17 Questions to Ask Before Forming an LLC

LLCs are a popular choice for many business owners due to their adaptable tax arrangements, liability protections, and operational flexibility. However, starting an LLC without asking yourself some crucial questions can result in costly misunderstandings, missed opportunities, and compliance issues down the track.

Our comprehensive guide explores all the essential factors you need to consider before launching your LLC.

By reviewing these considerations, you’ll gain a deeper understanding of the formation process and your compliance responsibilities, proactively tackle any issues that may arise, and establish a clear blueprint for your business’s success.

Key takeaways

• Limited liability companies (LLCs) are a popular business structure in the US that provides limited liability protection while offering the tax benefits of a sole proprietorship or partnership.

• When forming an LLC, it’s essential to consider several questions to help you plan, protect your business, and ensure smooth operations.

• Key questions include where to form your LLC, whether it needs an operating agreement, how it should be taxed, and how profits will be shared between the business owners.

What is an LLC?

An LLC is a business structure that blends the limited liability benefits of a corporation with the favorable tax arrangements of a sole proprietorship or partnership.

Business owners often choose an LLC structure because it’s straightforward to set up and run while still offering flexibility and scalability.

This versatile structure is suitable for businesses of all sizes. LLCs can have one owner (single-member LLC) or many (multi-member LLC), making them equally ideal for small family businesses and large, well-known brands like Amazon Services LLC.

Key features of an LLC include:

• Flexible ownership arrangements. LLCs offer more flexible ownership arrangements than other types of business entities, like S corporations (S corps). LLCs can have one or many owners, called members. There are few ownership restrictions—individuals, foreign corporations, and other LLCs can be members. Members have the freedom to decide how ownership interests are divided, and profits are shared.

• Limited liability. Unlike sole proprietorships and partnerships, LLCs are separate legal entities from their owners. As a result, members’ liability is limited to their investment in the business. If the LLC owes money or goes bankrupt, members’ personal assets, like their homes and cars, are protected from creditors.

• Pass-through taxation. By default, single-member LLCs and multi-member LLCs are taxed as sole proprietorships and partnerships, respectively. This means that profits and losses pass to its members, who report them on their tax returns and pay personal income tax on them. As a result, LLCs avoid paying federal corporate income tax, ensuring profits are only taxed once.

• Flexible taxation. LLCs can also opt to be taxed as a C corporation (C corp) or S corp if they meet specific criteria—for instance, members can only be individuals, certain trusts, and estates. Depending on the LLC’s and owners’ circumstances, this flexibility may offer tax advantages such as reducing an LLC’s payroll taxes.

• Reduced compliance obligations. LLCs have fewer administrative and regulatory requirements than corporations. For example, LLCs aren’t legally required to hold regular meetings, adopt bylaws, or appoint officers or directors. This can make an LLC easier and more affordable to run than a corporation.

Like any business structure, there are also potential downsides to forming an LLC. These include:

• Higher initial costs. LLCs are more expensive to set up than sole proprietorships or partnerships. They must pay filing fees and may also be subject to annual reporting fees.

• More complex transfer of ownership. In a corporation, shares can easily be sold or transferred. Ownership changes in an LLC are typically more complicated. For example, an LLC’s operating agreement may restrict the transfer of ownership by requiring the consent of all members. In some states, LLCs must dissolve and then reform if a member leaves or a new member joins.

• Potential limits on investment. LLCs present a more complicated arrangement for passive investors, who may be more interested in corporations where ownership is transferred by buying and selling shares. In contrast, transferring ownership in an LLC requires amending the operating agreement, which can be lengthy and complicated and often needs the consent of all members.

• Self-employment taxes. LLC members are generally considered self-employed for tax purposes. This means that members must pay Medicare and Social Security taxes on the business income they declare in their personal returns. Depending on the business’s and members’ circumstances, this tax treatment may not be advantageous.

• Limited duration. Unlike a corporation, many LLCs dissolve when a member leaves or dies. However, LLCs may set out other arrangements in their operating agreements to allow the business to continue. In comparison, corporations can exist indefinitely.

LLCs are governed by state law. To find out the requirements for forming an LLC in your state, contact the Secretary of State’s office or relevant business formation agency. The Small Business Administration (SBA) has a helpful tool for locating the appropriate agency in your state.

17 questions to ask before forming an LLC

Once you’ve decided that an LLC is the right structure for your business, there are some questions to think about before moving forward. Considering these in advance will help you plan and budget effectively and proactively address any potential issues, preparing a solid foundation for your LLC.

Administration

1. Where should I form my LLC?

Deciding where to form your LLC involves several considerations.

Many business owners choose to form their LLCs in their home state for convenience and easy access to local services. This may also make them eligible for state government small business loans and grants.

