What is an LLC? Definition and steps on how to form an LLC

Benefits of forming an LLC

The benefits of creating an LLC — as opposed to operating your business as a sole proprietorship, general partnership, or corporation - typically outweigh any perceived disadvantages.

• Limited liability: Members (term used to describe LLC owners) are shielded from personal liability for acts of the LLC and its other members. Creditors cannot pursue the personal assets (house, savings accounts, etc.) of the owners to pay business debts. With a sole proprietorship or general partnership, where this is no legal distinction between the business and the owners, creditors and other parties can go after the personal assets of the owners in order to satisfy the business’ debts.
  
  Note: It is possible for an LLC (as well as a corporation) to lose its limited liability. This is known as “piercing the veil”. For more information, see How to avoid piercing the corporate veil.
  
  Related: Single-member LLC vs. sole proprietorship, LLC vs. partnership
  
  
• Flexible membership: LLC members (owners) can be individuals, partnerships, trusts, or corporations, and there is no limit on the number of members. S corporations (which is a corporation that has elected to be taxed as a pass-through entity under Subchapter S of the Internal Revenue Code) are much more restricted in who can be a shareholder, and there is a maximum limit on the number of shareholders.
  
  Related: LLC vs. S corporation
  
  
• Management structure: LLC members (owners) can manage the LLC or elect a management group to do so. When an LLC is managed by members (a “member-managed” management structure), the owners oversee daily business operations. When managed by appointed managers (a “manager-managed” management structure), the LLC resembles a corporation, where business management is the responsibility of the directors and officers rather than the owners (shareholders).
  
  
• Pass-through taxation: LLCs typically do not pay taxes at the business entity level. Any business income or loss is "passed-through" to owners and reported on their personal income tax returns. Any tax due is paid at the individual level. Corporations that cannot or choose not to be taxed as an S corporation are taxed at the business entity level and their shareholders are taxed on the income distributed to them. (This type of corporation, which is the default when you incorporate, is known as a C corporation because it is taxed under IRS Subchapter C of the IRC.)
  
  Related: LLC vs. Inc (corporation)
  
  
• Heightened credibility: Starting an LLC may help a new business establish credibility more than if the business is operated as a sole proprietorship or partnership.
  
  
• Limited compliance requirements: LLCs face fewer state-imposed compliance requirements and ongoing formalities than corporations (whether taxed as S corporations or C corporations).

LLC considerations

There may be several perceived disadvantages to choosing an LLC as your business structure. (But in many cases, the advantages outweigh the drawbacks.)

• Cost: An LLC usually costs more to form and maintain than a sole proprietorship or general partnership. States charge an initial formation fee. Many states also impose ongoing fees, such as annual report and/or franchise tax fees. Check with your Secretary of State's office.
  
  
• Compliance obligations. An LLC (as well as an S or C corporation) has ongoing compliance obligations. These can include state obligations, such as maintaining a registered agent and filing an annual report. Federal obligations may include having to keep up-to-date beneficial ownership information with the U.S. Department of the Treasury's Financial Crimes Enforcement Network (FinCEN).
  
  
• Transferable ownership. Ownership in an LLC is often harder to transfer than with a corporation. With corporations, shares of stock can be sold by the corporation to increase ownership and, unless there is a shareholder agreement to the contrary, the shareholders can sell their shares to someone else. Typically, with LLCs, unless the members agree otherwise, all members must approve adding new members or altering the ownership percentages of existing members.
  
  

How to create an LLC: A step-by-step guide

LLCs are generally easier to form than a corporation, but there are some administrative and compliance tasks to be done. Although requirements can vary by state, these are the basic steps for setting up an LLC.

Step 1: Choose a state in which to form your LLC

You can choose to create an LLC in any state — even if the LLC won’t be doing any business there.

However, most LLC owners choose to form an LLC in the state in which they plan to do business — which, in many cases, is the state they live in. One reason is that if the LLC is formed in a state where it is not doing business, the LLC will also have to register as a foreign LLC (aka foreign qualify) to do business in the state where it is doing business, which can increase formation and administrative costs.

