need to obtain additional licenses in order to do business in your local community. 
• Third, your LLC must register with the appropriate state taxing authority in order to collect sales taxes and withhold state and local taxes from your employees’ paychecks. 

Get Ready to File Annual Reports

Some states will require your LLC to file an annual report every year – a document stating the yearly, detailed financial results of your business. While the task may sound daunting, you should work with your accountant or attorney on creating one.

While creating an LLC may be an arduous process, it will go a long way in legitimizing your business and cutting down on legal liability. Your business will have its own identity and be more organized for future growth.