Prior to establishing a Limited Liability Company you should ensure that this entity format is the best for your business. The LLC only has real value if a well written ‘Operating Agreement’ is drafted. Without this highly developed and detailed document, there will be nothing to gain from the Limited Liability Company formation. You will be as well served with the traditional corporation entity format or as a sole proprietorship depending on the circumstances. I strongly urge you to read my other articles explaining each of these different business formations:
In addition, I have written an introduction article about the basic principles of a Limited Liability Company. Read: Limited Liability Company – Introduction to Basic Principles.
The LLC is really beneficial for those that are well versed in the respective financial flexibility and control issues. It is designed for the more sophisticated business entrepreneurs. If your business circumstances fit the dynamics of this entity format and you are willing to spend the necessary amount to create a Partnership Agreement that will suite your needs, then the following is a step by step process to set up the Limited Liability Company.
The key is to understand that you must be certified by your state first prior to applying with the Internal Revenue Service.
- Choose a name following the guidelines the state issues for legal names of Limited Liability Companies. It must be unique; most states have an online database that allows the reader to review existing names. In general, each state will recognize the applicant if the name is discernable from the existing pool. As an example, Best Buy LLC and Best By LLC may not be distinct enough to be acceptable if one of the names already exists. However, Best Buy LLC and Best By Jim LLC would be unique enough to meet the standard. Often, you have to submit the name and allow the state to determine acceptability.
- Most states require a set of ‘Articles of Incorporation’ which identify the date of creation, initial directors, and initial ownership percentages. Each state is slightly different in what is required in these articles. Often a recognized format of the articles is online for the state and you simply fill in the blanks. Some states require you to file the articles with more than one department. The most common file holder is the Secretary of the State and/or State Corporation Commission, Department of Commerce or a Division of Corporations and Commercial Code.
- Generate a ‘Membership Agreement’ which is akin to a Partnership Agreement. There is a series of articles on this site in the legal section of Basic Business Principles that explain the partnership agreement. In an LLC, the term member is used instead of partner. This is a legal way of making sure that outside parties are aware that this is not a partnership but a limited liability company. If you understand a Partnership Agreement, then you’ll have the foundation for a Membership Agreement. Often attorneys will use the term ‘Operating Agreement’ instead of membership agreement. The key for you is that the format, presentation, and concepts are all the same in all three types of agreements. The primary difference is whether the term ‘Member’, ‘Partner’ or ‘Operator’ is used.
- File for the required respective licenses and local permits. Many local or county governments need your Internal Revenue Service identification number to complete the application. It will benefit you to complete the first step in the IRS recognition process below before applying for the various business licenses, occupancy permits, and franchise license.
IRS Recognition & State Tax Departments
The very first step for the IRS is to file Form SS-4 which is an application for an identification number. This is similar to your Social Security Number in that it is nine digits and it is the entity’s Federal Identification Number, often referred to as EIN or FEIN (Federal Identification Number). In the application, there are a series of questions that ask you the type of entity for tax purposes you desire the business operate under. There are three IRS acceptable answers. The first is as a sole proprietorship. Basically, if you are a single member, just you, nobody else; then you can elect to file as a Schedule C filer within your personal tax return (Form 1040). The second option is to elect S-Corporation. This one is rare as it complicates matters due to the operating partnership agreement and status as an S-Corporation. If you are restricting the nature of your business to one active member and several silent members, then this option is worth discussing with your CPA. The third and the one I advocate is the partnership arrangement. This form of tax recognition provides the MAXIMUM flexibility in allocation of profits and losses. None of the other forms of entity status will allow for such flexibility in financial affairs as this format does for two or more ‘Members’. If you are a single member, then you can only choose between the Sole Proprietorship and the S-Corporation. You cannot elect the partnership arrangement until you have a second person involved.
You may apply via the on-line program. Make sure in Block 8 that you indicate that this application is for an LLC.
You will receive the EIN immediately if using the online system. In addition, you’ll get a letter in the mail from them, DON’T LOSE THIS LETTER. It states which form you must file and when the documentation period begins. I suggest scanning in the document and then send a copy to your CPA. Also, send a copy to your attorney. Keep the paper copy with your important papers and have a scanned copy on your computer and off-site (I use a Cloud account).
Once you have your EIN, if you elected S-Corporation status, you must file Form 2553 which is an affirmation notice to the IRS that all parties to this business (members/shareholders) recognize by signing the document that this entity is an S-Corporation and that each member will receive a Form K-1 allocating income and losses for activities.
After completing the EIN process and if necessary the Form 2553 process; be sure to file Form 8832. This is very similar to the 2553 in that you are electing as a domestic partnership and all the members sign the document. Again, scan the document to your records and send this form via registered mail and indicate on the registered document Form 8832. Scan in the receipt to your legal documents once returned from the IRS. As I stated above, keep a duplicate off-site.
With an EIN, the business is now allowed to file the application with the respective department of revenue/taxation for a state identification number. In addition, you will have to apply to your employment bureau for an identification number and a tax rate.
There are several other steps once all these are done. These include contacting the insurance company for insurance, changing the title on assets to the company’s name and so on. But these steps can’t happen without an EIN. Make sure you get that done after state recognition of your Limited Liability Company.
Altogether, the above takes about 8 hours of work combined. The only part that requires a lot more time is the creation of the ‘Operating Agreement’.
In summation, if you feel that your business situation meets all the circumstances I’ve laid out in my introduction article and you feel you are sophisticated enough to take advantage of this entity format, then follow the basic steps I’ve outlined above. Again, I remind you that this entity format has ZERO value and no real benefit to you without a well crafted and well documented ‘Operating Agreement’. It is much easier and simpler to stick to the corporation entity format and receive S-Corporation status from the IRS. You’ll get the exact same legal protection and the bulk of the financial benefits associated with pass-through tax entities. Act on Knowledge.