Should you transform your sole proprietorship into a limited liability company (LLC)? The benefits of an LLC include liability protection and tax advantages. For many small business owners, the benefits of forming an LLC outweigh the initial costs.

An LLC is one of four types of business structures. It combines aspects of partnerships and corporations, making it a good choice for small business owners. But before you make any changes, it’s important to understand LLC advantages and disadvantages. For best results, you should choose a business structure that supports your long-term strategy.

Learn how an LLC differs from other entities. Next,, review the pros and cons of forming an LLC and use this information to make an informed decision. Setting up your LLC only takes a few steps. Once complete, optimize your network and get ready for growth.

Differences Between an LLC and a Corporation

The main difference between an LLC and a corporation is ownership. Before forming an LLC, you’re a sole proprietor or a partner of the business. If you create an LLC, then you’re a member. Corporations use the term "shareholders."

LLC: Members

Members of an LLC may receive profits regardless of their financial investment. Your operating agreement and articles of organization define your structure and terms. For example, you may choose to share profits equally between partners. You could do this even if one member invested less money in the business. This helps you:

  • Recognize physical or mental labor of members as a form of investment
  • Allow more funding from one member without giving up full control to that person

Your operating agreement puts rules in place for transferring membership. It also notes what happens if a partner leaves the company. Without a contract, then state law governs your business terms. For instance, if a member leaves, then a state may dissolve your business by default.

Corporation: Shareholders

With a corporation, shareholders own stock in the company. You may issue, sell or transfer stock to different people. Doing so may give individual shareholders a bigger stake in the company. Since a corporation is its own entity, it exists regardless of who owns shares. The retirement or death of a shareholder doesn’t affect the structure of the corporation.

However, laws govern more aspects of a corporation. You have less control over what happens when a shareholder sells the stock.

LLC Versus Corporation: Management and Reporting

The benefits of having an LLC include flexibility in management as well. You’re free to oversee the operations yourself or use a manager-managed LLC. Corporations require a formal structure. You must form a board of directors and choose corporate officers. Corporate officers manage daily operations while shareholders remain separate from business decisions.

You’ll also have certain LLC advantages when it comes to reporting. Depending on state requirements, you may need to file annual reports. Your yearly reports keep your operating agreement valid. You do not need to hold annual shareholder meetings. Nor must you follow strict documentation records of these meetings.

Tax Advantages of LLCs and Corporations

With an LLC, you have the flexibility to choose how the Internal Revenue Service (IRS) views your business for tax reporting purposes. You may opt to claim taxes on your personal return or as a corporation.

Many business owners choose an LLC for its pass-through tax treatment. This means that each LLC member claims income from the company on their personal taxes. Doing so saves you from the double taxation that corporations face.

However, you may elect to be taxed as a corporation. You'll submit a corporate tax return, then pay tax on your dividends. The latest tax law changes tax corporations at 21%. If this is lower than your personal tax rate, then you may benefit from going this route. Your business is still a legal LLC. But for tax purposes, the IRS views your company as a corporation. This LLC tax advantage can save you money.

Types of Business Structures

There are several ways to structure your business. Each one has distinct advantages and disadvantages. Talk with your certified accountant before making a decision. By choosing the right structure from the start, you'll save yourself time and money.

According to the National Small Business Association (NSBA):

  • 35% of small businesses are LLCs
  • 33% of companies are S-Corporations
  • 19% of businesses identify as corporations
  • 12% of small companies are sole proprietorships

Like LLCs, S-Corporations are pass-through entities. They do, however, have more restrictions. You're limited to 100 shareholders, and there are rules for investors. With an LLC, you can have as many members as you want.

Advantages and Disadvantages of Starting an LLC

While there are many benefits of forming an LLC, some drawbacks exist also. Review the LLC advantages and disadvantages to determine if this business structure is right for you.

LLC Advantages

A huge benefit of having an LLC relates to liability. In most cases, personal creditors cannot access an LLC’s assets. If one member faces bankruptcy, an LLC protects your business. A judge cannot usually force an LLC to make a distribution to pay off debts.

Liability protection also extends the other way. If your business has unpaid debts, a judge will not use your personal property as payment. This protects your assets, like your car or home, from business-related debt collection. Other LLC advantages include:

  • Flexible tax reporting options: Choose which format fits your needs
  • No ownership restrictions: You determine how to share profits
  • Easier to maintain: Less paperwork and recordkeeping requirements
  • No management requirements: Your operating agreement lays out the structure, not the government

LLC Disadvantages

Forming an LLC also comes with certain disadvantages. Many of the cons pertain to individual state requirements. Each state controls LLC regulations. You'll pay higher fees in some areas or have fewer liability protections. For instance:

  • Yearly filing fees and state taxes may be higher for LLCs
  • Single-member LLCs may not get the same liability protections as multi-member LLCs
  • A corporate checking account is required to cash checks made out to the LLC
  • An unclear operating agreement may result in business closure if one member leaves

How to Form an LLC

The benefits of forming an LLC tend to outweigh those of a sole proprietorship. Yes, setting up an LLC is more difficult than a partnership. But the LLC advantages pay off in the long run. Anyone who wants to form an LLC will follow certain steps. The process may differ according to the rules in your state.

