Chances are, you 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. The 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.
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. 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."
The original version of this article appeared on AOL Small Business on 6/7/10.