If you’re an independent consultant, you’ve probably at least considered forming a limited liability company (LLC) for your business.
The LLC is a popular option for all sorts of businesses looking for asset protection, and it has a handful of other major advantages as well.
Of course, forming an LLC isn’t the only option for your consulting firm, so our mission is to help you decide if it’s the best choice for you. There are many different factors to consider when you’re forming a business entity for your consulting business, so let’s dive into the details of the LLC to figure out if you should form one for your firm.
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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.
Why Starting an LLC for a Consulting Firm Is Important
Personal Asset Protection
The top reason to form an LLC for an independent consulting business is to gain access to the personal asset protection provided by this business structure. Whether you work alone or with a team of fellow consultants, you need the limited liability protections that an LLC can provide.
As an example, let’s say that you (or one of your co-owners, or one of your employees) provides a client with bad advice that costs them a considerable sum of money. Perhaps they even feel that your business operated in a fraudulent or negligent manner. If you operate your consulting firm as a sole proprietorship or general partnership, your personal assets — like your house, car, personal bank accounts, etc. — would be at risk if that customer decides to sue your business.
On the other hand, if you form an LLC for your consulting firm, and you operate and maintain that LLC in a compliant fashion, the scope of your customer’s lawsuit will be limited to your business assets. In other words, your personal assets will be protected by the business structure you’ve chosen.
However, this is just the tip of the iceberg when it comes to the advantages of the LLC for a consultancy firm. Another important aspect is taxation. The LLC actually provides its owners with a selection of options regarding how they want the business to be taxed, which can save you a considerable amount of money compared to simply operating as an informal business entity.
Sole Proprietorship/General Partnership
Your consulting LLC can be taxed as a sole proprietorship (for single-member LLCs) or general partnership (for multi-member LLCs), which is the default option. With this tax structure, your consulting firm itself does not pay taxes, but rather the profits are passed through the business entity and your owners pay taxes on that money when they file their own personal taxes.
You can also choose for your firm to be taxed as a C corporation, although this option isn’t very popular because it subjects your business to what’s known as double taxation — meaning that your profits are taxed first on the corporate level and again on the personal level when they’re distributed to your owners.
The other option is S corporation taxation. There are quite a few limitations to electing S corp taxation, but most consulting businesses have no trouble meeting these requirements — your business cannot have more than 100 owners, they all must be either residents or citizens of the United States, etc.
S corp taxation can help your firm save money by reducing your self-employment tax burden. Instead of paying self-employment taxes (a 15.3% tax that includes the employer and employee portions of Medicare and Social Security) on all of your business income, you can pay yourself and your co-owners a reasonable salary for your roles and only pay self-employment tax on that portion of your income, while you can reinvest the rest of it into your business without paying this tax.
Compared to operating a sole proprietorship or general partnership consulting business, the S corp taxation model can save you quite a bit of cash that you can use to make improvements to your office space or deal with other business expenses, rather than writing a big check to Uncle Sam.
Enhanced Credibility and Name Uniqueness
Finally, an LLC structure can enhance the credibility of your consulting business venture. Informal business entities don’t have exclusive assumed business names and typically operate under the personal name(s) of their owner(s). For instance, if your name is Johnny Smith and you operate a consulting sole proprietorship, your company’s name is also “Johnny Smith,” which obviously isn’t a great name for a firm.
In this scenario, you could register a DBA (doing business as) name to give your business the ability to operate under an assumed business name, but DBAs have no exclusivity regarding their naming rights in many states. This means that if another business wants to use your DBA name as their own, they’re not only allowed to do so, but they can actually register a formal business entity with that name, preventing you from continuing to use your own assumed name.
With an LLC, you not only have the rights to exclusive use of a business name, but you will also have either the phrase “limited liability company” or the letters “LLC” in that business name. This provides your business with a jolt of respectability because customers respect the professionalism displayed by an LLC. Also, they typically feel more comfortable writing checks to a business entity rather than to an individual.
How to Start an LLC for a Consulting Firm
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The formation process for LLCs varies depending on which state you’re forming one in, but in general, the process has some universal steps that need to be taken no matter what state your business is located in. If you want a comprehensive overview of all the steps required to form an LLC, check out our complete guide on the topic. The basic steps in the LLC formation process in any state are as follows:
1) Choose an LLC name
Coming up with the perfect name for your new LLC is an important step. You’ll need to choose a name that represents your company and describes what you do, and you’ll also have to make sure it isn’t already in use by checking your state’s business database.
2) Designate a registered agent
Your LLC’s registered agent (which can be an individual or a professional service) is responsible for receiving important document deliveries from the state — like service of process, annual report reminders, etc. — and forwarding them to you. The registered agent ensures that the state always has a reliable point of contact for your business.
3) File your formation documents with the state
The form used to create an LLC is usually called the Articles of Organization, although the name can vary (some states call it the Certificate of Formation or something similar). You’ll need to provide the state with some basic information about your business and its owners. In exchange, the state will formally create your LLC.
