Do You Really Need an LLC?

What is an LLC and why do you need one? How is this better than a corporation? This episode covers the 4 common types of business entities small business owners can choose from and the pros and cons of each one.

Key Takeaways

• There are 4 main types of business entities small business owners can choose from: sole proprietor, partnership, LLC, and corporation
• Sole proprietorships and partnerships provide zero liability protection - if you get sued, your personal assets are at risk (house, car, savings, retirement accounts)
• Forming an LLC is the best and simplest way to protect your personal assets (house, car, savings, retirement accounts) from the risks of doing business

Resources Mentioned

• Download the 9-Step Checklist
• Watch the free masterclass
• Follow Amy on Instagram @artfulcontracts

Next Steps

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Episode Transcript

Everybody says you should form an LLC, but what does that actually mean? How is it different from what you're doing right now? That's what we're talking about today. The different types of entities that you can form for your business, and why an LLC is usually the best choice for a lot of people. How to tell if that is you. Let's get into it.

Hey, I'm Amy Nestheim, licensed attorney for online business owners and founder of my own business, Artful Contracts. You're listening to Legal Made Easy, the show that makes the legal aspects of online business easy to understand and implement so you can grow your business with confidence knowing you've got it all covered. Let's dive in.

First things first, what we're talking about is the legal structure of your business. The phrase business entity just refers to, under the eyes of the law, how is your business treated? What type of container, what type of legal person, what type of theoretical object is it? I say it like that because business entities, the legal structure of your business, that's all we're talking about, the legal structure of your business, it's all a fiction, right?

People came together a long time ago and said, we want businesses to be separate from people. We want to have a business that exists outside of the individual person who owns it. And we want to have multiple people be able to own something. And that's how, you know, laws were written and business entities came into place. And obviously, there's way more detailed history than that that you don't need to know. But basically, it's a legal fiction. It's something that the laws decided that this thing exists. Let's make that a little bit more concrete.

For online business owners, for service providers, coaches, consultants, course creators, there are basically four types of business entities, legal structures for your business that are available to you. Two of them happen by default, and two of them happen with intention. You have to actually go out and create it.

Here's a list: sole proprietorship, partnership, limited liability company, and corporation. Those are the four basic choices. There are more than that that exist out there in the world, but for right now, what's important for you as a small business owner is these four.

We're gonna start with the default. So if you are, if you own your business and you're just one person, you don't have a partner, by default, your business structure is sole proprietorship. So it is like it sounds there is a sole proprietor, there is a single owner, one person who runs the business. That's the default. So you don't have to do anything to create it. It's just what a business owner is called when there is no other legal structure attached to the business. In a sole proprietorship, there is no legal distinction between you and your business. You are one and the same. You are your business, you're the same legal person. You can't own things separately from your business. Anything that your business owns, you actually own it. And that also means that any debts or obligations that your business has, you have them. There is no separation. The benefit of this is that you don't have to do anything to create it. You just start your business, you sell things, and you're a sole proprietorship. And there's no implications for taxes, you just pay your regular taxes, you put it on your Schedule C, and there's no extra hoops to jump through there.

On the other hand, you have zero liability protection. Yes, you can get insurance, but what you don't have is separation between you and your business legally. If your business gets in trouble, if your business gets sued, if your business has a debt, you are personally responsible for that obligation, for the money, for the lawsuit, for the debt in your business. You're personally responsible. That means that that money can come from your personal accounts, your personal savings account, your house, your car, your retirement savings. If there is a lawsuit against you and the court levies a judgment against you, they can put a lien on your house to pay for that judgment.

So to recap, it's the simplest to create because you don't have to do anything, but it also doesn't create any distinction between you and your business, which means you're responsible for everything in your business. You and your business are one and the same, legally speaking, and all of your money is up for grabs.

