The limited liability company (or LLC for short) was first introduced into the American business landscape back in the 1970s.
Since then, the LLC has become a popular entity type for entrepreneurs looking for a formal business structure for their companies.
However, the LLC isn’t the perfect business structure for every single business, and forming one is a decision you shouldn’t make lightly. But once you’ve decided that the LLC is the right business structure for you, how do you know when you should convert your company into an LLC?
While there isn’t any single consistent answer that we can apply to all entrepreneurs, in general there are a few handy indicators you can use to determine whether it’s time for you to form an LLC or not. Let’s discuss what these indicators are, and how they might apply to your business.
When It’s NOT Time to Form an LLC
1) When you detest paperwork
Let’s be clear: LLCs actually have pretty minimal paperwork requirements, especially when compared to corporations. Some of the most common requirements are your formation documents, annual reports, business license applications and renewals, and industry licenses.
If that doesn’t sound like too much of a hassle, then you should be able to tolerate the paperwork for an LLC, but if that list of requirements overwhelms you, then perhaps you’re better off sticking with a sole proprietorship or general partnership.
Or, if you still want to reap the many benefits LLCs have to offer over those more casual business structures, maybe hiring a business formation service is a better plan.
2) When you aren’t keeping business and personal assets separate
LLCs are legally separate entities from the people who own them. In the eyes of the law, the LLC acts like an individual – it owns assets and capital, pays its own taxes, and can enter into contracts.
That’s why an LLC’s finances technically don’t belong to the owners – they belong to the LLC. The LLC’s owners, then, must keep their finances separate from the business accounts in order to maintain their personal asset protection.
If you act as a sole proprietorship or general partnership, then your personal finances and your business assets are legally one and the same, because the law does not distinguish between your business and you as a person. In this instance, there is no legal reason for you to separate your business and personal assets, although there are obviously still some practical reasons.
Before changing a sole proprietorship or general partnership into an LLC, you’d need to separate your personal and business finances. If you’re not ready or willing to do that just yet, then now isn’t the time to form an LLC.
3) When the filing fees to form an LLC are too much to handle
There is no fee to form a sole proprietorship or general partnership ― in fact, you can simply start running your business. The only startup fees would be for licenses required by your state or your industry.
LLCs have those licensure fees plus a few other costs. For one, you’ll need to pay a filing fee when you submit your articles of organization to your state. Then, you’ll also pay fees each year (in most states) with your annual report and/or franchise tax filing. Some of these fees are burdensome, with costs exceeding $500 in some locations, depending on your state.
If you’re operating a business on an extremely tight budget, it might not make sense to invest any funds into paying these fees.
When It Is the Right Time to Form an LLC
1) When you need personal asset protection
By far the most significant advantage of forming an LLC is its limited liability protection. In the event of a lawsuit or debt, a creditor can only lay claim to the assets of the LLC itself ― they cannot take your personal assets, or those of any other member.
This protection is commonly referred to as the corporate veil. This term refers to the layer of distinction between an LLC’s business assets, and the personal assets of each owner. While the corporate veil is an incredibly powerful aspect of the LLC, it is not infallible.
For example, a court may rule to “pierce” the corporate veil if you’re involved in fraudulent practices, or if you neglect to separate your personal and business finances. In these situations, you would lose the protection of your corporate veil.
In a sole proprietorship or general partnership, this corporate veil doesn’t exist, and you’ll be held personally liable for all the debts your business incurs.
As an example, let’s imagine that you own a small bakery. You create top-notch cookies, but one of your customers gets sick from a bad batch, and they successfully sue your business for $75,000. The bad news? Your business does not have enough money to pay that.
In this situation, the LLC would pay out what it can. But if you’re the sole proprietor or a general partner of the bakery, and the business itself cannot pay the settlement, then the court would order you to make up the difference from your personal assets: your car, your house, and your private accounts. Forming an LLC helps you avoid this unfortunate situation.
2) When you want tax flexibility & benefits
A big benefit of an LLC is the fact that you can choose how to be taxed: as a pass-through entity (like a general partnership), an S corporation, or a C corporation. Depending on your LLC’s profits and membership structure, this flexibility may help reduce your tax burden.
Breaking down the details of the benefits of being taxed as a corporation or a pass-through entity would take too much time for this article. In general, we would simply like to get the point across that the LLC essentially allows you to pick who pays the taxes: your members or the LLC itself. If your members pay, then the income is taxed at each owner’s personal income tax rate. If the LLC itself pays, then it’s the corporate income tax rate.
Sole proprietorships and general partnerships do not get to choose ― the owner always pays the taxes at the personal income tax rate.
3) When you want the enhanced credibility of a formal business structure
While it’s arguably not as important as the taxation options or the corporate veil protection, one of our favorite parts of LLC ownership is how it provides a level of legitimacy to your business venture.
Sole proprietorships and general partnerships do not have unique rights to their business names ― even if you file a DBA (doing business as) name for your business, any other business entity can swoop in and use your name as their own.
That’s not the case with LLCs, because the LLC’s business structure reserves your company name for your exclusive use. Not only can competing businesses not use your exact name, but they also cannot use any names that are deemed to be too similar to yours.
This is a massive point in the LLC’s favor when it comes to credibility, as your ability to reserve a unique name for your exclusive use provides a considerable amount of legitimacy to your business.
Knowing the exact right moment to form an LLC isn’t the easiest aspect of business ownership, and there really is no one-size-fits-all answer to the question of when to take this leap.
Still, generally speaking, we think you should form an LLC as soon as your business takes on any liability ― preferably, before you enter into any contracts, or sell any products or services.
This is because the LLC’s personal asset protection is a vital piece of the business ownership puzzle, and without it, you could easily go bankrupt if your business makes even one seemingly small mistake.