Once you’ve determined that an LLC aligns with your business needs, follow these five steps to form your LLC.

1. Review LLC State Guidelines

Each state has specific requirements. Rules govern your business name and reporting standards. Plus, you may need to file for a license and permit. For instance, many states require your business name to contain the words:

  • Limited liability company
  • LLC or L.L.C

States also insist that your business name be unique. Perform a search on your state’s website to see if your desired name is available. Then, you may opt to pay a fee and complete a form to reserve a name for 90 days before filing LLC paperwork.

2. File Articles of Organization

Check your state's website for filing information. It provides a form or offers online filing for your articles of organization. The fee for this is usually around $100-$150. To file, you'll need a business name, registered agent and management structure.

A registered agent is a person who receives legal papers on behalf of your company. This person may be an LLC member, or you can hire a private service company to act as your agent.

When it comes to management, most LLCs choose a member as a manager. But you can also appoint an outsider to manage your LLC, which is like a corporate board of directors. Most filing documents include the following information:

  • Business description
  • Name of the company
  • Mailing address
  • Extra information about owners or managers
  • The name and contact information of your registered agent

4. Create an Operating Agreement

Many states do not need an LLC operating agreement. But if you don’t complete this step, then state law determines certain aspects of your business. Your contract states how you'll handle a member leaving your company. Without an agreement, the state dissolves your business.

For sole members, having an operating agreement gives you extra benefits. It helps differentiate your company from a sole proprietorship for liability purposes. This can protect your assets during a dispute with creditors.

Your operating agreement is an important document. Invest in legal services to ensure a correct operating agreement. The main parts of an operating agreement include:

  • Statement of business purpose
  • How the IRS taxes your LLC
  • The process for adding new members
  • Any current capital invested by members
  • How members divide profit or loss
  • What happens if a member dies or wants to transfer membership

5. Understand Tax and Regulatory Requirements

To experience the benefits of an LLC, you’ll also need to understand what extra tax or reporting tasks you’ll need to do. Start by applying for an employer identification number (EIN). The process is quick and free. You'll find information on the IRS website.

Other considerations include:

  • Local and state business licenses and permits
  • Sales and employer taxes for your state taxing authority

6. Check Your LLC Annual Reporting Requirements

In some cases, if you fail to file an annual report, then your state government dissolves your company. Other states do not need yearly paperwork, but you must pay a fee. That’s why it’s vital to review what documents you need to send annually. The cost of annual filing can be expensive, so consider the fees associated with reporting. Then, work that expense into your budget.

Benefits of an LLC as Part of Your Business Strategy

Choosing a legal entity for your business affects several elements. The biggest benefit of forming an LLC is its flexibility. With an LLC, you get the benefits of a corporation and a partnership. A clear plan limits your personal liability and offers tax advantages. Plus, you don’t have the extensive reporting requirements necessary for a corporation.

Flexibility for Tax Advantages of LLC

If tax law changes occur, then you can change your filing for tax advantages of LLC entities. When a new year begins, you have two months and 15 days to make changes. Corporations and sole owners cannot switch their filing status. Before making a decision, get advice from an accountant. They'll help you file the right paperwork and avoid an audit.

Flexibility for Business Structure, Ownership and Management

A benefit of having an LLC is the flexibility to set your own rules. Corporations must follow the rules from a board of directors. Plus, the management and reporting processes are stricter. With an LLC, you can adjust daily operations to your and other members’ needs. You can step away from the business. Or hire a manager to oversee your contact center, for example. You will not need to report these changes to a board of directors.

Align Your Business Structure and Strategy

When forming your business, there are a lot of moving parts and questions. It's vital to enlist expert advisors for each step. Doing so helps you avoid major issues in the future. For example:

  • A certified public accountant helps with accounting and tax decisions
  • Marketing or advertising professionals boost revenue
  • Communications experts and consultants help you optimize your office setup

In each case, clear communications ensure your small business is up to speed. You have the freedom to hold video conferences as opposed to shareholder meetings. This control saves you from going to a board for input on small changes. When forming your LLC, think about ways to streamline operations. Successful companies use precise methods to handle distributed workforces and reduce customer wait times.

To implement these processes, consider strategic partnerships with reputable companies. With 30.7 million small businesses, you can stand out from the competition with a clear plan.

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