4) Acquire an EIN
The Employer Identification Number (EIN) is a federal tax ID number that essentially functions as a Social Security number for a business. The EIN allows your business to hire employees, pay taxes, apply for bank loans, and more. You can easily obtain an EIN from the Internal Revenue Service free of charge.
5) Create an LLC operating agreement
Most states don’t require operating agreements but every LLC should have one regardless. This is an internal document that outlines several key operational aspects of your LLC. The value of the operating agreement is how it can help prevent ownership disputes down the line by clearly explaining how the LLC will be run.
6) Create a financial infrastructure
You will need a business bank account for your LLC, and you’ll probably want a business credit card for work-related expenses as well. It’s also a good idea to use accounting software like QuickBooks or even hire an accountant to handle your bookkeeping for you.
7) Handle taxes, licenses, and permits
Depending on your state, you may need a general business license to operate your LLC in compliance with state requirements. Depending on the exact type of consulting services your LLC provides, you may need to obtain a professional service license. Don’t forget to check with your state to see if there are franchise or privilege taxes assessed on LLCs, and also see if your municipal and/or county government entities have any further licensing requirements.
8) Understand maintenance requirements (annual reports, franchise taxes, etc.)
Again, these requirements can vary by state, but most states require some sort of regular report to ensure that your LLC’s info is up-to-date in the state’s business database. Some states require reports each year, while others only require them biannually or not at all. No matter what your state requires, you’ll need to stay on top of it to keep your LLC in good standing.
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Additional Resources for Starting a Consulting Firm
Process Street has plenty of great information for independent consultants, and their core service is a highly convenient workflow management tool. For the sake of this article, we’d like to point out their incredibly valuable “68 Small Business Resources to Make Consulting Easy” article. While it’s a few years old, the information in this article is as relevant as ever and should make your life as a consultant significantly simpler.
Owned and operated by a former McKinsey case interviewer, Case Interview shares tricks of the trade to help consultants land more business. Victor Cheng once passed an incredible 60 out of 61 case interviews and shares his methods with other consultants through a wide variety of case interview training resources, including videos, newsletters, partner matching services, and more.
Consulting Magazine is one of the top resources for consulting firms, thanks to its wealth of knowledge and their comprehensive coverage of issues that matter to consultants. They balance evergreen content like the best firms to work for with timely and relevant articles about pressing issues in the consulting world, and they’re a great resource for consulting firms of any size.
Looking for a convenient collection of consulting tools? Look no further than Free Management Library. Just on this one page, they have dozens of links to valuable insights regarding many different aspects of the consulting world, from problem-solving and collaboration to entrepreneurship and strategies.
Mashable’s list of 11 essential consulting resources has links to tools you can use to improve your marketing, recruiting, general productivity, and more. Not all of these resources will be relevant to every single independent consultant, but we’re confident you’ll find something interesting in this list.
Frequently Asked Questions
What liability risks do consulting firms face?
Operating a consulting firm without liability protection is extremely risky. If one of your customers thinks you provided erroneous or even fraudulent advice, you run the risk of a costly lawsuit.
Furthermore, a data breach could lead to extensive liability issues for your firm, as your clients line up to sue you one after the other for failing to protect their sensitive information. In short, protecting your personal liability with an LLC is a no-brainer for a consulting firm.
Why should I form an LLC instead of a corporation?
Everyone’s situation is different, and we are not here to provide legal advice. That said, the limited liability company has some concrete advantages over the corporation that makes it the preferred option for most small businesses.
Corporations tend to have more complex formation and maintenance requirements, and they don’t have the taxation advantages of an LLC. The corporation has some advantages of its own (for example, it’s easier to attract investors to a corporation) that make it worth a look but the LLC is a simpler and more flexible business structure.
Can I serve as my LLC’s registered agent?
You certainly can! Every state allows entrepreneurs to serve as their own registered agents. However, while the role of the registered agent can seem like that of an unnecessary middleman, there is more complexity to this position than some people realize.
For instance, you would need to be present and available at your business location during all standard business hours. In addition, if you serve as your LLC’s registered agent, you may need to make your home address a matter of public record. Not only does this have privacy concerns, but there’s also the matter of unwanted junk mail as well.
Why should I hire an LLC service when I can form my own LLC?
The DIY route is always an option for LLC formation. However, LLC services are so affordable that there’s really no good reason not to use one these days. In addition, some of these companies often throw in free bonus features that make them an even better bargain.
Should I form my LLC in my home state, or choose a state like Delaware or Wyoming?
Some people like to form their LLCs in states with favorable legal settings. For instance, Delaware is often seen as the most business-friendly state, as it has an entire court system that’s dedicated solely to business matters. As for Wyoming, this state has some of the most generous anonymity laws for LLC ownership.
However, for most people, your best option is to simply form your business in your home state. Forming in a different state can be a tremendous hassle, and it can add some unnecessary complexity to tax issues as well.
How much does it cost to form an LLC?
The costs of LLC formation can vary quite a bit depending on which state you’re forming one in. For in-depth information about LLC formation costs in your specific state, take a look at our comprehensive guide to state-by-state expenses.
Start an LLC For Your Business
We break down the LLC formation process in detail for different types of businesses. View all of our guides below.