At What Point Do I Need an LLC? What You Need To Know

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Tom Smery

Tom Smery is a certified CPA for over a decade. In his free time, he writes articles to pass on his expert knowledge on taxes and accounting. Thomas has a wide range of deep knowledge on 1099 taxes, and finance topics. You can find him fishing when he is not preparing taxes for his clients or writing about accounting.

Limited Liability Company — or LLC — sounds more formal than anything your small business could ever need. But whether you've been in business for a while or you're just starting out, as a sole proprietor you may form an LLC (or limited liability corporation) easily, without taking too much time or incurring much expense, and with significant benefits.

Here’s what you need to know about when to start an LLC, the advantages (and disadvantages) of converting your business to an LLC, and how to go about doing so.

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When Should You Create A Limited Liability Company (LLC)?

An LLC is a business structure that protects its owners (or members) from being liable for claims against the business. This legal protection shields the LLC’s owners’ personal property from creditors seeking payment for the LLC’s debts, as well as from claims (such as for personal injuries) filed against the business.

When you form an LLC, you create a legal wall around your personal assets, but that personal liability protection doesn't change the way the business’ income is managed or taxed: for tax purposes, LLC’s remain pass-through businesses, just like a partnership, small businesses, or sole proprietorships.

As a business entity, the income the LLC generates passes through to its owners or investors and is taxed at their personal tax rate.

When a business owner has personal liability protection, they can't be held personally responsible if the business suffers a loss. This means personal assets (car, house, and bank account) are protected. If your business already earns a profit or if it carries any risk of liability, you should start an LLC immediately.

Many folks say you should form an LLC once you earn over $100,000. However, many lawyers insist you start an LLC from the get-go.

An LLC could help reduce the risk of your personal belongings being sought after. On top of that, it would be harder to transition your accounts and contracts from your name after you make the change. If you live in a State where creating a business entity does not cost much, you should consider the extra layer of protection.

Put simply, a sole proprietorship is useful for a low-profit and low-risk businesses. A sole proprietorship doesn't protect your personal belongings. When starting a business, an LLC is the best choice for most small business owners because they can protect your personal assets.

How are LLCs Taxed?

Unlike corporations, an LLC’s taxes are filed via its owner's (or owners’) personal income tax return. There's no such thing as an IRS form for Limited Liability Corporations. Once an LLC is formed, owners report profit or loss on their 1040, as they always have.

Different types of LLCs have their own tax processes:

Single-member LLCs file a 1040 using Schedule C
Multi-member LLC members each file a 1040
LLCs operating as corporations use Form 1120 and send out a Schedule K-1 detailing each member’s LLC profit and loss share. Each then completes their 1040, attaching Schedule E

As is true of sole proprietorships, LLC members are considered self-employed and must pay self-employment tax.

Your state may impose its own LLC taxes based on your business’ income, or annual registration fees, renewal fees, or franchise taxes. Though these fees are generally nominal, it's still important to investigate requirements to cut the risk of fines.

Can Anybody Form an LLC?

If a business offers professional services (i.e., attorneys, physicians, or CPAs), the LLC is referred to as a PLLC, or Professional Limited Liability Corporation.

There are a few types of businesses, including banks and insurance companies, that aren't permitted to form an LLC, but beyond that there are few restrictions. Foreign entities can establish LLCs, and so can corporations and other LLCs.

What Are the Advantages of Forming an LLC?

LLC’s are essentially hybrid entities, offering the advantages of being taxed and operating like a sole proprietorship or partnership while providing the personal liability protection enjoyed by corporations. The benefits you get when you form an LLC can be boiled down to five key aspects:

Eliminating liability concerns

As the name suggests, one of the key benefits to a Limited Liability Company is that it makes your business an entity operating separate and apart from you. Your bank account and personal assets are protected from the business' creditors and other claimants.

The protection provided an LLC contrasts with sole proprietorship or general partnerships, where owners’ personal assets (including homes and savings accounts) are at risk of being liquidated to pay the business’ debts.

Independence

For many business owners, the main driver to starting a business was no longer taking orders from a boss. Unlike corporations, a business owner who operates an LLC continues running their business without having to answer to shareholders for decisions they make. This is especially true if you form a single member LLC.

If you're concerned about issues of control regarding an LLC with multiple owners, you may include specific responsibilities within your LLC operating agreement to restrict others’ ability to overrule you.

