Today I'm going to teach you the 5 things that you need to know before starting a business as an LLC. This will help you decide whether or not an LLC is the right entity choice for your business. Let's do this.
#1 – Where Did LLCs Come From Anyway?
Number one, let's start with the historical context behind LLCs. LLCs were started in Wyoming way back in 1977, and they were started as a way to bridge the gap between the traditional corporation and the partnership. There's a lot of benefits to both of those entities, but sometimes the things that you get from a corporation are not necessarily the things that are helpful. And some of the disadvantages to a partnership are things that you would need a corporation for. So basically the Wyoming legislature decided to merge those two things into an entity called the limited liability company.
Now, when this was initially formed, the IRS didn't know what to do with it because they didn't know how to tax this entity because it was something completely new and unique that nobody ever seen before. And so for a while, they tried to tax them as corporations, then they had some tests that they evolved to decide, well, maybe we'll tax them as a partnership or a sole proprietorship. Weren't really sure what to do. Up until about 20 years later in 1996, the IRS figured out that we'll just say, you know what? You decide how you want to be taxed. And at that point there've been a couple other states that enacted statutes for their own limited liability companies. By 1996, all 50 states have enacted statutes that allow for the creation of a limited liability company.
Now, the one thing you need to know is a limited liability company is a state specific entity, which means it's not a federal thing, this is a state specific thing. So each state is different, each state is unique.
I've talked about this before in other videos, but it's really important that you understand that in most cases, I would say 99% of the cases, you're going to want to form your business entity if you do decide to go with an LLC in the state where you live. Now, if you have questions about the specific requirements in your state, you're going to need to direct them to an attorney who is licensed in your state. But today's video, we're just going to talk big picture. The things that you need to know that are generally specific to pretty much all 50 states when it comes to limited liability companies.
#2 – What is an LLC?
All right. Number two, let's talk about what is an LLC? Well, let's talk about what an LLC is not. It is not a corporation. It is a company that is organized to provide limited liability to its members, who in the case of an LLC, are not considered shareholders, they're called members. Those are the owners of the LLC. That is a really important distinction that you must be aware of if you decide that an LLC is the right entity for your business. In general, LLCs are much more flexible than corporations. This is in large part because you can draft an operating agreement that dictates how you're going to run your business and all the rules that you're going to follow. And this operating agreement can supersede the state statute that govern how LLCs are to be run.
So basically what this means is, if you do not have an operating agreement, then your LLC is going to be governed by your state statute, wherever you have formed your LLC. Those are going to be the default rules. I would tell you, nine times out of 10, those default rules are not going to be sufficient for you. Basically, if you do not have an operating agreement in place, then the default rules in your state are going to dictate how your LLC is going to be governed and how it needs to be run.
As I was saying, nine times out of 10, those default rules are not going to be sufficient for what you're trying to do with your LLC. So in most cases, you're going to want to have a rock solid operating agreement in place that is going to be the bedrock of your limited liability company. Because it's going to be basically the foundation that's going to provide all the rules, procedures, and things that you need to know to run your business effectively.
#3 – LLCs vs Corporations
All right. Number three, let's talk about how an LLC differs from a corporation. There's a number of different ways it differs. We've already talked about flexibility. An LLC is much more flexible than a corporation. We've talked about the names of the people that own the business. With an LLC we're talking about members. With a corporation we're talking about shareholders or stockholders.
For a corporation, you have officers and directors. Those are the officials that run the business, that are separate and apart from the shareholders. So you have centralized management. That's one of the core fundamental principles of a corporation. With an LLC you don't necessarily need to do it that way, but you can. And if you do decide to have centralized management, what you would have are managers. So that would be a management managed LLC versus a member managed LLC. And that is a core distinction that a lot of people don't really understand and don't really consider when they're setting up their operating agreement.
So when you form an LLC, you get a membership interest in the LLC or a certificate of membership versus a stock certificate or a stock in a corporation. If you have a corporation, when you distribute profits, those are called dividends. With an LLC and you distribute profits, they're going to be called distributions. Now some people will call them dividends and things like that, but the legal term would be a profit distribution when you have an LLC.
