I often get asked, “Ok, how do I make my business idea official?  Do I need to setup an LLC?”

The answer, in most of the situations I see, is “No, not yet.”

When should you use an LLC (Limited Liability Company)?  What are the benefits of it?  If I’m not organized as an LLC, what am I?  The answers are important to understand when starting and growing a business.

By default, unless otherwise specifically designated, any individual engaging in a business venture is considered a “sole proprietorship.”  In a sole proprietorship, there is no legal distinction between you, the owner, and the business.  Income taxes in a sole proprietorship are recorded and paid via a Schedule C form on your personal tax return.

The primary advantage of a sole proprietorship is simplicity.  There are no annual reports outside of your taxes.  Nothing to set up aside from a basic DBA designation (doing business as) so you can open a bank account in the business’ name.  You don’t have to do two tax returns, just an extra form on your personal form.

To settle a common misconception, a sole proprietorship can “write off” (take as a tax deduction) everything that a corporation or LLC can.  With very limited exception, the same expenses deductible by law for an LLC or corporation are deductible for a sole proprietorship.  So if your friend is taking their family to Hawaii and claiming they can do it because they have a corporation, either their entire family has legitimate business there, or they’re not following tax regulations, and we can hope for their sake they don’t get audited.

When just starting out, I don’t recommend immediately moving to an LLC in most cases because the real benefits of an LLC don’t apply right off.  Let’s look at the two major advantages of an LLC.

First, an LLC creates a separate legal entity from yourself.  This is very beneficial if someone were to take legal action against your business.  An LLC (remember, Limited Liability Company) creates a “corporate veil” that in most states protects the individual owners/members of an LLC from legal action against the business.  This protection is extremely valuable if you have a significant net worth, high income, or other notable personal assets.

Let’s look at an example.  Let’s say (God forbid, but crazier things have happened) that a groomer/driver for Josie’s Mobile Dog Wash Service, LLC (fictional company) caused a wreck that permanently disabled another individual.  Let us also say that the insurance coverage for the business ran out after $500,000 in damages, so Josie’s Mobile Dog Wash Service, LLC was on the hook for another $300,000.  The whole situation would be horrible, and the business might even shutter following an event like that, but Josie would not have her personal assets like her home and retirement funds levied to pay the bill.

If you have significant personal assets or will be starting a business in an overly-litigious industry, an LLC will serve you well.  Most of the businesses I consult with don’t fall into either of those categories, so generally speaking, my answer is “not yet,” simply because the business is not large enough to be the target of a lawsuit.

The second benefit to having an LLC is a tax benefit, providing that the LLC makes a certain election regarding how it is taxed.  By default, an LLC is a pass-through entity, meaning all the income and expenses, and therefore net profit flow through onto a Schedule C form, somewhat like a sole proprietorship.  However, an LLC can make a designation to be taxed as an S-corporation, C-corporation, or partnership.

If the LLC elects to be taxed as an S-corporation, the owners may take a share of compensation as wages/salary (because they work in the business) and a share of compensation as a shareholder distribution (because they own the business).  This distinction is important because wages are taxed at a higher rate (your incremental income tax rate + Social Security + Medicare) versus shareholder distributions, which are taxed at the capital gains rate of 15%.  Consult a CPA in your state to set up a payment schedule for wages and shareholder distribution that is acceptable within IRS regulations.

These two primary benefits of an LLC, liability protection and tax savings, don’t generally apply to businesses that are just starting out.  Therefore I say to small startups, don’t worry about it, just file as a sole proprietorship for now, then go out and make some money!  Once you’ve got some cash flowing in, then we can worry about an LLC; for now, just go build your business!