Is an LLC Necessary for My Business?
An LLC combines the relative ease and flexibility of a sole proprietorship or general partnership with the increased risk protection and tax advantages of a corporation. Because LLC owners (known as members) are a separate entity from the LLC, they aren’t personally liable for business obligations. LLCs have to appoint a registered agent, file official paperwork, and pay registration fees in the states where they do business. The act of registering an LLC with the state is what creates the necessary separation between the LLC and its members. This separation between the business and its owner(s) is what provides liability protection against lawsuits and bankruptcy.
Do I Need an LLC to Start a Small Business?
An LLC isn’t required to start a small business. If you’re mowing lawns for money or selling carrots at your local farmer’s market, you’re already in business as a sole proprietor. If you bring on a business partner, you’re doing business as a general partnership. Both types of businesses are popular because they are easy to form and maintain. The main drawback of course is that neithersole proprietorships nor general partnerships offer any liability protection. This means that if your business gets sued or goes bankrupt, you or your business partners might have to kiss their personal assets (house, car, savings, 401k) goodbye. To truly protect your assets, you’ll need liability protection, which is where the LLC comes in.
To get a better understanding of the LLC structure, check out our page on Types of LLCs.
What is a Sole Proprietorship?
A one-owner business is a sole proprietorship. As a sole proprietor, you’ll have total control over how you run your business. With no formal state paperwork required to establish a sole proprietorship, you’ll also face relatively few legal and regulatory burdens, and you won’t have to fork over any money to the state to legally register or maintain your business. The only paperwork a sole proprietor needs to worry about is if they need to obtain state or local licenses for the products or services the business sells. However, as a sole proprietor, you are your business, which means that there is no legal separation between you and your business. Your personal assets could be garnished if your business gets sued or goes bankrupt.
Learn about the differences between a Sole Proprietor vs. LLC.
What is a General Partnership?
A general partnership is when two or more people go into business together. The partners share the business assets, profits, and debts of the business. As with a sole proprietorship, a general partnership doesn’t have to file any formation paperwork with the state to do business, except for any required business licenses. Just like a sole proprietorship, a general partnership does not create a separation between owner and business. This means that it won’t protect its owners and their personal assets in the event of a lawsuit or bankruptcy.
Discover the differences and similarities of Partnerships vs. LLC.
|Sole Proprietorship||General Partnership||LLC|
|Number of Owners Allowed||One||Unlimited||Unlimited (in most cases)|
|Personal Asset Protection||Owner has unlimited personal liability||Unless structured as a limited partnership, owners have unlimited personal liability||Owners (members) are not typically liable for the debts of the business|
|Taxation||Pass-through taxation, meaning income from the business is passed through to the owner’s personal taxes||Pass-through taxation, meaning income from the business is passed through to each owner’s personal taxes||Pass-through taxation by default, but with the flexibility to elect to be taxed as either an S-Corp or C-Corp|
|Formation||No state filings required, just do business||No state filings required, just do business||Must file formation documents with the state and pay filing fees|
|Price Tag||No cost||No cost||$40 to $3,000 depending on state|
|Annual Compliance and Formalities||None||None||All states require an LLC to appoint a registered agent, and most states require LLCs to submit annual or biennial reports and pay a fee|
|Growth Potential||Lack of liability protection and legal formalities make it harder to raise money||A general partnership can raise money by bringing on new owners or appealing to investors, but the lack of liability protection means potential investors may not feel comfortable risking personal assets||LLCs can add members to raise funds, and banks may be more likely to lend LLCs money because of their liability protections|
Why Choose an LLC?
If sole proprietorships and partnerships are so easy and cheap to start, why would anyone bother with the paperwork and costs associated with forming an LLC? Here’s a few reasons why forming an LLC is often the best choice for small business owners.
An LLC creates a legal shield between you and your business. This means that if your business ever gets sued or goes bankrupt, your personal assets (house, car, bank accounts) won’t be on the line. Similarly, in most cases, if another LLC member gets sued or goes bankrupt, the assets of the LLC won’t be subject to garnishment. Sole proprietorships and general partnerships offer no legal separation, which means your personal assets could be used to satisfy a lawsuit or bankruptcy judgment.
Like sole proprietorships and general partnerships, LLCs are taxed as pass-through entities by default. This means that you’ll report your share of business income and expenses on your personal tax return and pay income tax on any business profits. However, LLCs have the flexibility to elect to be taxed as an S-Corp or a C-corp, which in some cases can allow LLC members to save money on taxes. This tax flexibility allows LLC members to choose the tax structure that best meets their needs.
Unless a sole proprietor or general partnership files for a DBA (“doing business as”), their business name is usually their name or a combination of names. Using your own name for your business is a good way to end up with tons of junk mail, scam phone calls, and hackers looking to steal your identity. An LLC, on the other hand, is required to register its name with the state. A registered business name is the first step in creating a shield between the members of an LLC and the public. An LLC is also required to appoint a registered agent. You can appoint yourself or someone you know and trust, but many LLC owners prefer to hire a registered agent service. A good registered agent will list their name and address on all state filings allowable. This will help to keep your private information off public record.
Learn more about how to Live Privately with an LLC.
Many small business owners find that forming an LLC gives their business credibility that it didn’t have as a sole proprietorship or general partnership. An LLC conveys to your customers that they can trust you, that you’re not just some random person in business with no legal entity to back it up. Officially registering your business name with the state, and having the “LLC” at the end of your business name helps to lend your business a certain level of prestige.
LLCs have the personal asset protection they offer. When an investor looks at an LLC, they know that in most cases, their personal assets won’t be at risk. While LLCs and general partnerships can each raise money by bringing on additional members or partners, only LLCs carry the credibility, tax flexibility, and limited liability that most business owners crave. At the end of the day, the potential for growth all comes back to the liability protections of the LLC, which sole proprietors and general partnerships just can’t match.
Can you convert a sole proprietorship or general partnership to an LLC?
Yes. Sole proprietorships and general partnerships are businesses that haven’t registered with their respective state or jurisdiction. In order for each to become an LLC, they’ll need to appoint a registered agent and submit a formation document, often called Articles of Organization, with their state’s Secretary of State. Once a decision has been made and paperwork (and filing fees) have been submitted, the LLC will be open for business. Of course further maintenance will be required, such as writing an LLC operating agreement, preparing and filing annual or biennial reports, and obtaining an EIN if you’re a multi-member LLC.
Check out our page on Why You Should Turn Your Sole Proprietorship into an LLC.