What is an LLC?
An LLC (limited liability company) is one of the most popular business structures. Many entrepreneurs incorporate as LLCs to separate their personal and business finances, but there are other, more tangible advantages, too.
When you form an LLC, you get taxed like a sole proprietor or partnership while receiving the liability protection of a corporation. Plus, there’s flexibility with the set-up. You can be a sole owner or one of multiple owners (also called members).
If you’re considering incorporating as an LLC, keep reading to learn more about the benefits, types, and equity options to see what makes the most sense for you.
What are the advantages and disadvantages of an LLC?
Easy to form: Every state has different requirements and incorporation fees, but in general, the process is fairly straightforward and doesn’t require a lot of paperwork.
Personal liability protection: Unlike a sole proprietorship, an LLC offers business owners limited liability protection for business debts. That means creditors can’t go after your personal assets—like your home or car—if your business defaults on a loan or faces a lawsuit.
Flexible management structure and profit sharing: Members of an LLC can either oversee the company, manage operations, and make decisions themselves, or hire outside parties to take on those roles. LLC members also have flexibility when divvying up the company’s profits.
Flexible tax reporting: You can choose how you want to be taxed. The most common option is the pass-through method, where business profits go directly to LLC members without being taxed as a corporation. However, you can also make a C-corp or S-corp election, which means you’ll be taxed as a corporation but may get certain advantages when filing.
Self-employment taxes: The IRS looks at LLCs like partnerships or sole proprietorships in terms of taxes. If you choose the pass-through method, you’re technically considered self-employed, which means you have to pay social security and medicare taxes based on your business’s net earnings.
Can be difficult to raise money from investors: LLCs are a riskier choice for venture capitalists, so you may be limited in the amount of money you can raise from outside investors. Most investors prefer to put their money into C-corporations, which generally have more options for liquidity and more straightforward tax reporting.
What are the different types of LLCs?
There are a few different types of LLCs include a single-member LLC, multiple-member LLC, and series LLC. The one that’s right for you will depend on your industry, finances, and business goals.
Similar to a sole proprietorship, a single-member LLC is an LLC with one owner. For tax purposes, the IRS considers single-member LLCs disregarded entities. This means the owner pays self-employment taxes like a sole proprietor and reports all business activity on their personal federal income tax return.
A single-member LLC can be a good option if you’re a small operation with few or no employees and you want to retain sole ownership of your company.
A multiple-member LLC is a company with two or more owners (or members). Unless the members file taxes as an S-corp or C-corp, multiple-member LLCs get taxed like partnerships, which means each member pays a portion of the business’ taxes on their personal income tax return. However, unlike a partnership, the members of an LLC aren’t personally liable for unpaid business debts.
A multiple-member LLC can be a good option if you own a small to medium-size business, have multiple owners, and want to share profits among them.
A series LLC is a business entity where you can separate business assets, debts, and more into independent units and assign different members or managers to each unit. Each unit is only liable for and taxed on the specific assets or debts it owns.
A series LLC can be a good option for venture capitalists, real estate companies, holding companies, or entrepreneurs who want to run several different LLCs as one company. However, they’re only allowed in certain states
How do LLCs structure their equity programs?
When you’re building your business, it’s important to consider how equity comes into play, both for you and your employees.
Rather than issuing stock options like you would in a corporation, in an LLC you hold membership interests. If you’re the sole member of an LLC, you retain 100% equity. However, if you’re part of a multiple-member LLC, equity is distributed among members based on the terms of your operating agreement.
You can give profits interest units to employees
Unlike a profit share, which is a portion of the company’s profits, profits interests typically amount to a portion of the value an LLC gains over time. For example, imagine an LLC is worth $500,000 at the time an employee receives a profits interest. If the LLC is valued at $2 million in five years, the employee is entitled to a percentage of the $1.5 million in value gained.
Typically, profits interest units have vesting options with no purchase requirements. In most cases, profits interests come in the form of an employee award or grant. If the employee makes an 83(b) tax election, they will likely experience similar tax advantages to those afforded by incentive stock options, meaning the employee won’t have to pay taxes when they get the grant.
However, there are a lot of factors that affect how much an employee will be taxed for profits interests, so it’s crucial to consult an accountant and lawyer to go over your options.
Create an operating agreement
An operating agreement outlines the rules and requirements around your business’s finances, structure, and management. It’s critical to write an operating agreement in case your business dissolves or a member fails to make their required capital contributions.
You can work with an attorney to dictate your terms, but many business owners base equity and profit shares off of each member’s capital contributions to the business. How much you collectively invest is up to you, but it’s a good idea to gather enough funds to cover startup costs and at least six months of operating expenses.
Make sure you track each member’s initial investment in the business, their subsequent capital contributions or withdrawals (and the dates they were made), and each person’s percentage of profits and losses.
Becoming an LLC
Incorporating as an LLC can be a smart move if you want greater protection over your personal assets, distinct separation between your personal money and business profits, and more flexibility with management and profit sharing. Depending on your goals and the stage your business is in, you may choose to file as a single-member or multiple-member LLC. If you opt for the latter, you can distribute equity among the business’ members and set up equity programs for employees using profits interest units.
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