The next option is similar, but it's if you have a partner. So the default rule: if you operate your business with someone else and you both think of yourselves as owners of the business, but you have not formed any type of legal structure other than that, you are considered a partnership by default in the eyes of the law. You are joint owners of your business, and that means that you own everything together. You own all of the income together, and you also own all of the liabilities together.

By default, it's split 50-50. If you have a partnership agreement, if you put something writing formally, then it can be split in terms of what assets you contributed to the business or however you want it to be. The drawback with a partnership is that both partners can make decisions for the company, and both partners are equally responsible for those decisions. That means if your partner goes out and gets a business loan without you knowing about it, you are personally responsible for that obligation. That money can come out of your accounts, your personal accounts, your savings, your house. Same as with a sole proprietorship, except this time your partner went and got that, got that loan or uh got sued and now it's on you because you are equally in legal terms, jointly and severally, liable for that obligation. For this reason, I do not recommend forming a partnership. If you have a partner, get an LLC or form a corporation. If you're running your business with someone else, be intentional about your business structure or you can get yourself in trouble.

So I just mentioned the next two options, and these are the intentional options. So by default, if you're one person, you have a sole proprietorship. By default, if you're two people, you have a partnership. If you want an LLC or a corporation, you actually have to put effort into creating it. All it takes is filing some formation documents and writing up either bylaws or an operating agreement, and you're good to go. It exists, but it's not, it's it's non-zero effort, basically. Non-zero effort.

All right, so what are these two and whether the what are the differences and which ones should you choose? So a limited liability company, an LLC, that's what LLC stands for, limited liability company. This is probably the most common, besides a sole proprietorship, it's the most common choice for business owners, for small business owners, because it's pretty easy to set up and maintain. Taxes are pretty simple, but you also get the benefit of liability protection that you don't get in a partnership or a sole proprietorship.

Here's what that means. When you create an LLC, you are creating a separate legal person from yourself. The business exists separate of you. You own the business, but you are not the business. You're creating a legal wall in between your business assets and your personal assets, in between your business debts and your personal debts. They are not one and the same. That means that your business can enter contracts and you are not personally on the hook for those contracts. Your business can get debts or get sued and you are not personally responsible.

That means if you get sued in your business for something that went wrong in your business, then your personal accounts, your house, your retirement savings, your car, anything that you own personally outside of the business is totally safe. It is not on the hook if you're managing your LLC properly.

This is obviously really attractive because it takes some of the risk out of running a business. If you get sued, the only thing that's at stake is whatever money is in your business bank accounts. Worst case, you run out of money in your business, but you still have your house. LLCs are also attractive for small business owners because they're super simple to set up and run. There are not a ton of formal requirements for maintaining an LLC. There are some things you have to do. You have to have separate business bank accounts, you have to keep track of your bookkeeping, you have to keep your money separate, and you have to file in your reports, but it is a lot easier to run than a traditional, the original traditional business structure, which is a corporation. And they're also, they also have tax benefits.

So an LLC is considered a disregarded entity by the IRS. Basically, it's invisible to the IRS. The IRS pretends it doesn't exist and you're taxed in the same way if you're a single person, if you're a single owner of your LLC, if you don't have a partner, you're taxed in the same way as the sole proprietorship. If you have a partner, you're taxed in the same way as a partnership. It's just it's your regular taxes with the schedule C on it, or a schedule K if you have a partner. This avoids double taxation, which you have in a corporation, which I'll get to in a second. So basically, if you want liability protection without tons of complication, an LLC is a good choice.

The last option is a corporation. This is the most complicated type of business, the most formal type of business entity. Setting it up is very similar to an LLC. You file paperwork, you pay a fee with a Secretary of State just like an LLC, but running it is more complicated. There's more formality than an LLC. You have to have a board of directors, you have to have officers, so management is more complex. You can't do it with just one person. You also have the fund problem of double taxation. If you're one person, it doesn't make any sense. Here's what this means corporations are taxed at the corporate level. The profits of the corporation are taxed. And then you get you take a salary, if you're the owner, you take a salary out of the business or you take distributions out of the business. You also have to pay taxes at the personal level.

