It is possible that you have decided to start a business because you’re passionate about your product or service — not because you love the intricacies of business law. But now you find yourself having to make legal decisions left and right, like how to set up a limited liability company, or LLC.

But there is good news “Forming an LLC is relatively simple,” says Jennifer Reuting, author of “Limited Liability Companies for Dummies“ and founder of MyLLC.com, a Westlake Village, Calif., firm that specializes in forming LLCs and corporations. The LLC structure can also offer a lot of advantages for entrepreneurs.

This article contains everything you need to know before starting an LLC.

• What Should I Know Before Starting an LLC?
• Is it Worth it to Start an LLC?
• What are the Pros and Cons of Starting an LLC?
• How Difficult is it to Start an LLC?

What Should I Know Before Starting an LLC?

So what’s the best way to jump-start the LLC process? Here are five things you need to know.

1. Understand what an LLC is — and what it’s not. There are a handful of business structures to choose from — from sole proprietorships and partnerships to S corporations and LLCs. Each offers its own advantages and disadvantages.

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Nolo.com, a free legal site, describes an LLC as a hybrid that mixes “the best parts of partnerships and corporations.” A more detailed breakdown and additional resources can be found in Nolo.com’s article “LLC Basics.”

2. Consider the benefits of an LLC structure. “Flexibility” is one of the terms most often used to describe LLCs — and for good reason. “You can freely decide how you want your LLC to be taxed, who gets management rights, and how profits are distributed to the owners,” Reuting says. “This makes LLCs the perfect choice for small businesses.”

Even better, she adds, with an LLC, entrepreneurs can transfer assets in and out completely tax free. And as the name implies, LLCs offer limited personal liability to the owners.

3. But remember the downside. If your LLC has just one member — you — the company is “automatically treated as a sole proprietorship for tax purposes,” Reuting says. “You can get around this by issuing a small percentage of shares to a close friend or relative, thereby creating a true partnership.” Unfortunately, spouses don’t count.

4. LLCs are suitable for any type of business — well, almost. Due to its many advantages, the LLC structure is the best choice in most cases. One notable exception: If you plan on taking your company public someday, a corporation is the smarter option. “Converting your LLC to a corporation, later on, could incite a taxable event, so you’re going to want to have as much foresight as possible when it comes to this,” Reuting says.

Constance E. Bagley, co-author of “The Entrepreneur’s Guide to Business Law“ and professor in the practice of law and management at the Yale School of Management, points to another exception: entrepreneurs who expect to raise early rounds of capital from VC firms. “An LLC is not suitable for businesses financed by venture capital firms,” she says, “because of tax restrictions applicable to VC funds’ tax-exempt partners, such as pension plans and endowments.”

5. The process is not as difficult as you might expect. In fact, according to Reuting, forming an LLC can be broken down into four main (and for the most part, relatively straightforward) steps:

• Pick a name for your LLC — just ensure the name you want isn’t already in use.
• Decide how the business will be managed. “LLCs can be structured either as ‘member-managed,’ where all owners have an equal say in the day-to-day management of the business, or ‘manager-managed,’ which includes any other arrangement,” Reuting says.
• File the articles of organization with your state’s secretary of state — and make sure a business attorney reviews the document. Alternatively, you can use an online filing service like Nolo.com. (Reuting’s company, MyLLC.com, also provides this service.)
• Create your LLC operating agreement. “The structure of your LLC — formatted to your particular business needs — is compiled in the operating agreement,” Reuting says. “It’s akin to building a house. If you’ve filed your articles, you’ve poured the cement. But the operating agreement, that’s the true foundation.” This last step is complicated. Bagley suggests entrepreneurs do this only with the help of a knowledgeable attorney. “But [don’t] hesitate to try to negotiate a cap on fees or an agreement to defer payment until financing is secured.”

Is it Worth it to Start an LLC?