It’s important to note that formation fees, annual report fees, taxation, and LLC laws can vary significantly from state to state, making some states more advantageous for certain small business owners.

Related: Why incorporate in Delaware, Nevada, or Wyoming?, How to select a state for LLC formation.

Step 2: Choose a business name for your LLC

In order to form an LLC, you’ll have to choose a business name that is “distinguishable on the record”. That means the name is not already on the Secretary of State’s records as being the name of another domestic or qualified LLC or other business entity. This is important to know since many sole proprietors already operating under a registered “doing business as” (DBA) name or trade name may want to use their DBA name as their legal business name when they decide to set themselves up as an LLC.

To check the availability of the business name you want for your LLC, whether it’s registered as your DBA name or not, you should conduct an LLC name search on your formation state’s website and see whether your desired name is already in use. If you’re not ready to file your LLC formation document, it is a good idea to reserve the name. For a small fee, states will allow you to reserve a business name for a short period of time.

It’s also a good idea to conduct a trademark search of the name you want to use in order to avoid intellectual property infringement.

Step 3: Choose a registered agent

In starting an LLC, or registering an existing LLC to transact business in a foreign state, you are required to have a registered agent in the state of formation (or qualification).

A registered agent, also known as an agent for service of process, receives important legal notices and tax documents on behalf of a business registered with the state. These include important legal documents, notices, and communications mailed by the Secretary of State (such as annual reports or statements) and tax documents sent by the state’s department of taxation. A registered agent also must be available to receive service of process (sometimes called Notice of Litigation), which are legal documents. These are typically a summons and complaint that provide notice that a lawsuit has been filed against the LLC. Other court documents, such as wage garnishment orders and subpoenas, are also served on the registered agent.

While the owner of an LLC can choose to serve as the LLC’s registered agent, there are a number of compelling reasons why business owners choose a registered agent service provider to assist with this important requirement. Among other things, if the registered agent is not available when time-sensitive documents are delivered, or if the person receiving them mishandles them, this can create serious problems for the LLC. The registered agent must also have a physical address in the state and cannot use a PO Box.

Step 4: Prepare your LLC operating agreement

An LLC operating agreement is required in nearly every state. And although most states allow oral agreements, it is highly recommended that every LLC have a written operating agreement. As the name implies it is an agreement among the members and between the LLC and the members as to how the LLC will be operated. Even if there is only one owner (as with a single-member LLC), it is important to have an operating agreement. This shows that you respect the LLC’s separate existence (and can help avoid piercing the veil). It also gives you a chance to put in writing what you want to happen in certain circumstances such as if you can no longer manage the business and allows you to opt out of certain default provisions of the LLC statute that you might not want the LLC to be governed by.

It is particularly important for multi-member LLCs to have a well-drafted operating agreement. This document will clearly spell out the division of ownership, labor and profits, and often heads off disputes among the owners. It should detail, among other things, who has authority to do what, what vote is required to approve certain transactions, how membership interests can be transferred, how new members can be added, how distributions, profits and losses will be split, and more. It is recommended that the operating agreement be reviewed by your attorney to be sure that all the bases are covered.

Step 5: File your LLC’s Articles of Organization with the state

To make your new LLC exist officially, you must file LLC formation documents with the Secretary of State’s office or whichever department handles business filings in the state in which you are forming. This document is commonly referred to as a Certificate of Organization, Certificate of Formation, or Articles of Organization. Filing fees vary across the U.S.

Can an LLC be “incorporated"?

Although it is common to hear of an LLC being “incorporated”, the correct way to describe the creation of an LLC (or any entity type other than a corporation) is to say that the business has been “formed” or “organized”. “Incorporation” and Articles of Incorporationare terms that apply to a corporation (regardless of whether it is taxed as a C corporation or S corporation).

What are LLC Articles of Organization?

