If you want to limit your liability for the debts of your consulting business and also avoid paying high corporate taxes, a limited liability company (LLC) might be the business entity for you. An LLC is not the only business entity to choose from, and you might find you would prefer the ease of running a sole proprietorship or the tax benefits of a corporation. Further, if you are a licensed professional such as a doctor or an attorney, your state’s laws might prohibit you from forming an LLC. But if those considerations and constraints don’t apply to you, consider forming an LLC for your business.
A consultant is a broad term that includes a variety of professionals who provide advice in their field of expertise, such as marketing, technology, or human resources. Any kind of consultant can use the information in this article, but every business is unique. Take the time to consider your goals and the needs of your company to determine if you should form an LLC.
Reasons to Form an LLC
LLCs are a popular business structure among consultants, and for good reason. Some of the benefits the owners of LLCs enjoy include:
Limited liability: Owners of LLCs are not personally responsible for the debts and obligations of the business, as long as they follow corporate formalities. If someone sues an LLC, the owners’ personal assets like their homes and cars are not on the line to satisfy the judgment.
Flexible management structure: You can split profits and management responsibilities among the owners of your LLC in any way you see fit. In contrast, corporations are managed by a board of directors, and the corporation must make distributions in proportion to their shareholders’ ownership interests.
Pass-through taxation: Unless the owners elect C Corporation tax status, LLCs do not pay corporate tax on business income. The income “passes through” the business and the owners pay taxes on their share of the income on their personal tax returns.
Options for tax status: By default, LLCs report and pay taxes as sole proprietorships (for single-owner LLCs) or partnerships (for multi-owner LLCs). You can file paperwork to elect C Corporation or S Corporation tax status, which might allow you to avoid some self-employment tax and take deductions for fringe benefits.
Simple to form and maintain: As discussed below, you can easily create an LLC by filing paperwork with your state. Compared to corporations, LLCs have few administrative requirements.
Professionalism: Your clients might be more willing to trust and work with a registered business such as an LLC than with a business (like a sole proprietorship) that is not subject to registration requirements. By taking the extra step and incurring the additional costs of forming a separate business, you are demonstrating that you are committed to your company and your area of expertise.
Downsides of Forming an LLC
An LLC is not the best choice for every consulting business, and you might find that a sole proprietorship, partnership, or corporation would better meet your company’s needs (as discussed below). Some of the disadvantages of LLCs include:
Paperwork and filing fees: While LLCs are easier and less expensive to form than corporations, you will face some formation paperwork and filing fees, which you could avoid if you maintain a sole proprietorship or a partnership.
Higher taxes: Some states, such as California, charge a minimum franchise tax on all LLCs and corporations. Sole proprietorships and partnerships typically avoid franchise tax.
Duty to keep property separate: If you commingle your personal and business assets (such as using your personal bank account for your business), you could lose your liability protection. Sole proprietors and partners do not have the burden of separating their property.
Less attractive to investors: Investors typically prefer to put money into corporations instead of LLC,s because only corporations can issue stock. In addition, interests in corporations are easier to sell and transfer.
Not all licensed professionals can form LLCs (see below).
How to Form an LLC
To create an LLC, you must file paperwork with your Secretary of State, which your state might refer to as articles of incorporation or articles of organization. You should also create an operating agreement, which will provide the internal rules for how you will run your LLC, including how you will split profits and responsibilities among owners, and what happens to the business if the owners are no longer able to (or wish to) run it. As with any business entity type, be sure to research your local business licensing requirements and options for insurance. Click here to read more about forming an LLC.
Other Types of Business Entities for Consultants
You might consider other types of business entities, such as a sole proprietorship, partnership, or corporation. Each entity has a different structure, as well as the following advantages and disadvantages:
Sole Proprietorship: If you own the business by yourself (and in some states with your spouse) and do not register the business, you own a sole proprietorship. Like LLC owners, owners of sole proprietorships avoid corporate tax. The downside is sole proprietors are personally liable for the debts and obligations of the business.
Partnership: When you own a business with one or more other people and you do not register it with the state, you have a partnership. As with sole proprietors, partnerships avoid corporate tax, and the owners are personally liable for the debts of the business.
Corporation: The other option is a corporation, which offers liability protection and is attractive to investors, but is more expensive and time-consuming to form and maintain. Click here to read more about how to create and run a corporation.