Probably the most obvious advantage to forming an LLC is protecting your personal assets by limiting the liability to the resources of the business itself. In most cases, the LLC will protect your personal assets from claims against the business, including lawsuits.

This enables the small business owner—of sole proprietorships and partnerships—to gain the limited liability protection similar to that offered by corporations, but without the cost and complexity that corporations bring.

For example, under an LLC, you will not need to file a separate tax return for your business. Your income and expenses will continue to be reported on your individual income tax return, either on Schedule C for sole proprietorships, or on Schedule E for partnerships.

There is also the tax benefit to an LLC. This is particularly true in relation to “C corporations,” which the IRS recognizes as independent entities. Taxes must first be paid on net income to a corporation, before that income is distributed to the owner, where it is taxed again at an individual level.

This is what is known as double taxation, which you can avoid entirely with an LLC. (You can also avoid it with a Subchapter S Corporation but that will still involve a complicated set up, as well as ongoing compliance and filing requirements.)

Still another benefit is something of a soft advantage: having “LLC” or “Limited Liability Company” in your business name can make your business seem somehow more official. It implies that the business is registered with the state, and is somehow more substantial as a legal entity.

If you have a small business, either a sole proprietorship or partnership, you should take a serious look at creating an LLC. That will enable you to gain important legal protection for your personal assets, without disturbing the management and income flow of your business.

What are the Pros and Cons of Starting an LLC?

Limited liability companies (LLCs) are the simplest and most inexpensive business structure in the United States. The pros and cons of LLCs include being easy to form, protecting owners from personal liability, and offering flexible tax options. However, LLCs also make raising money difficult and can misalign owner tax burdens and their earnings from the company.

Pros

Many business owners use LLCs, with more than 2.2 million LLC tax returns filed in the U.S. in 2012. Limited liability companies come in all shapes and sizes, including very large companies like Koch, Cargill and Chrysler. LLCs are easy to set up, have a flexible tax structure and protect owners against personal liability.

The pros of an LLC include:

1. Limited Liability

The biggest advantage of a limited liability company is right in the name — it limits your potential liability as a business owner. If someone gets hurt using a product produced by your business or is hurt on property owned by your company, an LLC can prevent a would-be plaintiff from going after your personal assets.

Some potential liabilities that LLC owners can be shielded against include:

• Unpaid business debts:Unless you personally guarantee them
• Vendor disputes: If they try to bill more than you owe
• Damages: If someone is hurt by your business or on property you own

LLCs liability protection is similar to S-Corps and C-Corps and in contrast to sole proprietorship owners who have unlimited personal liability for the debts and actions of their business. Under a sole proprietorship, if your business borrows or loses money, you are personally liable for those debts. In an LLC, you are only liable if you provide additional personal guarantees.

There are some exceptions in which you can give up your limited liability. This is what’s called “piercing the corporate veil.” These circumstances include:

• Fraud: If, acting through your business, you defraud customers or investors, then you can be open to unlimited personal liability.
• Failure to meet LLC requirements: LLCs have certain requirements like holding annual meetings and keeping minutes. Failure to meet these requirements can result in unlimited liability.
• Commingling personal and business funds: Failure to segregate business and personal money can leave you personally open to liability incurred through your business. For more information, be sure to check out our article on keeping your business and personal expenses separate.
• Using personal money to meet business obligations: If you pay business bills using your personal money, this may leave you open to additional liability.
• Insufficiently capitalizing your business at startup: If you don’t start your business with enough capital to meet its obligations, you run the risk of being held personally liable for its debts.

Of course, if you’re going to have an LLC it’s also important that you maintain the right insurance to protect yourself from liability.

2. Easy to Create and Administer

It is incredibly easy to set up and administer LLCs. In most states, you can complete a new filing online in just a few minutes, paying with a credit card. You can also use a service like IncFile to help you incorporate, which cuts down on the time further, although it comes with a price.

Then, through the IRS website, you can file to get an Employer Identification Number (EIN) for your business, which you’ll need to set up a business checking account. This will help you keep your business and personal expenses separate and avoid the risk of piercing the corporate veil and losing your limited liability status.

