LLC

LLC is a flexible business entity that offers limited liability protection to its owners.

Small businesses love LLC.

And it's not a surprise.

LLC makes it super easy for business owners to grow their business and protect their personal assets at the same time.

In this guide, we'll cover what an LLC is and whether it is right for your business.

Definition

What is LLC?

LLC is a business entity which is like a hybrid between a corporation and a sole proprietorship.

It gives the owners protection from personal liability (like a corporation) and offers pass-through taxation (like a sole proprietorship). Best of both worlds!

LLC is governed under state statutes. Meaning - its rules are written by the state governments. Not the federal government.

This is important to know.

Because, LLC is just a legal entity and not a separate tax entity.

So, from a legal standpoint, LLC is something new. But for the IRS, LLC is nothing new.

That's why IRS always classifies LLC as sole proprietorship or partnership or a corporation for the purpose of tax collection.

More on that later. For now, let's remember that LLC is a flexible entity that's a mix of both corporation and sole proprietorship. It is introduced in the US fairly recently and has become quite popular among small businesses.

Now, let's see who can own an LLC.

Ownership of LLC

Can anyone own an LLC?

An LLC can have single or multiple owners. Those owners are referred to as members of the LLC.

In most states, anybody can be an LLC owner, including: individuals, corporations, partnerships, other LLCs, foreigners or even foreign entities.

And you can have only one member owning the entire LLC or multiple members sharing the ownership.

But, unlike a corporation, LLC can't issue stock to its members. The ownership is divided based on what members have agreed on in the LLC's operating agreement.

For example, you could have 3 members at 33-33-33 split or 70-20-10 or whatever you agree on.

Although it's not a strict rule to have an operating agreement, it's always a good practice to have one.

For non-residents

LLC is one of the business entities that non-residents can select for their business in US. An LLC can be owned by a registered business in your home country or even you as an individual. You don't have to visit US to start an LLC.

Now that we have some idea of what an LLC is, let's see what's special about it.

Advantages

What's so special about an LLC?

Limited liability

Limited liability is a protection from debts and liabilities of the LLC and keeps the members' personal assets safe, in case the LLC gets sued or huge debts. This protection is absent in sole proprietorship and partnership.

Pass through income

Business income from most types of LLCs is passed through to the members, without being taxed at the corporate level. Hence, there's no double taxation . It's taxed only once at the individual level. On the other hand, if your LLC is elected to be treated as a corporation, business income is not passed through.

Low formalities

LLCs are very easy to form and maintain. There are only a few annual reports(sometimes nothing) as compared to corporations.

Deduction of operating losses

In case the LLC incurs some losses, owners can deduct such operating losses to an extent from their personal income. Hopefully, you don't have to worry about this :)

Disadvantages

When is LLC not right for me?

Cannot issue stock

You cannot issue stock to your employees, contractors, investors or anyone in an LLC. However, there's something similar called membership units. It divides up the ownership of the LLC among its members. It's similar, but not as versatile or effective as stock.

Difficulty in raising capital

It's very difficult(almost impossible) to raise venture capital when you can't issue stock. Almost all venture capitalists need C-corp as their required business entity.

Piercing corporate veil

You'll sort of lose the liability protection if you fail to keep your personal and business matters separate. For example, if you use LLC credit card to pay for your personal expenses, it'll be hard to justify separation between business and personal assets if the LLC is sued in the court. Think of corporate veil as an imaginary curtain that protects your assets from lawsuits. Try not to pierce this corporate veil.

Tax on retained earnings

If the LLC is not elected as a corporation, members have to pay personal income tax on all business earnings whether that's withdrawn from the LLC account or not. Even if the business earnings are kept on the LLC bank account for buying inventory or to cover future expenses, you still have to pay income tax proportional to your share of profits.

Types of LLC

Which type of LLC is ideal for me?

There are 3 broad types of LLC: Single Member LLC, Multi Member LLC and LLC elected to be treated as a corporation.

Your LLC will fall under one of these, depending on the number of members and also whether you have requested IRS for a change in tax classification.

Single Member LLC

This is also known as disregarded entity, because IRS doesn't treat the LLC separate from its the owner.

