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Do You Need an LLC to Start a Business?

by Louis DeNicola on
9/14/2020
in Personal Finance
a freelance photographer in her studio

The following is presented for informational purposes only.

If you’ve started a company or work as a freelancer or contractor, inevitably, the question of whether you should form an “official” company will come up. Some people may even put off working for themselves because they think they need to form a company first. However, with many types of work, you can start and build a successful business without registering a limited liability company (LLC) or forming a corporation.

What is a limited liability company?

A limited liability company (LLC) is a legal entity that’s separate from you, the business owner. You register an LLC with a state—it doesn’t necessarily need to be the state where you live—and the state’s laws dictate the costs and responsibilities of the business’s owners.

Often, there is an initial filing fee with the state and requirement to file a report (and possibly pay an additional fee) every year. You may also need to register your business with your city, which can come with its own requirements and fees.

You can do the process yourself, or hire a company to help you prepare and file the paperwork. However, forming an LLC isn’t a requirement if you want to run a business. You can start a business simply by beginning to sell products or services to others, and you’ll have what’s known as a sole proprietorship.

In fact, if you’ve worked as a contractor (perhaps for a rideshare or delivery app) and received a 1099-MISC, you may have already filed your taxes as a business owner, even if you didn’t realize it. A sole proprietorship can be a great way to start as there’s no additional cost to get started. However, there are also good reasons to form an LLC.

Form an LLC to limit your liability

Unlike an LLC, a sole proprietorship doesn’t draw a legal distinction between the business owner and the business. One reason many business owners form an LLC is for this extra layer of separation and, as the name implies, to limit their liability.

For example, if you have a sole proprietorship and one of your customers gets hurt using your product, the customer may sue you for damages. You could be personally liable, and all your personal assets could be at risk if you lose the lawsuit.

If your LLC sold the product, the customer may only be able to sue the LLC, but not you personally. As a result, the LLC may have to pay for damages. However, even if the LLC doesn’t have enough assets to cover the cost, the other party might not be able to go after your personal assets.

The level of protection than an LLC offers can depend on a number of factors, including your involvement with the business and whether you’ve taken adequate steps to separate your personal and business finances. If you’re registering an LLC for liability protection, it’s best to speak with an attorney who can help you draft the necessary documents and advise you on how to separate and protect your personal assets.

Choose a tax option that can save you money

Whether or not you’re looking to limit your liability, you may also be able to benefit from different tax rules that you can choose for the LLC.

By default, an LLC isn’t a separate tax entity—it’s a pass-through entity. This means that the money the business makes or loses gets passed through to the owners’ personal tax returns. It will be as if you’re running a sole proprietorship (or a partnership if you have business partners), and you’ll use the same tax forms.

However, you can also elect to have your LLC taxes as either a C corporation or S corporation, and use those tax rules instead. Being taxed as a corporation can add new responsibilities and costs, such as running payroll for yourself, but you may save more on taxes than you spend on administrative fees.

As with hiring an attorney to discuss the legal protections an LLC can offer, you may want to hire an accountant who is familiar with your industry and state to discuss the tax options. For a one-time fee, many accountants can create a side-by-side comparison of the total tax liability with each option.

Deciding if an LLC makes sense for you

More complex situations can make the business entity choice particularly important. For example, if you’re forming a business with several partners or if you plan on raising money from investors, then there are different trade-offs to consider. But for solopreneurs and freelancers, the decision to form an LLC often comes down to how risky their business is and whether they can save money on taxes.

If you’re just starting and there’s not much risk involved, sticking with a sole proprietorship often makes sense. As your business grows, you can reevaluate the situation and decide if you want to transition to a limited liability company.

Tagged in Earning extra income, Laws and legal questions, Taxes

A corporate headshot of Louis DeNicola.

Louis DeNicola is a personal finance writer with a passion for sharing advice on credit and how to save money. In addition to being a contributing writer at MMI, you can find his work on Credit Karma, MSN Money, Cheapism, Business Insider, and Daily Finance.

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