The specific steps you need to take in order to incorporate include:

1. Choose the state where you want to incorporate
2. File with that state’s secretary of state’s office
3. Get an EIN from the IRS

LLCs exist in perpetuity, so long as they are kept current by members or officers. Each year, you need to file an annual report to keep your LLC current, but this can also be completed online quickly.

Once you’ve created an LLC, the things you need to do to keep your LLC in good standing include:

• File annual report: Most states require LLCs to file annual reports to stay current; these filings require a fee and involve updating lists of LLC members and managers
• Annual meeting: LLCs are required to hold a formal annual meeting
• Keep minutes: You must keep minutes at your annual meeting, no matter how brief
• Tax forms: Each year, LLCs need to complete applicable tax forms depending on how they elect to be taxed — most owners choose to file as a partnership and must complete Form 1065; they must also prepare and distribute K-1s to members

Fortunately, you can use a service like Rocket Lawyer or employ a lawyer to help you through this process. This is in contrast to other types of business structures that can be much more difficult to get started. A few other types of business structures include:

• Sole proprietorships: Informal business structures that do not have any filings or required tax forms but also don’t provide owners with any personal liability shield
• C-Corporations: C-Corps are the most robust type of business structure; they file their own tax returns and pay a second layer of taxes on corporate profits (typically 21%)
• S-Corporations: Closely held corporations with fewer than 100 shareholders, S-Corps are taxed as pass-throughs but can pay salaries to shareholders that are deductible to the business

Still, LLCs are the easiest and most inexpensive business structure that provides owners with protections against personal liability.

3. Ability to Change Tax Structure

Unlike other business structures, LLC owners can choose how they want to be taxed. The vast majority chooses the pass-through method — 95% of all American businesses are pass-throughs. This means that each LLC will prepare Form 1065 to report partnership income and distribute K-1s to its members. Each member’s respective tax liability will be included as part of their personal tax return.

While most owners use LLCs as pass-throughs, LLCs can also make a C-Corp election to file their own tax returns. Under this structure, LLCs are still typically less expensive than corporations and most other alternatives. Taxes on LLCs are much than C-Corps, which are taxed twice on corporate profits. LLCs are only required to pay self-employment tax.

Lastly, LLCs can use an S-Corp election to take advantage of certain tax benefits. These include the ability of members to pay themselves a salary without self-employment tax. S-Corps are also exempt from the second layer of taxes on corporate profits, which is unlike C-Corps.

Remember, however, that if you choose the pass-through tax method that you’re subject to self-employment taxes. This can be as high as 7.5% since you have to cover the employer-portion of FICA taxes. We discuss this in greater detail in the section below.

4. No Restrictions on Number of Members or Partners

LLCs can get started with any number of members. Single-member LLCs are not uncommon and can even be owned by other LLCs as a multilayered company. This is a very common strategy in some industries, including:

• Real estate
• Pharmaceutical
• Branded retail products
• Segregating product lines and services

Although single-member LLCs are common, you can also start an LLC with any number of partners — there is no restriction. This is different from other structures, including limited liability partnerships (LLPs), which must have more than one partner; S-Corps, which are capped at 100 owners; and sole proprietorships, which can only have one owner.

While LLCs can legally have any number of members, administration becomes more difficult as the number of partners rises. This is partially due to the fact that LLCs do not issue shares that can be bought, sold or redeemed, as is the case for C-Corps and S-Corps.

5. Unrestricted Pay to Members or Partners

LLCs aren’t restricted in how they pay members. Each member can be paid more or less than their respective share of ownership. They can also receive more or fewer tax write-offs for business-related expenses and reimbursements for expenses they pay personally through guaranteed payments.

Obviously, this is of little consequence for single-member LLCs or companies owned by married spouses who file joint tax returns. In these circumstances, all taxable revenue and deductible expenses would be passed along to the sole owners.