Members

Has only a single member

Tax classification

By default, IRS treats the LLC as sole proprietorship.

Tax payment

Income taxes are paid by owner and reflected on the individual tax return

Read in detail

What is Single Member LLC? Taxes, Hiring, Filing

Multi Member LLC

Multi member LLC is like general partnership, but with limited liability. The LLC is not treated as a separate tax entity from the partners.

Members

Has 2 or more members

Tax classification

By default, IRS treats the LLC as general partnership

Tax payment

Income taxes are paid by each partner in proportion to their share of profits

Read in detail

What is Multi Member LLC? Taxes, Hiring, Filing

LLC as a corporation

An LLC can elect to be treated as a corporation by filing a form with the IRS. Post that, taxes are paid like a corporation.

Members

Has single or multiple members

Tax classification

IRS treats the LLC as a corporation

Tax payment

Income taxes are paid by the LLC at corporate income tax rate and are not passed on to its members

Read in detail

What is LLC as a corporation? Taxes, Hiring, Filing

For various businesses

If you’re just starting out and expecting to spend most of your profits on customer acquisition, you can choose to be elected as a corporation. If you’re looking for venture funding soon enough, it’s better to register as a corporation instead of an LLC, because all VCs require corporation as the standard business entity.

Single member LLC would be ideal during the initial days. However, it's important to keep your personal assets separate from your business assets. If you have softwares for personal and business use, keep them separate.

Electing your LLC as a corporation would save some money on taxes as compared to the default multi member LLC. For agencies operating on thin margins, this is some relief.

For a high growth SaaS company, C-corporation is usually the better business entity. Only a corporation can issue stock to your employees, contractors or investors.

Taxes

What are my tax obligations?

LLC usually pays 3 types of taxes: Income tax, payroll tax and franchise tax.

They are paid to the federal government and state agencies.

All taxes are not paid the same way.

Depending on the type of LLC and how members are paid, tax treatments can vary.

The 3 most common taxes are:

Income tax

In single and multi member LLC, the LLC doesn't pay income taxes; the members pay them individually. That's how pass-through taxation works. The entire LLC income is transferred to the members and is reflected on their personal tax returns.

For an LLC elected as a corporation, things are slightly different. Here, the LLC pays corporate income tax directly. It's not transferred to the members.

If members are paid dividends from company profits, then there will be double taxation— first at the corporate level, second at the members' personal level.
If members are hired as employees, there will be no double taxation, though. Their salaries are deducted as business expenses and are only taxed once at their personal level.

Payroll tax

Social Security tax, Medicare taxes and unemployment insurance are commonly referred to as 'payroll taxes'. Half of this tax amount is collected from the employee's paycheck. And the other half is contributed by the LLC.

Since the members are considered 'self employed', they have to pay self employment tax (which is kind of another name for payroll taxes). Since there is no paycheck for a member, this tax amount is collected in proportion to the share of profits.

If a member isn't actively part of the operations, then he/she does not have to pay self employment taxes. Regulations around this are slightly complicated, though.

Franchise & Excise taxes

Most states charge an annual fee from LLC, often called as "franchise taxes", "renewal fees" or "annual registration fees". In certain states, this is the only state income tax. This really depends on how the state calculates it. Most states have a fixed fee between $50 - $800. For example, Delaware, charges $300 and Wyoming charges $50.

Excise taxes are typically imposed on manufacturers and retailers of goods and services. Not very common, however still important to many types of businesses.

When to pay taxes?

If you thought, you could pay all the taxes in one shot at the end of the year, sorry to break it to you; IRS won't buy it.

You will have to estimate the annual income for each member ahead of time and split it into 4 quarterly payments. This is referred to as estimated taxes.

So, should all LLCs pay taxes this way?

If you estimate to pay more than $1000 amount annually, you'll have to split it into 4 and be paid in April, June, September and January.

IRS is pretty serious about this.

They charge a penalty if you fail to pay an instalment or pay it late.

So, keep this in mind.

Also, if you're just starting up or if you haven't earned any income during a quarter, you can skip an instalment entirely.

Tax rates

These are some of the most common tax rates applicable to an LLC.

Of course, some of these numbers will vary depending on your situation.