However, you can choose to form your LLC in a different state. When weighing up your options, here are some key factors to think about:

• Tax implications. Some states offer potentially more favorable tax arrangements for LLCs. For example, Wyoming is a popular choice for LLC formation due to its lack of personal or corporate income tax and franchise tax (a state tax on entities doing business in a state).

• Administrative ease. Setting up an LLC can be quicker and cheaper in certain states. Some states, such as California and Wisconsin, have accessible online business services, making them attractive options for business owners who want to set up and run an LLC easily. Other business owners may look for states with affordable filing fees and no annual reporting requirements to reduce costs.

• Legal environment. Corporations law is state-based. Certain states may have more clearly defined corporate laws and regulations than others, making them a more predictable business environment. For example, Delaware is known for its extensive, clear corporate law.

• Privacy considerations. States like Delaware, Nevada, New Mexico, and Wyoming offer strong privacy protections and limited reporting requirements. These laws allow LLC members to remain anonymous, which may appeal to some business owners.

When you initially form an LLC in a state, it’s referred to as a domestic LLC. If you do business in other states, you’ll need to register as a foreign LLC with their respective business formation agencies. Specific requirements and filing fees for this process vary between states. Use the SBA’s online tool to find the relevant agency in your state.

2. What should I name my LLC?

When deciding on a name for your LLC, begin by checking the naming rules with the business formation agency in the state where you’re establishing your LLC.

LLCs typically need to include a form of “limited liability company” or “LLC” in their business name. States also usually prohibit certain terms or words, like those that imply the business is part of a regulated profession. For example, New York prohibits business owners from using words such as “bank,” “lawyer,” or “insurance.”

Your LLC’s name must also be unique. You should first check if it’s already being used at the state level. Many state business formation agencies have an online business name database you can search. You can also conduct a wider search using the US Patent and Trademark Office’s trademark database.

Some businesses operate under a different name than their registered LLC name, known as a “doing business as” (DBA) name. Businesses often use a DBA to distinguish between their products or services. If you use a DBA name, you need to register it with the relevant state and local agencies where you do business.

Understanding these naming rules before you form your LLC avoids having to change the name at a later stage or potential legal issues.

3. Who will be the LLC’s registered agent?

All LLCs must have a registered agent in each state where they are formed and registered. This individual or entity is responsible for receiving legal documents and formal correspondence on behalf of the LLC and forwarding them to the owners. For example, if an LLC is sued, the court documents will be served on the registered agent.

A registered agent typically must be a person or entity who resides in the state, has a physical address (not a PO box), and can receive mail during regular business hours. Each state has further specific criteria for who can be a registered agent.

Some LLCs nominate a member, employee, or family member as their registered agent. Many use a professional registered agent service, like LegalZoom or NorthWest Registered Agent, to guarantee that someone is always available to receive important documents on behalf of the LLC.

4. Can I change my LLC to a different business structure later?

Understanding the other business structures available to you gives your LLC flexibility in the future. For instance, some LLCs may later convert to corporations once the business reaches a certain size.

Check with your state business formation agency to see if there are any limitations or specific requirements for converting your LLC to another structure.

Your operating agreement should also address the decision to change structure. Set out how the decision will be made, such as whether it requires a majority or unanimous member vote.

5. Does my LLC need a business license?

Your LLC may need licenses or permits from federal, state, and local authorities.

There’s no general business license at the federal level. Instead, the types of licenses you need depend on the nature of the products or services your business offers. For example, businesses selling alcohol require a federal license to do so.

The SBA has further information on federal licensing.

Check with the Secretary of State or business formation agency in your state and local area to confirm whether you need any other licenses. For example, all LLCs in Delaware must apply for a State of Delaware Business License each year.

6. How much will it cost to form and run my LLC?

Considering this question from the outset helps you budget for the administrative costs of running your LLC. It can also help guide decisions like where to form your LLC.

Here are some costs you should take into account:

• State filing fees. Each state charges LLCs a filing fee for their articles of organization, which is the legal form required to start an LLC and contains basic information about the business. These fees vary between states. For example, Hawaii charges $50, while Texas charges $300. States typically charge extra for expedited filing.

• Annual reporting fees. Some states require LLCs to file annual reports. Like filing fees for articles of organization, these also vary. For instance, Arkansas’s annual report costs $150 to file, while Michigan’s costs $25.

• Annual licensing fees. Depending on your location and industry, annual licensing fees may apply.

• Annual franchise tax. This tax, also called a privilege tax, is levied on LLCs for the right to conduct business in the state. Exact rates vary between states. For example, California charges $800 a year, while other states base it on a percentage of the business’s capital or sales.

• Service provider fees. Costs for services like LLC formation or registered agent services should also be accounted for. As an example, annual registered agent fees typically cost between $100 and $300.