The biggest difference in pay to LLC owners is that, unlike with C-Corps or S-Corps, the IRS does not recognize the right of LLCs to pay salaries to owners. S-Corps and C-Corps can pay salaries to owners that are deductible against corporate profits while LLC payments to owners are treated as draws and do not count against partnership income. This can lead to a misalignment of tax burden of LLC owners, which we discuss below.

Cons

Despite the distinct advantages, an LLC also has several drawbacks compared to other business structures. Added paperwork and costs can be burdensome for young or growing businesses, especially if they don’t yet have sufficient operations to require liability protections. New startups can also find it harder to raise the money necessary to grow the business.

Some disadvantages of LLCs include:

1. Licensing & Filing Fees

There is a fee to file a new LLC with a state — typically between $50 and $500. This is an addition to annual filing fees required to keep your LLC current, which varies widely by state and range from $0 to $820.

These filings are handled by individual state’s secretaries of state. Most can be completed online but almost all have fees. Some have additional requirements including a local agent, which charge additional fees in addition to state filing costs.

However, you don’t have to create an LLC in the state where you live or do business — you can pick a state that makes sense for your business. Some states are known for being more business-friendly than others, including providing more or less protection for small business owners. Be sure to research various states before choosing where to file.

To find more state-specific information, be sure to check out your state’s secretary of state website. You’ll see that the cost to establish and maintain an LLC can be modest compared to other structures like an S-Corp or C-Corp, but it’s far more expensive than a sole proprietorship, which doesn’t require filings at all except for special licenses.

2. Required Self-employment & Excise Taxes

In addition to filing fees, many states have dedicated businesses levies, franchise or excise taxes. If you create an LLC in another state where you don’t live or do business, you may be taxed on income in that state. However, depending on the structure of your business, you may also be required to pay self-employment taxes on profits, up to 7.5%.

Luckily, LLC owners are exempt from self-employment tax on profits if they elect to file as an S-Corp or C-Corp. However, they still have to pay self-employment taxes of 7.5% on their salaries, which is the employer-portion of FICA taxes.

If you don’t make this election, as an LLC owner you must pay self-employment tax on your share of profits in an LLC, regardless of how much was actually distributed to you. Self-employment tax generally adds 7.5% to your income tax liability, compared to W-2 income.

3. Additional Tax Forms

Aside from new potential tax liability of starting an LLC, the process of preparing taxes becomes more complicated. Even if your LLC is as a pass-through entity, and even if there is no money coming in or going out, you will still need to prepare K-1s for each member of the LLC. These K-1s will be filed with each owner’s personal tax return as part of his or her Schedule C.

Typical tax forms for an LLC include:

• Company tax filing: Each year, an LLC must prepare its own tax filing; most LLC owners choose to be taxed as partnerships and use Form 1065
• K-1s: Once partnership returns are complete, LLCs must prepare and distribute K-1s to individual members to show their individual tax liability for the year, based on their percentage of ownership
• Franchise and excise taxes (if applicable): Some states charge individual franchise or excise taxes that require additional filings

4. Member Salaries Can Misalign Tax Burden

The IRS doesn’t recognize the right of LLC owners and members to collect salaries from their LLC. Members can still take money out of an LLC, but it’s in the form of draws — a kind of advance on profit-sharing. LLC members are taxed on their respective share of profits, regardless of any payments made to members.

One exception to this is guaranteed payments, which LLCs can pay to members to reimburse them for the use of capital by the LLC or if a member provides a service or other benefit to the company. If you have partners in an LLC and each of you takes draws from the company that is not directly proportional to your respective ownership shares, you may be taxed on more or less than you actually earned from the business.

5. Harder to Raise Money

If you’re setting up a new business and intend to raise money from outside investors, this can be made more difficult by using an LLC. The pass-through nature of LLCs and their flexibility for managing members make them a greater risk for outside investors, who are more likely to invest in C-Corps and other types of entities.