So first, the profits of the corporation are taxed. And then second, your income is taxed as the owner. With an LLC, the LLC doesn't exist, and you're only taxed one time on that for the money that you actually take home. So this is why an LLC is more attractive to most small business owners than a corporation. The only reason a corporation would might make sense is if you want to have silent investors, LLCs can have multiple owners and they can have owners that own small percentages, and they can have owners who are not involved in the management. But if you want to have a lot of owners, let's say more than five or ten, and they don't want to have to deal with the day-to-day management of the business, then maybe a corporation is a good choice.

All right, so now you know the differences between the different types of entities. How do you make the decision? So basically, if you're a single person running a business, you already made a choice, you chose a sole proprietorship. That doesn't mean that choice is forever. You can change your mind. You can go out and switch over to having an LLC. And we're gonna have another episode on the steps to making that transition and things that you have to do after just filing the paperwork to make sure you followed through all the way. But already you have a sole proprietorship.

If you have not done anything else, you have a sole proprietorship. And that might be okay. That might be fine if you're just starting out, if you won't be taking on much debt, if your business isn't super risky, then that could be fine. And you know what? The other thing is cash flow, right? The cost of LLC formation varies widely across the states.

In New Hampshire, it's $100. In California, it's $800. In Illinois, I think it's even more than that. So if you're not making any money yet, it might be tough to swing $1,000 to form your LLC. Depends on where you live. So definitely look into what the price is for that filing fee before you decide.

But if you're gonna be doing high ticket, if you're gonna have a really high volume of sales, those are things that are a little bit more risky. And so you might want the LLC protection. An LLC is a good choice. If, like I said, you have high risk in your business. If you have a partner, definitely form an LLC. If you're gonna be taking on debt, if you have startup debt, or if you just own things that you want to keep.

If you own a house, if you have a good amount in savings or retirement that you want to make sure is protected, if you have kids and you want to make sure they're insulated from the risk of your business, or if you're gonna be hiring employees, that is another risky thing, then those are all reasons to form an LLC. I reiterate, don't pick a partnership. There's just no good reason to do it. You don't have any advantages with a partnership that you can't get with an LLC.

And generally speaking, you don't need to form a corporation, you just need an LLC, unless you are gonna be taking on big investors who don't want to be involved in the daily operations of the business and have some other reason that they don't want to have an ownership interest in an LLC.

Now I know somebody's gonna say, well, what about S-corps? That's a corporation, right? That's a conversation for another day, but just know this: you can choose as an LLC to be taxed as an S-corp. S-Corp is a taxation decision, it's not a type of entity. So I'll do another episode on what an S-Corp is and when to choose to be taxed that way. But just by choosing an LLC, you're not limiting yourself there. You can still be taxed as an S-corp if you have an LLC.

All right, there you have it. That is the four types of entities that small business owners can choose, what the differences are, and how to make that decision for yourself. It's gonna be a pretty personal choice because it depends on your income, your risk tolerance, your long-term decisions, whether you have a partner, all that kind of thing.

But basically, if you want to make sure your personal assets are protected and/or you have any good amount of risk in your business, an LLC is a good choice. Another thing, if you haven't already, I definitely encourage you to go back and listen to episodes two, three, and four of the podcast because those walk through the nine steps to start and run your business legally. And that is a great resource when you're just getting started. And there is also a free checklist guide that goes along with that so that you don't have to memorize it and you have a nice little handy cheat sheet when you're going through all of those steps.

And if the podcast has been helpful for you, if you're enjoying it so far, I would so appreciate if you would head on over to Apple Podcasts and leave a review. That really helps me so much. I love reading them. We've gotten some great ones so far. It really helps us a new podcast as we're getting started. Thanks again, and I'll see you next week.