• Accounting and legal fees. Many business owners seek legal and financial advice when forming an LLC and beyond. The cost of these varies between service providers and the type of services required.

7. Does my LLC need an operating agreement?

An operating agreement acts as a roadmap for an LLC, addressing key issues about its ownership, management, and operation. It’s a contract that sets out decision-making and conflict-resolution processes and clarifies how the LLC will run. Operating agreements are usually written but can also be implied or oral.

It’s mandatory to have an operating agreement in several states, including:

• California
• New York
• Missouri
• Maine
• Delaware

While not a legal requirement in other states, an operating agreement is strongly recommended to protect members’ interests and help the LLC run smoothly. If an LLC doesn’t have an operating agreement, default state LLC laws usually apply, and these may not represent what the members want or intend to happen.

For instance, default voting rights laws may require a unanimous vote for major business decisions. This can be impractical for large LLCs and slow down decision-making. To reduce this risk, an LLC’s operating agreement could allow for majority consent instead.

Even single-member LLCs can benefit from having an operating agreement. It supports the “corporate veil” or separation between an LLC and its owner’s personal assets, reducing the risk of the LLC being categorized as a sole proprietorship.

Operating agreements can be tailored to the needs of the LLC and its members, as well as any relevant laws. Key elements typically addressed include:

• Purpose of the LLC: What is the LLC’s main product or service, and where does it operate?
• Membership interests: Who owns the LLC and how membership interests are divided, how profits and losses are divided between members, member roles and duties, how new members will be added, how members can leave, and how membership interests can be transferred.
• Management: Whether the LLC is member-managed or manager-managed and management duties.
• Taxes: How has the LLC elected to be taxed?
• Voting rights and processes: For significant decisions like adding new members or dissolving the LLC.
• Meeting requirements: When and how meetings are conducted.

Each operating agreement is unique to the LLC. When preparing an operating agreement, you should speak to an attorney to ensure it addresses all the key issues and complies with relevant laws.

Financing

8. Should my LLC bring in outside investors?

LLCs are funded by their members, who typically also manage the business. However, LLCs can also have passive investors who provide capital without participating in its management or operations.

It’s important to note that LLCs aren’t always the preferred choice for investors. Reasons for this include:

• A C corp allows investors to easily transfer shares by buying and selling them. Transfer of ownership in an LLC usually involves amending the operating agreement, which may require agreement from all members.

• Tax filings are typically more straightforward for investors in a C corp.

• Unlike an LLC, there’s no pass-through taxation, so investors are only taxed on the dividends they receive rather than the business’s income.

If you decide to involve investors, you should carefully set out the arrangements in your operating agreement to reduce the risk of conflicts or misunderstandings.

Ownership

9. Who is going to own my LLC?

One key issue when forming an LLC is ownership rights—who owns the business, and how will their ownership interests be divided?

In a single-member LLC, ownership is straightforward—one person owns the entire business. In a multi-member LLC, you need to determine each member’s ownership interest. These are typically allocated based on members’ contributions to the LLC via capital, their expertise, and the time they put into the business.

Ownership may be split equally or proportionally to the members’ capital investment. For example, if a new LLC has three owners, one contributing $10,000 and the others contributing $5,000 each, ownership interests might be divided as 50%, 25%, and 25%.

However, LLC members have a high degree of flexibility regarding ownership interests and can allocate them however they like to reflect members’ non-financial contributions, like expertise or time.

10. How will profits and losses be shared?

Like ownership interests, profit-sharing arrangements for LLCs are flexible. Profit-sharing is often proportional to members’ ownership interests or the capital they contributed. However, members can divide profits differently, provided they comply with Internal Revenue Service (IRS) requirements for special allocations.

You should address profit-sharing arrangements in your operating agreement. Otherwise, state laws apply. In many states, the default position is that members split the profits equally or proportionately to their ownership interest.

11. How can new members join my LLC?

As your LLC grows, you may want to add new members to inject capital or expertise into the business.

From the outset, carefully consider whether new members should join your LLC. Doing so dilutes the ownership interests of existing members and potentially introduces more voices into management decisions. It’s also difficult to remove a member once they’ve joined.

There may also be tax implications. For example, if a single-member LLC brings in new members, it’s automatically taxed as a partnership rather than as a disregarded entity, requiring different tax forms.

If you envisage new members joining the LLC, set out the process in your operating agreement. Multi-member LLCs typically vote (unanimously or by majority) on adding new members. Consider addressing issues such as:

• What capital contribution do new members have to make?
• The ownership interest they will receive in return.
• The percentage of profits/losses allocated to them.
• Whether they will be involved in the management of the business.

If the operating agreement is silent on the issue, the relevant state law applies.

In some states, new members can only be added if the LLC is dissolved and a new one is formed. Other states allow LLCs to amend articles of organization or certificates of formation to reflect ownership changes.