Because LLCs can’t issue shares, the only way for an outside investor to invest in an LLC is to buy-in as a member. This makes it nearly impossible to raise equity capital. If you plan to raise outside capital, you should plan to restructure as an S-Corp or (after you reach 100 owners) a C-Corp.

How Difficult is it to Start an LLC?

Many small business owners decide to set up an LLC for the liability protection it provides. An LLC, or limited liability company, exists separately from its owners (known as members), and the owners are therefore not personally responsible for business debts.

To form an LLC, you’ll need to file paperwork with the state where your business is located. Every state has its own rules and procedures, but there are several steps you’ll need to follow to get your LLC up and running, no matter where you live.

Step 1: Choose a Name for Your LLC

Most states don’t allow two different business entities to have the same name. So you can’t, for example, have “Joe’s Donuts, LLC” and “Joe’s Donuts, Inc.,” even if they’re located in different cities. Many states also restrict companies from using certain words in their names, such as “bank.”

You can search existing business names online in many states to determine whether your proposed LLC name is available. You should always check name availability in your state before filing LLC paperwork.

In addition to state law restrictions, it’s wise to research whether other similar businesses in your area are using the same name or a similar name. Choosing a unique name can help avoid confusion and trademark infringement claims. You might also consider whether a domain name is available that matches your business name.

Step 2: Reserve a Name (optional)

If the LLC name you’ve selected is available, but you aren’t going to be filing your LLC documents right away, you may want to reserve the name. Nearly every state allows you to reserve a name by filing a form and paying a name reservation fee. The length of the reservation period, filing fees, and renewal policies vary from state to state.

Step 3: Choose a Registered Agent

Almost every state requires its LLCs to name a registered agent (also sometimes called a statutory agent). A registered agent is a person who agrees to receive lawsuits, subpoenas and other official documents on behalf of the LLC and to pass them along to the appropriate person at the LLC.

Most states allow anyone who is a state resident over age 18 to serve as a registered agent—including a member or officer of the LLC. There are also companies that provide registered agent services for a fee.

Step 4: Prepare an LLC Operating Agreement

An LLC operating agreement is the roadmap that describes how your LLC will be run. It specifies such things as the ownership interests and voting rights of the members, how profits and losses will be allocated, how meetings will be held, how the business will be governed, the rights of the members if one of them dies or leaves the business, and the way the company will be dissolved if it goes out of business.

Read Also: 10 Best Accounting Apps for Small Businesses

The operating agreement typically isn’t filed with the state and may not be required by your state’s laws. However, it is an important way for business owners to define their rights and responsibilities and minimize future disagreements.

Step 5: File Organizational Paperwork With the State

Each state has its own form and procedure for establishing an LLC. In general, you must file articles of organization that list such things as:

• The name and address of the LLC
• The length of its existence, if not perpetual
• The name and address of the registered agent
• The purpose for which the LLC was formed

The paperwork usually must be signed by the person forming the LLC, and in some states, the registered agent must also sign.

In most states, you’ll file LLC formation documents with the secretary of state, but some states have a different department that handles business filings. All states charge a filing fee, but the LLC cost varies from state to state.

Step 6: Obtain a Certificate from the State

After the LLC’s formation documents are filed and approved, the state will issue a certificate or other document that confirms that your LLC formally exists. Once you’ve received the certificate, you can take care of business matters like obtaining a tax ID number and business licenses and setting up a business bank account.

Step 7: Register to Do Business in Other States (optional)

If your LLC does business in more than one state, you may need to register to do business in other states. To do this, you’ll need to fill out and submit paperwork that’s similar to the paperwork you filed when you formed your LLC. You’ll also need a registered agent in each state where you are authorized to do business.

Lastly

An LLC is a popular and flexible business option that works well for many small business owners. In most states, LLCs are relatively easy to set up and maintain. However, it’s important to fill out the paperwork properly and have an operating agreement that defines the members’ rights and responsibilities.