Take this only as an approximate figure.

32-37%

Top 3 personal income tax rates

21%

Corporate income tax rate on profits

23.8%

Individual income tax on shareholder's dividends

6.2%

Employer portion for social security tax

1.45%

Employer portion for medicare tax

Total FUTA tax including state credit

For non-residents

Non-residents don't have to pay any income tax in United States. Therefore, your LLC essentially doesn't need to pay any income tax. If you have an employee(or any other dependent agent) who is dependent on your income in the US, you have to pay payroll taxes

Non resident aliens are not subject to self employment taxes

Pay Yourself

How do I pay myself from an LLC?

A very popular topic: paying yourself.

All your effort, sweat and time put into growing your business.

Now, it's time to reward yourself.

There are mainly 3 ways of taking money out of an LLC: Making a member's draw, taking a salary or through dividends.

The last two methods are almost exclusively meant for LLCs elected as a corporation.

Member's draw

When your LLC is not elected to be treated as a corporation, you can withdraw money from your LLC's account in proportion to your share of LLC profits.

This is known as a member's draw.

This is how members typically get paid from an LLC, when they are not an employee.

And when you make a member's draw, your LLC doesn't have to withhold tax for social security and medicare taxes. Because it's not a paycheck. It's your 'share' of profits.

As a member, you'll have to pay taxes on this share of profits separately.

It's important to plan your members' draw. You don't want your LLC to run out of working capital.

Taking a salary

For an LLC elected as a corporation, taking a salary is almost always the best method of getting paid if you want to avoid double taxation.

Also, it's kinda legally required to consider shareholders as employees.

This doesn't mean you take an exorbitantly large paycheck, though. There are checks and balances.

The salary amount has to be on par with industry standards.

And it shouldn't look like you are evading tax. Talk to your CPA about this.

On the other hand, single and multi member LLC members cannot be hired as the employees. They will HAVE to take a member's draw.

Earning dividends

For LLCs that are taxed as a corporation, members can be paid dividends on the company profits.

But dividends are not tax deductibles. Meaning: it is subject to double taxation though.

The income is taxed at corporate tax rate of 21% first, then up at individual tax rate at 23.8% on the dividends.

For non-residents

A single member US LLC can be owned by a foreign entity or a founder. You can take member's draw without having to pay any income tax to US

Costs

How much does an LLC cost?

There are different types of costs involved in an LLC.

Let's talk.

Costs depend on a lot of factors: state of formation, nature of business, etc.

Following is a list of some of the common costs that you might incur in the initial days.

One time

Formation fee for the State

$90

Reserve business name

$75

Annually

Registered agent costs

$100 - $300

State franchise tax

$50 - $800

Quarterly

Income tax

21 - 37%

Payroll tax (employer)

7 - 10%

Service charges

Lawyer

$100 - $500/hour

CPA

$100 - $500/hour

Hiring

Can I hire employees in an LLC?

One of the main reasons to register a business is to be able to hire employees.

LLC is an ideal entity for this.

It is simple enough for you to start hiring and complex enough to protect you in case of employee lawsuits.

You can hire employees whether it's a single member or a multi member LLC.

It comes with a few responsibilities, though.

LLC has to withhold tax from the employee's wages for Social Security, Medicare and unemployment insurance, deposit it with the IRS and state agencies.
LLC has to file Form W-2 for each employee with the IRS.
Depending on the state you're in, LLC has to notify state and local authorities about the new hires.

For non-residents

If a non resident-owned LLC has an employee living the US, you would have to start paying payroll taxes. If you wish to avoid having to payroll taxes, you can hire independent contractors or freelancers. The law asks you to pay taxes if you have a 'dependent agent' in the US. How to establish 'dependence' is a slightly complicated area. It is best to speak with a lawyer regarding this.

State of Formation

Which state should I form my LLC in?

As a rule of thumb, if you have a physical office or an employee located in the US, it is best to form your LLC in that state.

01For example, if you have a boutique shop in California, where you sell your goods, form your LLC in California.

If you have an e-commerce store that you manage online, but you stay in Texas → Form your LLC in Texas.

If you form your LLC in Delaware, but ended up having a store in California, you'll have to file your LLC as a 'foreign LLC' in California as well. So, pick your home state if you're a resident.

