Incorporating an LLC: A Simple Guide
Every business owner hopes that their business is sustainable and can grow. While expansion from an LLC to a corporation isn’t the end goal of most owners, it’s a sign that the company is growing. For one thing, incorporation gives businesses access to more funding from external sources.
Incorporating an LLC is no small task, but not to worry; we’ve got all you’ll need to know covered in this guide.
LLC vs. Corporation
First, let’s make a distinction between limited liability companies and corporations.
Limited Liability Company
A limited liability company is one of the most common options for small business owners. That’s because it offers protection from liability, is flexible to manage, and also gives great tax advantages. Such a company exists as a legal business entity, separate from the affairs of its owner, hence the name - limited liability company.
This means that LLC owners cannot be held liable for any debts or liabilities related to the business. Personal properties are unaffected in the event of bankruptcy, which is a pretty substantial advantage, especially with how volatile going into business can be. LLCs are straightforward with their structuring, which can make business operations smoother.
Another simple-structured option is a DBA, also known as Doing Business As. It’s a side conversation, but be careful not to mix them up. As similar as they may be, DBA vs. LLC comparisons will show you just how different they can be.
Let’s talk about taxes for a moment. Operating an LLC means you get pass-through taxation, which means that tax is not levied at the entity level. Income or losses made by the LLC are passed through to the owner. The owners must then report these on their personal tax returns and make any necessary tax payments. If there is more than one person running the business, a tax return must be completed.
LLC tax benefits are just one reason to open this type of company. Other advantages of an LLC are raising credibility (an LLC is more likely to be considered trustworthy than a partnership or sole proprietorship) and having limited compliance requirements.
Putting LLCs one up in the sole proprietorship vs. LLC debates, limited liability companies do not have to endure the strict compliance requirements that sole proprietorships and other business types (general partnerships and even corporations) face.
On the flip side, however, the disadvantages of an LLC cannot be ignored, either. For one, this type of company generally costs more to establish and run. In some states, you will have to pay an initial formation fee, and many others charge annual report fees, franchise tax fees, or other levies.
Additionally, transferring ownership of a limited liability company is tough work. It is usually seamless only when all the members agree to add new members or alter how much each owner has. LLCs also have a hard time getting credit facilities from banks and other financial institutions, and when they do, they are usually secured with personal wealth as a guarantee.
Creating an LLC might be simpler, but corporations also have their advantages. You can choose to form either of the two corporation types; a C corporation or an S corporation.
S corporations are pass-through entities, so establishing them isn’t that much different from forming an LLC. S corporation owners are taxed on the corporation’s profits and losses. On the other hand, C corporations are taxed at the corporate level, meaning the tax accrued is corporate income tax, separate from the business’s owners.
Advantages of Running a Corporation
C corporations are the most popular corporation types. This is because they have the distinct advantage of profits remaining within the business, eventually being paid out as dividends to the shareholders. Raising capital under a C corporation is also somewhat easier, as they can issue shares to public buyers.
Another advantage of corporations has to do with excess profits. There is more flexibility with the extra profit made by corporations, as opposed to the LLC business model. All the income earned in a limited liability company goes back to the owners but in S corporations, income (and losses) are passed on to shareholders, who will then report it in their individual tax returns.
This means that S corporations do not pay corporate tax, meaning they have fewer expenses and can save more money (for context, corporate taxes are usually higher than ordinary taxes). As a bonus, if the corporation can meet some regulations, dividends paid are also tax-free.
Corporations are not without their disadvantages. C corps face double taxation, as they are also required by law to remit a portion of their income as federal corporate tax annually. That’s another deduction from shareholders' earnings.
While having a good structure is great, it also comes with many formalities. To run a corporation legally, you must have an appointed board of directors, and schedule and hold board and shareholders’ meetings, among other structural and managerial requirements. In a nutshell, incorporating means spending more on expenses.
Steps to Incorporating an LLC
Before we dive in, if being taxed as a corporation is what you seek for your limited liability company, then there is a way to go about that without needing to incorporate. Incorporating LLCs can be tricky, and there is no reason to do it if all you seek are tax benefits.