When you form a corporation, you file with the Secretary of State's office in your state, what are called articles of incorporation. When you have an LLC, you're going to file articles of organization that are telling the state that you're organizing your company as a limited liability company. We've talked at great length about the importance of having an operating agreement when you have an LLC. If you have a corporation that the similar document that you're going to have to that are called the bylaws of the corporation.
Now, finally, one big thing that an LLC has that a corporation does not have is what is called charging order protection. This is really important and something that a lot of people miss. What that means, if you have an LLC and you have this charging order protection, that is going to protect the LLC from the member creditors. In other words, the people that a member of the LLC might owe money to. They can sue the LLC to get at that membership interest, but all they can get is what's called a charging order.
#4 – How is an LLC Taxed?
All right. Number four. Let's talk about how an LLC is taxed. I've already alluded to this, but one of the main benefits of an LLC is it's not tied to any particular taxing structure. What does that mean? It means you basically can choose to do whatever you want. If you form a corporation, you're kind of tied to the fact that you're going to be taxed as a corporation, which is not necessarily a good thing, unless you elect S-corporation status. I have talked about that in other videos, if you form a partnership or something else, then you're going to be taxed as a partnership. And again, you can always elect S-corp status, but that's generally speaking the way that's going to work. Now, with an LLC, you can choose to be taxed however you want.
The default rules are that if you are by yourself in a single member LLC, you're going to be taxed as a sole proprietor. If you have other members with you that are forming the business with you, then the default rule is that you're going to be taxed as a partnership. And this means that your LLC is going to be a flow through entity and all the income that comes from your LLC is going to flow through to you on your 1040 and proportion to the amount of your ownership interest in the LLC. Now, you can always elect to be taxed as a corporation by filing form 8832, or you can elect to be taxed as an S-corporation by timely filing form 2553.
#5 – Why You Should or Shouldn't Choose an LLC
Finally, number five, we're going to talk about the advantages and disadvantages, just kind of on a global scale of what we've talked about so far. And then that hopefully is going to help you to decide whether or not this is the right business entity for you. Let's just talk about some of the main advantages. Number one, you can choose how you want to be taxed. We just talked about that at length.
Number two, there's the limited liability component. That's why most people form a limited liability company because you want that limited liability. Now, this is different than a partnership that you're not responsible just for your investment in the partnership, you'd be responsible for all the debts of the partnership, all of the other partners that you have. That is a big disadvantage to forming a partnership. So that's the second main advantage of an LLC is, you're only responsible for your debts as they relate to the limited liability company.
Number three, there's less administrative paperwork with an LLC. Typically, you're going to file some annual reports. You're going to need to make sure you do your meeting minutes. Things like that. If you make big decisions related to the LLC, that's always very important. Avoid piercing the corporate veil, but in general, there's going to be less administrative hassle with an LLC than there is with a corporation. And finally, the other main advantage to an LLC is that you've got that charging order protection. So just to wrap up all those advantages, there you go.
Now, there are some disadvantages to having an LLC. Let's talk about those for a second. The main disadvantages related to an LLC are going to be that it's going to be difficult to raise capital, because most investors in a business want to see that standard corporate structure. So if you're looking for investors, if you're looking for angel investors, if you're looking to go public at some point with your business, if you've got an idea that you're going to have a lot of shareholders in the business, maybe an LLC isn't the right choice for you.
The other significant disadvantage to an LLC, which can be rectified by filing that form 2553 and electing S-corp status is that the default rule is that it's going to be a pass through entity. Now, sometimes that's not necessarily a great thing because you're subjected to that 15.3% self-employment tax. Talked about that in prior videos. And that could be a problem. For most people that's a minor problem that can be rectified by making the proper tax selections.
Some other disadvantages are the franchise fees. So if you're in a state like California, where the franchise fee is $800, that might be cost prohibitive for a lot of people, but once you're making money and profit from your LLC, then hopefully that's not too big of a deal. Also, the renewal fees for LLCs are typically more expensive than for corporate entities. That's a general statement, it's not always true. And it's going to depend on the state where you're located, but you always want to check that I would check the LLC fees versus the corporate fees. If you're making that decision. In general, the benefits of running an LLC are going to outweigh those increased costs in my opinion.
Make sure you stay tuned. Have a great day folks!