Many small businesses are organized as limited liability companies, or LLCs, because an LLC offers many of the same liability protections as a corporation, but with a less rigid structure and fewer administrative requirements.
But not everyone needs an LLC. Some businesses will do just fine as sole proprietorships, while others should form a corporation instead. Here are some basics to help you decide what's right for you.
What will an LLC do for me?
Forming an LLC gives your business its own legal identity. In the eyes of the law, it's a separate “person" that can own money and property, have a bank account, make agreements, sue people, and be sued.
Because of this, your business's creditors generally can't go after any money or assets that aren't owned by the LLC. Your home, bank account, and other personal assets are protected. By contrast, if you operate a sole proprietorship or general partnership, you and the business aren't legally separate, and everything you own is at risk.
LLCs also have other advantages:
- If you have business partners or employees, an LLC protects you from personal liability for your co-owners' or employees' actions.
- An LLC gives you a structure for operating your business, including making decisions, dividing profits and losses, and dealing with new or departing owners.
- An LLC offers taxation options. Most LLCs are taxed as a sole proprietorship or partnership, but LLCs can also choose S corporation or C corporation taxation.
Here's what an LLC can't do
Unlike a corporation, an LLC can't issue stock, and this complicates matters if you want to take on investors. Many investors prefer corporations over LLCs.
If you are a licensed professional such as a doctor, lawyer, accountant, architect, or engineer, your state may not allow you to form an LLC.
Depending on your state, you may choose to form a professional limited liability company, professional corporation, or professional limited liability partnership instead.
There are also limits to an LLC's liability protection. You will still be personally liable if someone sues you for your own negligence or wrongdoing—even if the accusations are related to your business. An LLC does not protect your assets if you personally guarantee a contract or loan. And it won't protect the business itself from losing everything in a fire, flood, lawsuit, or economic downturn. LLC owners may also face the risk of so-called "alter ego" liability, which, under certain circumstances, can make them personally liable for their company's debts and obligations. You can help mitigate this risk by making sure to observe the formalities of operating an LLC, such as by holding board meetings, keeping business bank accounts separate from personal accounts, and using separate office space, among other things.
Because of these limitations, an LLC is never really your first line of defense against business problems. Insurance is essential to protect you and your business against the unexpected. An LLC then adds an additional element by helping to protect your personal assets from your business's creditors.
Who benefits the most from an LLC?
Your business is most likely to benefit from being an LLC if either of these is true:
- You have co-owners or employees. Without an LLC or other business entity, your personal assets are at risk if your business is sued for something a co-owner or employee does. An LLC's operating structure also helps to avoid conflict and misunderstandings between you and your business partners.
- Your business has significant risks. Some types of businesses are at high risk for failure. Others have both financial and liability risks. For example, multiple LLCs are a common strategy for rental property owners to ensure that financial problems with one rental don't jeopardize the others—or your own life savings.
Who can skip LLC formation?
Forming a business entity like an LLC or corporation is almost never a bad idea, but it isn't always an absolute necessity for solo business owners.
To decide whether you need an LLC, consider:
- Whether you plan to have partners, employees, or outside investors.
- Whether you have significant contracts or creditors that might lead to financial problems or lawsuits. For example, an unpaid creditor or court judgment could easily cause personal financial trouble if you own commercial real estate, but that's much less likely for most consultants and Etsy sellers.
- Whether you want to have the additional expenses and obligations of forming and running an LLC. There's a fee to form an LLC, and in most states, you must file annual reports and pay an annual fee. You will also need a separate LLC bank account.
If you're trying to limit your business liability, make sure you have adequate business insurance. If you have business partners, employees, or significant risks, an LLC can provide another important layer of protection.
Find out more about Starting a Business