Jack DonaldForming a limited liability company (LLC) is not the only course of action you can take with a new business entity, but it’s by far the most optimal.
An LLC is equally suitable for reorganizing your sole proprietorship or general partnership and starring a new company altogether.
What makes the LLC model so popular is its inherently flexible and structurally accommodating nature. By blending the benefits of both corporations and informal business structures, the LLC is able to provide legal securities and ease of management.
Despite their adjustability, LLCs may not be compatible with certain businesses or startup goals. This article provides a comprehensive seven-step checklist to help you determine whether the LLC structure will be beneficial for your business.
What Is an LLC?
An LLC is a formal business entity with limited liability insurance and a flexible taxation structure. Where an informal entity like a sole proprietorship puts the owner in a vulnerable position in the event of litigation, an LLC is similar to a corporation in this regard as it provides reliable personal asset protection in the face of a lawsuit.
But unlike regular corporations, namely C-crops, an LLC can choose to be taxed as a pass-through entity which resembles the system used by sole proprietorships and general partnerships. You can still choose for your LLC to be taxed as a corporation if federal income tax is something that your business requires.
7-Step Checklist to Determine if the LLC Is the Right Choice for You
Step 1. Do you need personal asset protection?
The degree to which your personal assets might be affected by your business activities varies depending on the entity type. A sole proprietorship or general partnership, for instance, will put almost always your personal capital at risk. But if you form an LLC, the structure will provide certain limited liability protections.
It’s important to understand that regardless of how well a business structure is designed to protect personal assets, it will still be liable as a legal entity, meaning that avoiding legal action in the world of active entrepreneurship is near impossible.
As such, any customer can potentially sue your company if they are dissatisfied with your goods or services. And if you manage to avoid economic damages and lawsuits related to the product quality, your company is still vulnerable to other general liability claims such as personal injury claims that could happen at your location/office.
The difference is, when a sole proprietorship or general partnership faces such legal claims, it threatens the personal assets of the ownership group, while an LLC shields the assets of its members.
In short, running an informal entity means your personal capital can be sued for damages and your personal property can be seized by creditors, whereas if you form an LLC for your business, the only liable assets will be those of your company.
Step 2. What are your budgetary limitations?
If you do your business from home and don’t have employees on a payroll, there is not much sense in paying a fortune in LLC’s startup and maintenance fees.
Small-scale entrepreneurship often relies on limited cash flow, meaning the revenue of such an entity is likely to suffer by attempting to meet LLC’s financial requirements.
Even though forming and running an LLC won’t cost as much as operating a corporation, the startup capital and subsequent fees involved in filing annual reports and other forms will add up to a hefty sum.
There’s also the fact of formation fees. Certain states charge hundreds of dollars for LLC formation itself, so a solo operation based from home may see significant losses before it can even launch properly.
If you have a limited budget or can’t afford any additional expenses, LLC may not be a good choice for you. Consider running a sole proprietorship or, if you plan to split the responsibility, a general partnership instead.
Step 3. Do you want to register a unique business name?
The reality of sole proprietorships and general partnerships is that they are not recognized as separate formal entities, unlike corporations or LLCs.
In the eyes of the law, entities of this type act as an extension of you as an individual. So a sole proprietorship formed and run by someone called John Smith will be simply called “John Smith.”
If you want to appear more reputable to customers and potential partnerships, there is a way to operate under an assumed name instead of your own. This can be done by registering the so-called “doing business as” (or DBA) name for your company.
At the end of the day, DBA names can sure come in handy but they do not guarantee exclusivity or liability protections. Forming an LLC, on the other hand, can do both. Most states let you reserve your preferred business name for an extra fee, while many service providers offer business name search tools to check name availability.
Step 4. Can you take advantage of flexible taxation?
Among the key advantages of forming an LLC is the ability to select your preferred taxation model.
As already mentioned, you can register your LLC for pass-through taxation similar to that of a sole proprietorship or general partnership.
The distinction is in your company’s internal structure: sole owners who run single-member LLCs can choose the former taxation model while multi-member LLCs can go with the latter.
An LLC can also file taxes as a C-corporation or S-corporation, though not every company can qualify for this tax structure.
It’s frankly impossible to explain all intricacies of business taxation succinctly, so feel free to check out this more in-depth guide to LLC taxation. But the main takeaway here is that no other business structure allows this freedom of choice.
Step 5. Do you have a large ownership group?
Despite LLC and PLLC models supporting a multi-member structure (though not on the same scale as corporations), it’s generally recommended to operate with a modest number of owners or members.
If you plan to expand the ownership group to hundreds and more members, it’s best to form a corporation from the get-go instead of an LLC. Corporations are less flexible but they are designed to support large internal structures where all operational roles are clearly defined.
This rigidity is what keeps them so organized even when the ownership group is expansive. LLCs are more relaxed in that respect, accepting almost anyone as a member regardless of their field of expertise. Being so lax with their membership roles, LLCs are at their best when operated by smaller groups.
Step 6. Do you have ambitious expansion plans?
It’s not always possible to plan that far ahead at your formation stage, but if as long as you’re not ruling out the possible expansion of your company, a corporation should remain on the table of your potential business structures.
Unlike LLCs, corporations are conceptually uniform on the federal level. Whereas most state governments outline what an LLC is within the context of their respective jurisdictions, corporations are nationwide entities that adhere to the standards of corporate law.
If you set up your company as an LLC and then expand beyond your home state, chances are you will face a number of unfamiliar laws and conflicting maintenance requirements, not to mention additional filing fees.
With corporations, it’s a bit easier to navigate the formation rules and maintenance prerequisites regardless of the state of formation and ensuing expansion. This model is also financially more beneficial for the entire expansion process compared to the LLC structure.
Step 7. Do you want to be able to issue stock?
Perhaps the main point of attraction that corporations hold for entrepreneurs is the ability to issue stock, i.e. sell company shares to build up investment funds for business development.
C-corps and S-corps are the only business structures legally allowed to sell shares in their stock, serving as an excellent platform for venture capitalists. Selling stocks is not the same as selling the actual assets of a corporation. What corporations do is sell future profits shares by putting their stocks on the market through IPO, short for initial public offering.
Despite having ownership shares, LLCs don’t actually have shareholders. A shareholder is not the same as an LLC owner who holds a share of the company. Where corporations are subject to federal income tax, LLCs are only taxed as pass-throughs, meaning that each owner’s profit shares are taxed as income and filed with their personal returns.
But this structure also means that an LLC owner can only sell their ownership share in the form of a partnership agreement which isn’t ideal for VC investors who prefer to build equity in stocks.
If you plan to build your market presence from the start, then forming an LLC might not be the best idea. It would make more sense to incorporate your business and issue stocks to meet your financial goals.
In Conclusion
Doing business in most states can be accomplished with three major legal structures: LLCs, corporations, and informal entities.
To put it simply, you can choose to operate informally as a sole proprietorship or a general partnership, or you can run the show by forming an LLC or corporation which is a separate legal entity.
While LLCs are known for their flexibility, they cannot support certain goals. The key takeaways here are the financial and structural ineffectualness of LLCs when faced with limited budgets or ambitious expansion strategies.
If you don’t have a lot of funds to put into your formation, or your type of goods and services generate no liability, you might be better off running a sole proprietorship or general partnership.
Keep in mind that informal entities and LLCs won’t be able to effectively sustain a large ownership group, so if you plan to expand financially, structurally, or geographically, it would be smarter to incorporate your business.
And if you’d rather protect your personal assets, take advantage of flow-through taxation, and do your business under a unique name, then forming an LLC could be highly beneficial for your endeavor.