If incorporation is truly your end goal, however, then there are two ways to achieve this conversion:
- Statutory merger
- Statutory conversion
Incorporating an LLC through a Statutory Merger
Statutory mergers are especially useful when an LLC operates in a state like Arizona, which prohibits the other method of incorporation; statutory conversion. To convert by statutory merger, your LLC would need to:
1. Form a New Corporation
Becoming an LLC with full incorporation status would require the creation of a new corporation. You would have to file a Certificate of Incorporation to the Secretary of State.
2. Merge the New Corporation and the LLC Together
Next, you should begin a merger process between this new corporation and the LLC. As the LLC is absorbed into the company, ownership percentages are converted into shares in the new corporation.
Incorporating an LLC through Statutory Conversion
Using statutory conversion to make your business an LLC with corporation status is the easiest incorporation method. However, as mentioned earlier, some state laws do not allow it. In the states where it is not prohibited (say, California), the process isn’t always the same but does follow a similar pattern. To incorporate an LLC using statutory conversion, the owners must:
1. Unanimously Agree To Incorporate
There has to be a mutually agreed-upon plan for the incorporation. All members should typically be on board with the decision to incorporate the LLC, or it will not be a smooth conversion.
2. File a Certificate of Conversion to the State
Next, you must file a certificate of conversion to the state and other documentation such as the articles of organization of the LLC.
3. Issue out Shares to the Public
Issuing shares is the next step. As mentioned earlier, all ownership percentages will be converted into shares. This enables the business to issue shares to investors and the general public. Once the conversion is completed, the limited liability company is dissolved and is now a corporation.
Incorporating an LLC is challenging, but it can be made easier by getting a company that can help you with your LLC. Besides setting up an LLC and helping save you resources, LLC services can help you avoid mistakes while preparing and submitting your paperwork.
What Happens if I Can’t Incorporate My LLC?
It is a very rare occurrence, but if you fall under the category of LLCs that can’t be incorporated either by statutory conversion or merger, you may have to use a different tactic. This alternative method is called a non-statutory conversion. Being the last resort, though, it is a very complex process. You should contact the services of an experienced tax lawyer.
What Will Happen After an LLC Is Incorporated?
Now that your LLC is incorporated, what changes? Here’s what you should expect with the incorporation:
- A board of directors will be appointed.
- A certificate of incorporation will be submitted to the state.
- Business operations will adopt corporate bylaws.
- Annual board meetings and annual shareholders’ meetings will be held to make resolutions to key decisions. Meeting minutes will also be taken.
- Stock certificates will be issued to shareholders.
- The business will start paying corporate tax.
- Annual reports will be filed with the Secretary of State. Reports vary by state, but you can expect to include the company’s name and address, details of directors and officers, tax identification, business purpose, number of issued shares, and all authorized signatories or registered agents.
Again, enlisting the help of a capable LLC service makes all these new processes and changes easier to get through, so unless you know what you’re doing, it’s highly advised to get one.
Necessary LLC documentation includes:
- Internal Revenue Service (IRS) Form SS-4 (which is used to apply for an Employee Identification Number),
- Articles of organization,
- Operating Agreement,
- Name reservation application,
- Tax registrations,
- Business licenses (such as home occupancy permits, premises permits, and professional licenses),
- Initial and annual reports.
LLCs typically have two types of management structures. The first is a member-managed structure in which the business is managed by one or more members. Under the second type, a manager-managed system has the business’s affairs overseen by an appointed manager.
In member-managed LLCs, all members have the authority to make binding decisions for the company. Members of manager-managed LLCs can make structural decisions in the company, such as choosing who the manager will be, but they cannot make binding decisions.
LLCs are taxed on a pass-through basis, meaning earnings are passed straight through to owners, and they don’t need to pay corporate federal income taxes. Instead, taxes are paid as personal income taxes.
LLCs also have tax flexibility, meaning they can choose how they should be taxed: as S or C corporations or as a sole proprietorship and partnership. Ultimately, the benefits are tax flexibility and being taxed at lower rates.
Only one person is needed when incorporating an LLC company. Even though it’s not a common occurrence, many LLCs in the US are run by individuals.
Julia A. is a writer at SmallBizGenius.net. With experience in both finance and marketing industries, she enjoys staying up to date with the current economic affairs and writing opinion pieces on the state of small businesses in America. As an avid reader, she spends most of her time poring over history books, fantasy novels, and old classics. Tech, finance, and marketing are her passions, and she’s a frequent contributor at various small business blogs.
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