The ABCs of LLCs: How to Structure Your Small Business for Success
Q&A with CPA Kyle Pearson
The small business landscape is changing, with a growing number of entrepreneurs leaving the corporate world to start fresh and go it alone. If this sounds like you, it’s important to understand the financial and tax implications of structuring a small business. In the first of a series of articles dedicated to small business success, Kyle Pearson, founder of Collective CPAs + Advisors, a boutique CPA firm specializing in business finance, tax, payroll, and benefits, shares what entrepreneurs need to know when venturing on their own.
Q: What is an LLC? And why do you recommend it over a sole proprietorship?
Kyle Pearson: These two designations are not necessarily mutually exclusive. An LLC can, in fact, be a sole proprietorship in the eyes of the IRS. An LLC is a legal entity that exists separately from the individual owner, but its tax classification for federal tax purposes is flexible. This is important in future tax and business planning.
An LLC also adds legitimacy to your business, which can add credibility when dealing with lenders, partners, vendors, and customers or clients.
A sole proprietorship doesn’t offer these benefits.
Q: There are so many things to worry about when starting a business. Why do you recommend forming a limited liability company or LLC?
Kyle Pearson: People just starting out may not understand the implications of selecting a business structure. But the structure of your business matters, regardless of whether you intend to grow your company to millions of dollars or be a work-lifestyle entrepreneur—someone who creates a business to pursue their passion or preferred work style.
And not dealing with the structure can cause a myriad of headaches, not to mention lost opportunities for tax savings down the road.
One of the most effective ways to protect yourself and your business is to form an LLC, where you’re the only owner. Forming an LLC from the beginning is as simple as it gets. It also provides a direct pathway for future tax-saving opportunities as you grow, not to mention the legal liability shield it can create.
Q: Why is this important at tax time?
Kyle Pearson: An LLC creates the separation between you and your business by clearly delineating your personal life from your business life. You must be able to distinguish business expenses from personal expenses if you’re ever audited. The IRS checks to ensure that your deductions are ordinary and necessary. That’s hard to prove when you haven’t separated your business from your personal life.
Establishing an LLC at the beginning allows you to future-proof your business. That’s because LLCs are some of the most flexible entities that exist. They have the unique ability to change how they are taxed.
For instance, as an LLC grows, it can evolve into an S corp, if that provides a tax advantage. It’s important to note that if your business is an LLC currently taxed as a sole proprietor and you discover down the road that switching to an S corp could yield greater tax savings, you can change the tax structure and take advantage of these savings with a simple election. And just as important, you can do this without completely reframing your business operations, such as registering for a new Employer Identification Number or EIN, payroll registrations, and licenses, among other changes. You can’t, however, incorporate a sole proprietorship without reregistering the business.
Q: Should I consider forming an S corp instead?
Kyle Pearson: In general, S corps are more complex and carry tighter government restrictions and regulations. They still protect owners from liability, but there are additional requirements over an LLC that is treated as a sole proprietorship.
Most businesses don’t need the S corp structure initially. But that could also happen down the road, and an LLC provides that flexibility.
Q: How do I set up an LLC?
Kyle Pearson: You can file online at your state’s Secretary of State website. The process usually takes about 15 minutes. Fees vary from state to state, ranging from $40 to $800, with the current average cost to form an LLC in the U.S. being $132. You’ll generally continue paying registration fees to the state each year.
Q: If my company is set up as a sole proprietorship, how do I switch it to an LLC?
Kyle Pearson: The basic steps to forming an LLC generally include filing articles of organization in the state where you work and drafting an operating agreement. You can generally file with the state online through your home state’s Secretary of State website.
It’s best to have an attorney draft your operating agreement, but you may be able to find and use boilerplates that exist for LLCs with one owner, known as single-member LLCs. You may also need to file for an EIN for the LLC to open a bank account in your company’s name.
Remember, the IRS will continue to view the LLC as a sole proprietorship by default, so you wouldn’t affect the tax classification of your company at this point without further election. Lastly, get yourself connected to a tax professional who is well versed in business tax and financial matters.
Kyle Pearson is a CPA and founder of Collective CPAs + Advisors.