For non-residents

If you don't have any employees or a physical office in the US, you could choose either Delaware or Wyoming to form your LLC. It is because these two states are very business-friendly and have the best legal structure in place.

How to form your LLC?

Here are 6 steps to give you a basic understanding of formation.

01Choose a state of formation
02Pick a name and reserve it with your state before filing your LLC (optional)
03Nominate a registered agent
04Decide if the LLC is member-managed or manager-managed
05Draft an operating agreement
06Apply for EIN
07Open a bank account

If you wanna know more about the exact formation steps, read our step-by-step guide below

Converting LLC

Is LLC the best entity for me?

Once your business is up and running, you'll come across situations where you may want to change your tax classification or completely change your business entity.

You may want to reduce your taxes. Or accommodate a new member.

Whatever your reason is, let us see some of the conversions.

Why should you convert?

Being taxed as a corporation allows you to pay the lower corporate income tax, be hired as an employee of the corporation and make your life easier by making the LLC take care of filing a chunk of your payroll tax formalities.

How to?

You can change by filing Form 8832.

Why should you convert?

If you find the paperwork to be cumbersome(which isn't much, honestly) and if you're the sole shareholder.

How to?

You can change by filing Form 8832.

Why should you convert?

LLC as a corporation has lower corporate income tax, allows you to be hired as an employee of the corporation and pay your partners dividends.

How to?

You can change by filing Form 8832.

Why should you convert?

Very rarely people make this change in classification. You could choose this conversion if the partners have lower personal income tax liabilities.

How to?

You can change by filing Form 8832.

Why should you convert?

If you'd like to add your spouse or a business partner who would invest cash in the LLC.

How to?

Make changes to your articles of formation, operating agreement and file Form 8832 indicating IRS about the change.

Why should you convert?

Happens when one or more partners sell their ownership stake to one partner. There's no special benefit LLC gets from changing from multi member LLC to a single member LLC.

How to?

Make changes to your articles of formation, operating agreement and file Form 8832 indicating IRS about the change.

Why should you convert?

Multi member LLC offers personal liability protection that's absent in a general partnership.

How to?

Follow the process of creating a brand new LLC — file articles of formation, pick an LLC name, create an operating agreement, etc..

Why should you convert?

Personal liability protection, better protection when hiring employees, to keep personal and business assets separate.

How to?

You would have to follow the process of forming a new LLC — file articles of formation, pick an LLC name, create an operating agreement, etc..

Note

IRS has a 60-month limitation rule i.e, if you have already elected to change the classification once in the past, you'll have to wait for 60 months before changing it. There are exceptions to this rule though.

Comparisons

What are the differences between LLC and other entities?

Maybe, LLC isn't the right entity for you. Maybe it is a C-Corp. Only way to find out is to directly compare them all.

LLC vs Corporation (C-Corp)

LLC has liability protection, but cannot issue stock to members, whereas corporations have liability protection as well as the ability to issue stock

Read in detail

LLC vs Corporation (C-Corp)

LLC vs S-Corp

LLC is a business entity, where S-Corp is just a tax classification asking IRS to treat your entity as a partnership

Read in detail

LLC vs S-Corp

LLC vs DBA

The primary difference between LLC and DBA is that LLC offers personal liability protection to its owners, whereas DBA does not.

Read in detail

LLC vs DBA

FAQ

It's a business entity which is not recognized by the IRS as a separate entity from its owner. This is how single member LLCs are treated by default. Since the entity is considered "disregarded", it doesn't have to file a separate tax return. Income and losses are reported by the single owner.

No. There's no requirement for residency or citizenship to own an LLC or C-Corporation. Only for an S-Corporation, you need to be a US citizen.

No. For single and multi member LLCs, members cannot be the employees just to pay themselves a salary. It's almost illegal to do so.

Let's say you have formed your LLC in a state, but you are doing business in another state as well. In that case, you'll have to file your LLC as a 'foreign LLC' in the second state. For example, let's say you have initially filed your LLC in Arizona. Business grew and now you're selling your goods in California as well. In this case, you'll have to file your LLC as a foreign LLC in California.