Tax filings for limited liability companies, or LLCs, have seen insane growth over the last 30 years. A 2018 analysis found that while tax returns for corporations and partnerships are down from where they were in 1980, LLC filings have increased an average of 21% per year in that period, which includes 12 years without IRS data.

The federal government only started tracking LLC filings in 1992. Limited liability companies are relatively new, and the IRS doesn’t recognize them. On federal returns, an LLC typically files as a sole proprietorship, partnership, or S-corp.

What is an LLC?

A limited liability company is a state creation, and it’s a business entity, not a tax entity. “LLC” describes how your business is structured and who is liable for its losses. 

“An LLC offers similar benefits to operating a business through a corporation, but with more flexibility,” according to Wray Rives, a certified public accountant (CPA) and Chartered Global Management Accountant based in Texas. He provides virtual accounting and tax services for clients in all 50 US states and internationally.

When you form an LLC, you create an entity that is entirely separate from you. The biggest draws, Rives notes, are pass-through tax status and asset protection.

Protecting your assets

LLCs are wildly popular business structures, not only for actually operating companies, but also for holding assets. Because an LLC is an entity in its own right, its debts and assets are entirely separate from yours. If someone sues you and wins, only the LLC’s assets are up for grabs, and vice versa. 

That means that an angry client can’t take your yacht, and the ex can’t take your business furniture. 

The New York Times reports that LLCs have become the entity of choice for slum lords looking to protect their assets from tenant lawsuits. But Rives says it’s not absolute.

“You can lose the liability protection of the LLC if the action was directly as a result of personal actions of the owner or gross negligence of the owner,” he notes.

Pass-through tax status: big plus

Businesses don’t hate the LLC tax situation, either. Though it’s not a tax entity, an LLC has tax ramifications, and they’re generally beneficial. 

An LLC is a pass-through entity, meaning the business doesn’t pay taxes on its income. Business income “passes through” the LLC and lands on the owner’s individual income tax return. 

“The advantage being that all earnings after tax belong to the owner and there is no possibility of double taxation,” explains Rives.

In the corporate structure, business income is taxed twice: once at the business level, and once at the individual level when it’s distributed as earnings.

Rives says the downside to a limited liability company is the regulations, noting, “Most people miss that opening an LLC will pretty much always result in some additional tax compliance requirements.”

Filing requirements, however, are stunningly minimal.

Step 1. Pick a state 

You can form your LLC in a state other than the one in which you live and work, if you don’t have a physical location. This could be worth looking into, since LLC regulations are all over the map, and some states charge annual maintenance fees and LLC-specific taxes that can wreck your bottom line. 

In California, LLCs pay an annual flat fee of $800 and, if they bring in more than $250,000 a year, an additional annual tax that ranges from $900 to almost $12,000, according to the Wall Street Journal. 

Delaware, on the other hand, charges a $300 annual tax, as of 2018.

Income tax rates, though, are beside the point, explains Rives.

“My clients are primarily cloud-based business, and I see people, typically ones that live in high-tax states, who think they can set up an LLC in a lower-tax state and avoid taxation in their home state. It simply does not work that way.”

Rives says unless you’re planning to move, “registering in a different state only means you will now have to file taxes in two states rather than one. All the earnings will still be taxable in your home state.”

Step 2. Pick a name 

Don’t agonize over this. Naming your LLC isn’t as important as naming your business. You can name your LLC one thing and then operate under any “trade name” you want. You can associate more than one trade name with a single LLC.

Specific naming regulations vary by state, but you typically just need to pick a name that:

• Includes “limited liability company” or some version of “LLC”
• Does not include words that make you seem like a government agency (like “Treasury” or “Federal Bureau of Investigation")
• Is not yet taken by a business in your industry (you'll do a name search through your state's Department of State website)

Your state may also have additional requirements for specific words. For example, if you want to use the word “Attorney” or “Doctor” in the name, you might need to show there is at least one LLC member who is a certified attorney or physician.

Step 3. Fill out paperwork

Then, put that name on the articles of organization. Some states call it a certificate of organization or certificate of formation.

It’s a remarkably simple process for something government-managed, which is part of the draw of an LLC. You’ll find the form on your state’s Department of State website, and it should take you about 10 minutes to fill in. Again, it varies by state, but the gist is universal. Were you starting an LLC in Colorado, you would provide:

• Your name and contact info 
• Your business’s name and contact info
• The name and contact info of your registered agent (the person responsible for receiving legal and financial documents)
• The name of the person who manages the business

Sign, pay the filing fee, and submit via website or mail. You won’t pay much, as far as these things go: anywhere from $50 to $500, depending on the state. 

At this point, you have started an LLC.

If you want benefit from it, you’re not quite done.

Step 4. Write an operating agreement

An operating agreement makes your LLC’s organizational structure official. Most states don’t require one, but most experts recommend it. It will likely take no more than 10 minutes. 

An operating agreement describes:

• Who owns what
• Who decides what
• Who is financially responsible for the company
• How profits are allocated among members
• How and why the LLC would be dissolved

You especially need an operating agreement if you plan to take full advantage of the LLC’s management and earnings flexibility. If it’s not on file with the state, your creativity may not hold up in court.

Step 5. Get ready to do business

Your next steps vary by state and industry, but generally you’ll need to:

• Obtain an employer identification number so your business can file taxes. 
• Figure out your new tax requirements (for instance, you may have to pay quarterly estimated taxes).
• Separate your assets into business and personal accounts (and strictly maintain that division). 
• Obtain any necessary licenses or permits for your line of work (e.g., alcohol, construction, hazardous waste). 

After that, if your state charges a maintenance fee, you'll want to pay it: Most states will pull your LLC status if you don’t. And just like that, the yacht is gone.

Epilogue: Know the Lingo

LLC University notes a couple of common errors to be aware of on the language front:

• What you have formed is a “limited liability company,” as opposed to a “limited liability corporation,” which is not a thing.
• You haven’t “LLCed yourself.” You’ve “formed an LLC." The whole point of an LLC is that it is an entirely separate entity from you. 

(Also, “LLC” is not a verb.)

According to this educational organization, it is critical to understand these things “so you don’t sound like an idiot.” 

Acknowledgements:

Big thanks to to Wray Rives, CPA, CGMA, for his generous assistance with this article.