While each state’s LLC formation document is different to some extent, there are several common elements. These include the following:

• Name, principal location and purpose of the business
• Registered agent’s name and physical address
• Whether the LLC will be member-managed or manager-managed

Standard forms for the Articles of Organization for an LLC are generally available from each state. The person who formed the LLC must sign the paperwork. In most cases that person does not have to be a member (owner) or manager. In some states, the registered agent’s consent to act as registered agent is also required.

Once approved and filed, the state will issue a certificate or other confirmation document. The certificate serves as legal proof of the LLC’s status and can be used to open a business bank account obtain an EIN, and so on.

Note regarding the LLC publication requirement: Some states may also require that you publish a notice, often in a local newspaper, confirming the formation of the LLC. You may then need to file a certificate of publication with the state.

Step 6: File a beneficial ownership information report

Most LLCs will have to file a beneficial ownership information (BOI) report with FinCEN (U.S. Department of Treasury’s Financial Crimes Enforcement Network). A BOI report includes information on the individuals who ultimately own or control the business. Newly created LLCs that are not exempt will also have to submit information about the company applicant (the individual who directly files the document that creates or registers the LLC). For more information, visit the FinCEN website and you can file your BOI reports with BizFilings’ filing solution.

Step 7: Obtain EIN, sales tax ID, and licenses

After establishing the business entity, you must apply to the IRS for an employer identification number (EIN). This is the identification number your LLC will use on all its bank accounts, as well as income and employment tax filings.

In addition, you will need to apply to the state's tax department for a sales tax identification number, and you may need to register with the state's labor department in each state the LLC will be doing business. Your business may also need to obtain one or more licenses and permits for each jurisdiction.

Step 8: Open a business bank account

Opening a business bank account step is a key best practice for anyone who has created an LLC and is one of the steps outlined in our guide: 10 steps to starting a business. It is crucial to separate business finances from personal ones. This is one of the main factors that courts consider when deciding whether to pierce an LLC’s veil and hold the member liable for the LLC’s debts. A business credit card can also be used to keep personal and business transactions separate, as well as to help build business credit.

Most banks require company details to open a business account, such as formation date, business type, and owner names and addresses, and EIN.

Step 9: Register to do business in other states (if necessary)

If your LLC will be doing business in more than just the formation state, you will have to register — also known as “foreign qualifying” — in each additional state. (“Foreign” refers to a state or jurisdiction other than your formation state.) Foreign qualification generally requires filing an application for authority with the Secretary of State. A Certificate of Good Standing is often required as well. The LLC will also have to appoint and maintain a registered agent in each additional state.

Many factors are used to determine whether a company is transacting business in a state, and therefore needs to foreign qualify. Some of the common criteria include whether your company -

• has a physical presence in the state
• has employees in the state
• accepts orders in the state

Note that different states have different criteria. To determine whether your LLC needs to foreign qualify in a certain state, it is best to seek the legal advice of an attorney.

Comparing LLCs with other entity types

When forming a business, one of the most important steps is deciding on the business structure. There are several business entity options available that each present different advantages and disadvantages.

LLCs versus C Corps, S Corps, and DBAs
Understand the key benefits of LLCs, C Corporations, S Corporations and DBAs before deciding which entity type is right for you. Read our article Comparing company types: Understanding C Corp, S Corp, LLC and DBA Business Structures.

LLCs versus S Corps
While the S corporation and LLC both have pass-through taxation, the S corporation lacks the flexibility of an LLC in allocating income to the owners. Additionally, an LLC may offer several classes of membership interest while an S corporation may only have one class of stock. Visit our article on LLCs versus S corporations to learn about other key differences.

LLCs versus Partnerships and Sole Proprietorships
Learn about the advantages and disadvantages related to taxation, asset protection and other key criteria faced by LLC owners, sole proprietors and partners, whether general or limited partnerships in our article Sole Proprietorships, partnerships ,and LLCs are commonly used entities.

LLC state guides

When forming an LLC, one of the first steps is to choose your formation state.