Pass Through Tax Treatment

When business owners opt for a corporate structure, they get taxed on income they receive as shareholders and the corporation gets taxed too. By contrast, an LLC is able to treat profits the same way sole proprietors do — as pass-through income to be reported on their individual tax return, taxed at their individual tax rate. This holds true no matter the LLC structure, including partnerships and S corporations.

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Minimal paperwork

Though Limited Liability Corporations are offered many advantages enjoyed by corporations, they don't have the same administrative requirements. Though state dependent requirements exist, the formation of an LLC is generally a straightforward process.

Some states even waive the need to file the operational agreements others required. The most universal requirements include registering a business name and paying fees to the appropriate state office.

Choose your own profit-distribution plan

As an LLC, you have incredible flexibility in managing your profits. Sole proprietors who decide to shift to single-member LLC entities can continue exactly as in the past, continuing to enjoy 100 percent of their profits as income.

Though LLCS do have to comply with IRS rules requiring that distributions reflect genuine ownership interests and economic circumstances, beyond that they are generally free to divide profits among members based on ownership proportion or whatever distribution structure they agree to.

This is far different from partnerships, whose distributions are shared equally, or corporations which usually pay dividends based on ownership interest.

What Are the Disadvantages of Forming an LLC?

While you consider forming an LLC versus sole proprietorship, keep in mind that downsides do exist.

Piercing the corporate veil

Companies that opt for an LLC structure to protect their assets from liability may see those protections disappear if they aren’t careful about separating personal transactions from business transaction. The same is true if they're found to have perpetrated fraud or to have been negligent.

Consider the tax outcomes over a sole proprietorship

If you're operating a sole proprietorship you're already used to paying self-employment taxes, but members new to your LLC may be shocked to find themselves paying Social Security and Medicare taxes based on the business’ income. By contrast, if you form your LLC as an S corporation, owners will still have to pay the tax, but only on their compensation.

Dissolution Based on Member Departure

As a sole proprietor, you're the master of all that goes on within your business and the only one who can make the decision to dissolve the business.

By contrast, LLC existence is subject to the whims of its members: if one leaves (whether by choice, as a result of bankruptcy, due to disability, or death), the entire structure falls apart. This not only leaves all remaining members responsible for the entity’s obligations, but also means that the entire structure needs to be reestablished.

How to Form a Limited Liability Corporation

An LLC isn't difficult to establish. In fact, the rules around LLC formation are so simple you may be able to lower your cost by filing on your own. Read our guide to LLC costs. Though your state may have its own requirements, the basics are universal, and as a sole proprietor you may have already taken care of some of the basic steps.

They are:

Choose and register your LLC’s business name

Your name needs to be unique, so you’ll have to check to make sure it hasn’t already been taken. There are several resources available to do this, but the most reliable is usually online websites.

You’ll need to check on every state in which you do business. Once you’ve identified a name, you need to register it. There is generally a nominal fee for registration.

Some states also require that LLCs obtain business licenses or permits, while others require that owners publish a public notice indicating their intention to file Articles of Organization.

Identify and select a registered agent

Every LLC has to designate a registered agent that will receive official correspondence on its behalf. This agent may be somebody associated with your company, or a third-party company that offers to receive legal mail as a service. This individual or company’s name and address will be included on your articles of organization

Create and file articles of organization

The articles of organization refers to a document that contains your LLC’s identifying information, as well as how it is to be structured.

Apply for an Employer Identification Number (EIN)

Unless your LLC does not have employees, you will need to have an Employer Identification Number. This nine-digit number will be referenced within all of your federal tax forms.

Craft an operating agreement

Operating agreements contain information about the duties of management, how it is structured, what voting rights exist, and how profits and losses will be distributed. Not every state requires an operating agreement.

What Defines a Verbal Contract?

A verbal contract (formally called an oral contract) refers to an agreement between two parties that's made —you guessed it— verbally.

Formal contracts, like those between an employee and an employer, are typically written down. However, some professional transactions take place based on verbally agreed terms.

Freelancers are a good example of this. Often, freelancers will take on projects having agreed on the terms and payment via the phone, or an email. Unfortunately, sometimes clients don't pull through on their agreements, and hardworking freelancers can find themselves out of pocket and wondering whether a legal battle is worth all the hassle.

The main differences between written and oral contracts are that the former is signed and documented, whereas the latter is solely attributed to verbal communication.

Verbal contracts are a bit of a gray area for most people unfamiliar with contract law —which is most of us, right?— due to the fact that there's no physical evidence to support the claims made by the implemented parties.