12. How can members leave or be removed from my LLC?

In setting up your LLC, you also need to consider how members can leave it. This prepares for scenarios such as retirement or unresolvable conflict.

You can set out clear procedures for this in your operating agreement and address key questions such as:

• Will remaining members buy out the ownership interest of the member leaving?
• Can the departing member transfer their interest to a third party?
• Does the departing member have to offer their interest to existing members before they can offer it to an external person or entity?

If there’s no operating agreement or the operating agreement is silent on the issue, state law applies. In some states, the default position is that members can’t leave an LLC, and the LLC must be dissolved.

13. What happens if a member dies?

LLCs need to plan for all possible eventualities, including the death of a member.

If you’re the owner of a single-member LLC, the LLC often dissolves on your death, with the LLC’s assets forming part of your estate. Alternatively, you can set out a succession plan in your operating agreement, identifying someone to continue the LLC after your death.

In some states, single-member LLCs automatically dissolve on the death of an owner unless specific criteria are met.

Multi-member LLCs should address how to handle this situation in their operating agreements. A member’s interests may pass to their heirs (with or without management rights), or members may agree to pay the deceased member’s heirs for their ownership interest.

If these issues aren’t addressed in an operating agreement, default state laws apply.

14. How will my LLC be dissolved?

Most LLCs will end at some point, which should be addressed in the operating agreement for clarity among members. Your operating agreement may identify specific events that trigger dissolution, like a member's death, or require members to vote.

The operating agreement can also set out the procedure for dissolving and terminating the LLC, including the relevant forms to file, discharging the LLC’s debts and liabilities, and distributing the LLC’s assets between its members.

If your operating agreement doesn’t address dissolution, default state laws apply.

Management

15. How will my LLC be managed?

Another key question to consider is who is involved in managing the business's day-to-day operations.

LLCs can be member-managed or manager-managed. In a member-managed LLC, all members are involved in managing the business. This is a common arrangement for smaller LLCs.

In a manager-managed LLC, the business is managed by specifically elected members, an external manager, or a combination of both. This approach is often used where:

• There are passive investors (members) who don’t want to participate in the LLC’s management.

• The LLC has a large number of members, and it’s impractical to involve all of them in the management of it.

• Some or all of the members have no management experience.

Like ownership issues, management arrangements should be addressed in the LLC’s operating agreement. If they aren’t, many states automatically designate LLCs as member-managed.

Taxation

16. How will my LLC be taxed?

LLCs may be subject to federal, state, and local taxes. One of the main reasons business owners choose an LLC structure is because it offers flexibility regarding how the LLC pays federal taxes.

The IRS considers single-member LLCs as disregarded entities for tax purposes. The LLC doesn’t file a federal tax return. Instead, the owner includes the LLC’s profits and losses in their personal tax return and pays federal income tax. This avoids the double taxation corporations pay.

The IRS automatically taxes multi-member LLCs as partnerships. Like single-member LLCs, the business’s profits and losses pass to the owners, who are taxed on them at an individual level.

In both these scenarios, owners must usually also pay federal self-employment taxes. However, LLCs can also elect to be taxed as S corps or C corps. To be taxed as an S corp, an LLC must meet certain IRS criteria, including having fewer than 100 members.

Choosing to be taxed as a corporation may offer an LLC certain tax advantages—for example, where the business retains a large amount of its profits rather than paying them to members or for members who wish to reduce their self-employment tax liability.

17. Does my LLC need to apply for a federal tax ID?

Most LLCs require an employer identification number (EIN), an identifying number for federal tax purposes.

An LLC must apply for an EIN if:

• It has any employees.
• It’s subject to federal excise tax based on the goods or services it sells.
• It requires an EIN to open a business bank account.
• State law requires it to have an EIN.

In limited circumstances, single-member LLCs won’t need an EIN and can instead use the owner’s name and taxpayer identification number (TIN) for federal tax purposes.

Applying for an EIN online via the IRS website is quick and free.

Conclusion

LLCs are a popular business structure due to the liability protection, pass-through taxation, and management flexibility they offer. However, before forming your LLC, you should ask yourself the questions outlined above to save you time and money down the road. It’s also important to seek professional legal and financial advice specific to your situation.

This approach helps you address potential compliance issues, gain clarity on how your business will operate, and avoid common pitfalls.

Interested in learning more about LLC formation? Check out Best Financial for more helpful guides and information.

Disclaimer

This article is an informational overview and is not intended as financial or legal advice. The steps in forming an LLC vary based on individual circumstances and the relevant laws, which change regularly. While we aim to provide current and reliable information, we cannot guarantee the completeness or accuracy of this information. We strongly recommend consulting with a qualified attorney or financial advisor to address your specific needs and ensure compliance with all relevant laws.