How to form an LLC the right way

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Getting a business off the ground is hard work. But it’s only part of the battle. There are some legal hoops to jump through too.

One of the first steps is registering your business a separate entity, like a limited liability company. There are obvious advantages to doing so, such as protecting against personal financial liabilities should anything with the business go wrong. There can also be tax advantages with an LLC, or it can be a stepping stone before moving to incorporate.

Filing the paperwork and learning what forms are necessary for approval can be seem daunting if don’t know where to begin or if you’re just starting your first businesses with limited resources.

In fact, the process was so frustrating for entrepreneur Matt Horwitz that he decided to quit his job as a web designer to build LLC University, a tutorial site that helps others through the process. He makes money off the national site by linking to recommended services. Since 2010, he’s built step-by-step guides for the approval process, which can be more confusing in certain states compared to others.

Matt Horwitz, founder of tutorial site LLC University, has been blogging about LLC formation for over six years.
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“It took me six months to create a course for Pennsylvania, it took me three months to create [ the course for] Florida, and at that point I knew I wanted to go national,” he says.

Luckily, despite the differences in costs and protocol across state lines, the best practices are generally maintained. Here’s what Horwitz recommends it will take to get it done right, which took one New York-based CNBC Make It reporter as little as an hour and a half to complete.

1. LLC Name Search

Your LLC name will have to be unique. Search your desired LLC name on your state’s Secretary of State website to make sure it’s not already taken. The name generally should end with an allowable designator. In New York, for example, that means ending with “LLC,” “L.L.C.” or “Limited Liability Company.”

2. Registered Agent

A registered agent is a person or company who agrees to receive legal mail, like a subpoena or complaint, on behalf of your LLC. While you could technically serve as your own registered agent and use your own address, it increases your odds of getting spam mail and other unsolicited messages. That’s part of the reason why online filers like LegalZoom and incFile offer the service for a charge. In New York, things are different. By default, the Secretary of State is the Registered Agent for all companies (unless you choose otherwise).

3. Articles of Organization

This is the document that officially forms your LLC with the state. It can go by other names in certain states, such as Certificate of Organization or Certificate of Formation, but is always filed with the office of the Secretary of State. In New York, it costs $200, which is higher than the $135 average LLC filing fee across the US, according to Horwitz. The form can generally be can filed online for instant approval or mailed for approval in a couple of weeks.

4. Operating Agreement

An LLC Operating Agreement is where you will list the owners (called “members”) of your LLC, as well as how much of the business they own. It’s possible to have just one member with total ownership, or you can have multiple members and split the ownership any way you’d like.

5. Employer Identification Number

Part of the reason people file for an LLC in the first place is to set up an independent entity that’s separate from their personal finances. Key to this is the EIN, or Employer Identification Number (also referred to as a Federal Tax ID Number). It is assigned by the IRS after your LLC is approved. The number is used to identify your LLC for reporting purposes with the IRS. In just minutes, an LLC approved at the state level can receive an EIN online from the IRS for free.

6. Opening a business bank account

To open a bank account for your LLC, you’ll need your Articles of Organization (or similar document), the LLC’s EIN, and generally two forms of identification. It’s a crucial step that is necessary to fully finish the process of creating a separate financial entity for your business. Operating an LLC with a personal bank account all but defeats its purpose, according to Horwitz.

7. File Annual/Biennial Reports

Most states will have an annual report requirement that essentially requires keeping your LLC’s contact information up to date with the Secretary of State. Some states, like New York, have a biennial requirement that costs $9 to file every two years by the end of your LLC’s anniversary month.

Completing these steps would normally complete the process of forming an LLC in Texas. Certain states, however, have more hoops to jump through. New York, Arizona and Nebraska, for example, all have laws that pre-date the internet requiring LLCs to publish notices in newspapers. Notifying the public with newspaper ads in New York for six weeks, as required by state law, can cost over $1,000 in more expensive counties, according to Horwitz, or more than five times the cost to file the LLC in the first place.

After all that, you’ve successfully formed a legal LLC. If you’re ever unsure about any of the steps in your state, consider calling the respective office of secretary or seek help from an attorney.

LLC Taxes

Because a limited liability company (LLC) is a pass-through tax entity, it means that profits pass through the company to individual members. As a result, the individual members (rather than the company) must report the members’ share of the profits on their individual tax returns. The IRS treats an LLC as a sole proprietorship, a partnership, or, if the LLC elects, as a corporation for tax reasons.

Filing Federal Income Taxes as a Multi-Member LLC

The IRS automatically treats an LLC with more than one member as a partnership, unless the LLC opts for tax treatment as a corporation. Like a business partnership, the LLC must file Form 1065 (U.S. Partnership Return of Income), which includes a Schedule K-1. The LLC must report the profits and losses that pass through to each member on individual Schedule K-1 forms. Each member must report this information on a 1040 tax return and attach a Schedule E.

The IRS requires LLC members to pay taxes on their distributive share of the profits. In general, a distributive share is equal to the percentage of each member’s interest, but the LLC can distribute profits disproportionately. This is referred to as “special allocation.” Regardless of whether the LLC actually distributes any of a member’s distributive share, each member must still pay taxes on their entire distributive share.

Paying Self-Employment Taxes

The IRS requires LLC members to pay federal self-employment taxes on the profits received. Members must pay self-employment taxes if the member is “active in the business.” As a guideline, this means that the member participates in the trade or business for more than 500 hours in the tax year or the member works in an LLC that is a professional service business in the field of health, law, engineering, architecture, accounting, actuarial, or consulting. The IRS may not require non-active LLC members to pay self-employment taxes.

Members must report self-employment taxes on a Schedule SE. LLC members are responsible for paying the entire 15.3% (12.4% for Social Security and 2.9% for Medicare). Members can deduct half of the self-employment tax from their adjusted gross income.

Filing Federal Income Taxes as a Single Member LLC

When an LLC has a one member, the IRS automatically classifies it as a sole proprietorship for tax filing purposes. The member of the LLC must file a 1040 income tax return and report profits and losses on a Schedule C (“Profit or Loss From a Business”).

Paying Estimated Taxes

Taxpayers employed by an employer pay taxes through withholdings from a paycheck. Because profit distributions made to members in an LLC do not include tax withholdings, LLC members must pay estimated taxes on a quarterly basis to the IRS and to state governments (if applicable), similarly to self-employed taxpayers.

Filing State Income Taxes

LLC members must also file state income tax returns. Like the federal government, most states allow LLC members to pay taxes on profits through personal tax returns. A few states also require members to pay an additional tax on the income made by the LLC. For instance, a member may have to pay a tax on LLC income that exceeds a certain amount. Other states may require the LLC to pay an annual fee, sometimes called a “franchise tax” or a “renewal fee.”

Electing Corporate Tax Treatment

A limited liability company can choose corporate tax treatment. Because LLC members must pay taxes on all profits, this option may be beneficial if the LLC chooses to keep a significant amount of profits will in the business to contribute to the LLC’s growth.

It may also save individual members on taxes: corporate tax rates range from 15% to 34% on net taxable income under $100,000 and 39% on net taxable income between $100,001 and $335,000. Individual tax rates range from 10% to 35%, but on average, individual taxpayers pay from 27.5% to 35%. An LLC may elect corporate tax treatment by filing Form 8832 with the IRS and the LLC must file Form 1120 each year the election applies.