When is a Verbal Agreement Legally Binding?

For any contract (written or verbal) to be binding, there are four major elements which need to be in place. The crucial elements of a contract are as follows:

Offer and acceptance: An offer is made and accepted by another party involved in the agreement;
Consideration: The involved parties must exchange something of value (money, a service, time, etc), this is known as consideration;
Intention and certainty: All parties must fully understand the terms of the contract and intend to make a legally binding agreement freely; and
Capacity: The parties must have the capacity to legally enter into the contract; they're above age and of a stable mindset.

Therefore, an oral agreement has legal validity if all of these elements are present. However, verbal contracts can be difficult to enforce in a court of law. In the next section, we take a look at how oral agreements hold up in court.

How strong is a verbal agreement in court?

Most business professionals are wary of entering into contracts orally because they can difficult to enforce in the face of the law.

If an oral contract is brought in front of a court of law, there is increased risk of one party (or both!) lying about the initial terms of the agreement. This is problematic for the court, as there's no unbiased way to conclude the case; often, this will result in the case being disregarded. Moreover, it can be difficult to outline contract defects if it's not in writing.

That being said, there are plenty of situations where enforceable contracts do not need to be written or spoken, they're simply implied. For instance, when you buy milk from a store, you give something in exchange for something else and enter into an implied contract, in this case - money is exchanged for goods.

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When are verbal agreements not enforceable?

There are some types of contracts which must be in writing.

The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:

The sale of real estate or vehicles
Real estate leases lasting longer than one year.
Property transfer following the death of the owner.
The case of a party agreeing to pay debt for someone else.
Any contract that requires more than a year to fulfil.
A contract involving and exceeding a specified amount of money (which varies by state).

Typically, a court of law won't enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.

Contract law is generally doesn't favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it's always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.

How are Verbal Contracts Enforced?

Verbal agreements can be proven with actions in the absence of physical documentation. Any oral promise to provide the sale of goods or perform a service that you agreed to counts as a valid contract. So, when facing a court of law, what evidence can you provide to enforce a verbal agreement?

How can you prove an oral contract?

Unfortunately, without solid proof, it may be difficult to convince a court of the legality of an oral contract. Without witnesses to testify to the oral agreement taking place or other forms of evidence, oral contracts won't stand up in court. Instead, it becomes a matter of "he-said-she-said" - which legal professionals definitely don't have time for!

If you were to enter into a verbal contract, it's recommended to follow up with an email or a letter confirming the offer, the terms of the agreement , and payment conditions. The more you can document the elements of a contract, the better your chances of legally enforcing a oral contract.

Another option is to make a recording of the conversation where the agreement is verbalized. This can be used to support your claims in the absence of a written agreement. However, it's always best to gain the permission of the other involved parties before hitting record.

Written vs Verbal Contracts: What's the Verdict?

Fundamentally, most verbal agreements are legally valid as long as they meet all the requirements for a contract. However, if you were to go to court over one party not fulfilling the terms of the contract, proving that the interaction took place can be extremely taxing.

So, ultimately, the question is: written or verbal agreements?

Any good lawyer, contract law firm, or legal professional would advise you to make sure you formalize any professional agreement with a written agreement. Written contracts provide a secure testament to the conditions that were agreed and signed by the two parties involved. If it comes to it, a physical contract is much easier to eviden in legal circumstances.

Freelancers, in particular, should be aware of the extra security that digital contracts may provide. Many people choose to stick to executing contracts verbally because they're not sure how to write a contract, or they think writing out the contract terms is too complicated or requires expensive legal advice. However, this is no longer the case.

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Say hello to digital contracts

Today, we have a world of resources available at our fingertips. The internet is a treasure trove of invaluable information, platforms, and software that simplifies our lives. Creating, signing, and sending contracts has never been easier. What's more, you don't have to rely on a hiring a lawyer to explain all that legal jargon anymore.

There are plenty of tools available online for freelancers to use for guidance when drafting digital contracts. Tools like Bonsai provide a range of customizable, vetted contract templates for all kinds of freelance professionals. No matter what industry you're operating in, Bonsai has a professional template to offer.

Benefits of written contracts

A written contract makes the agreement much easier to prove the terms of the agreement in case something were to go awry. The two parties involved can rest assured that they're legal rights are protected, and the terms of the contract are sufficiently documented. Plus, it provides both parties with peace of mind to focus on the tasks at hand.

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