Are you starting a new business and wondering if forming a limited liability company (LLC) is the right choice for your company? Or perhaps you operate an existing sole proprietorship or general partnership, and you’re considering making the jump to an LLC?
LLCs are a very popular entity type, and for good reason. They blend the formalities and legal protections of a corporation with the simplicity and flexibility of informal business types. However, the LLC won’t be the perfect entity choice for every entrepreneur.
In this article, we’ll walk you through a seven-step checklist to determine whether the LLC is the right choice for you, or if you should explore other options.
What Is an LLC?
First off, let’s quickly outline what an LLC is. LLCs are formal legal entities that are typically taxed similarly to sole proprietorships and general partnerships, in that the owners include any company profits or losses into their personal returns — the LLC itself does not owe income taxes. An LLC may also elect to be taxed like a corporation, although this is not a very common option.
There are similarities to corporations too, especially when it comes to financial responsibilities. In an LLC, the owners or members are not usually personally accountable for the financial status of the business. This means that if someone sues your LLC, your personal assets are not at risk.
7-Step Checklist to Determine if the LLC Is the Right Choice for You
1) Do you need personal asset protection?
Our first few questions will help you determine if you should form an LLC, or operate your business as a sole proprietorship or general partnership. The first and most important question in this regard is whether your business needs limited liability protections.
Most businesses do produce some level of liability. For instance, if your products or services fail to live up to your promises, a client could sue your business. Even if your products and services somehow don’t generate any liability, you could still be subject to other general liability claims like slip-and-fall accidents at your business location.
If you don’t have the personal asset protection that comes with an LLC, any of these situations could lead to a lawsuit in which your creditors have access to your personal house, car, bank accounts, etc. However, if you form an LLC for your business, your creditors can only sue for your actual business assets.
2) What are your budgetary limitations?
If you run an extremely small business that doesn’t execute many transactions, paying an LLC’s startup and maintenance fees might not be worth it to you. While operating an LLC is usually less expensive than operating a corporation, there are still some fees involved that can total hundreds of dollars per year in some states.
If you don’t have room in your limited budget for additional expenses like these, it’s important to note that there are no fees associated with operating a sole proprietorship or general partnership.
3) Do you want to register a unique business name?
Typically, most sole proprietorships and general partnerships operate under their owners’ personal names. For example, if your name is Sam Johnson, your sole proprietorship would also simply be called “Sam Johnson.” This is because the government doesn’t consider these business types to be distinct entities from their owners. Rather, they are considered to be an extension of your own personality.
These informal business structures can register doing business as (DBA) names to operate under assumed names, but a DBA doesn’t actually provide you with any exclusivity over the use of that name. However, forming an LLC does provide you with the opportunity to register an exclusive business name.
4) Can you take advantage of flexible taxation?
One of the biggest advantages of forming an LLC is the fact that you can choose from several different taxation models. You can either choose to be taxed like a sole proprietorship (for single-member LLCs) or like a general partnership (for multi-member LLCs), or you can opt for the C corporation taxation model or the S corp model (if you qualify).
We won’t take the time to describe all of these options in-depth here, but if you’d like to know more about the taxation choices available to LLC owners, check out our comprehensive guide to LLC taxation. In short, one of the biggest advantages of an LLC is the way you’re allowed to choose how you want to be taxed. No other business entity in America has this many taxation options.
5) Do you have a large ownership group?
In our opinion, LLCs work best when they don’t have a large ownership group. If you do, we tend to recommend forming a corporation instead. The way corporations are set up — with all of their formalities and rigidly dictated roles — makes them a better option for large ownership groups, as opposed to LLCs, which can turn into a bit of a free-for-all if there are too many cooks in the kitchen.
6) Do you have ambitious expansion plans?
Do you plan to someday expand your business beyond the borders of your home state? If so, the corporation might be a better fit than the LLC. Each state has its own definition of an LLC, and as such, it can sometimes be confusing to follow different sets of rules and regulations for each state your business operates in.
On the other hand, corporations have a uniform structure nationwide, so it’s typically an easier business entity type to expand into different states. In addition, when it comes to financials, the corporation has a huge advantage over LLCs…
7) Do you want to be able to issue stock?
In our opinion, the biggest advantage corporations have over LLCs is their ability to issue stock. In fact, corporations are the only business entity that can sell stock to investors. For this reason, corporations are far more attractive to venture capitalists than any other business type.
It’s exceptionally rare to see any VC investment in LLCs. Even though an LLC can trade an ownership share in exchange for financial investment, the vast majority of VC investors prefer to purchase stock instead. Therefore, if you have ambitious financial goals for your business, you might prefer incorporating your business rather than forming an LLC.
For most entrepreneurs, you have three main options when it comes to operating your business. You can simply operate as an informal business entity, like a sole proprietorship or a general partnership, or you can form a formal business structure, like an LLC or corporation.
Generally speaking, if you’re operating on an extremely limited budget, or your business generates no liability, you can probably get away with simply running a sole proprietorship or general partnership. If you care about reserving a unique business name, you can take advantage of flexible taxation, and/or you have a small ownership group, we nearly always recommend forming an LLC.
However, if you have a large ownership group or you have ambitious expansion plans (whether geographically or financially), the corporation is probably your best bet.
We hope this article helped you decide if forming an LLC is the right option for your business!