Are you currently doing business as a sole proprietorship or partnership? If so, have you considered switching to a limited liability company (LLC)?

For most small and mid-size businesses, there are good reasons to prefer operating as an LLC rather than as a sole proprietorship or partnership.

Sole proprietors and partners are personally liable for all their business debts. Operating as an LLC or corporation will limit your personal liability for these debts, so either can be an appropriate choice. 

So in choosing between a corporation and an LLC, why do most businesses and their lawyers lean toward an LLC? For one thing, an LLC typically requires less paperwork. Also, it gives you greater latitude in how you manage your business and allocate profits.

Switching your business to an LLC should be easy and inexpensive. Here are some pointers on getting started.

The key paperwork

Setting up an LLC typically involves two legal documents — the articles of organization and the operating agreement.

You file your LLC articles of organization with your state’s LLC filing office — usually the secretary of state, located in your state’s capital city. By contrast, your operating agreement isn’t filed with any public agency. It’s an internal document that defines the rights and obligations of LLC members (which is what LLC owners are called).

You may be able to prepare these documents yourself using self-help books and software. If you do, play it safe: Have a lawyer look over the documents before they’re final.

Preparing your articles of organization

Preparing your articles of organization can be surprisingly simple. Many states provide a printed form. Just fill in the blanks, sign the form, and submit it to your state’s LLC filing office. If your state doesn’t provide a form, it may furnish something almost as good: a sample with instructions.

Chances are you’ll be able to go online and download the fill-in form or a sample form from the government’s website.
Typically, your articles of organization will include:

• The name and address of your LLC’s initial registered agent and office. You’ll probably name one of the owners as the registered agent — the person who gets served with lawsuit papers if someone sues the business. He or she will also receive official correspondence relating to the LLC.
• Statement of purpose. Usually, a general statement will suffice.  Example: “To engage in any lawful business for which limited liability companies may be organized in this state.”
• Type of management. You usually need to say whether your LLC will be member-managed or manager-managed. In most states, if you don’t specify the type of management, the members will manage it (that is, it will be member-managed).
• Principal place of business. You’ll give the address of your main business location.
• Duration. You may be able to choose between a “perpetual” (unlimited) duration, and a specific number of years. Some states put a limit on the number of years you can choose — 30 or 50 years, for example.
• Signatures of people forming the LLC. Usually, state law allows one person to sign the form as the organizer. You may prefer, however, to have all members sign.

Preparing your operating agreement

Once the filing office has accepted your LLC articles of incorporation, you’re officially in business. Now, you should prepare an operating agreement if your LLC has two or more members. It’s usually optional for a one-member LLC.

Consider covering:

• How a member’s percentage interest is determined. Typically, it’s based on how a member’s capital account compares to the total of all capital accounts. So if Suzy has $2,500 in her capital account, and the total of all LLC capital accounts is $10,000, her percentage interest is 25 percent.
• Voting. You’ll probably want to authorize a simple majority of membership interests to decide most issues, but you can also provide for a larger majority (two-thirds, for example) on major issues.
• Capital provisions. State how much money or property each member will contribute to the LLC, and what additional contributions may later be required. Also, cover how profits and losses will be allocated among the members, and when money may be distributed to them.
• Buy-sell provisions. Spell out what happens if a member dies, moves away, gets sick, or simply wants to get out of the business. Can a member’s interest be transferred to an outsider? If not, how does the departing member (or the member’s family) get fairly compensated for the LLC interest? How can the remaining members avoid having to work with a new member who may be incompatible with the others? How will the interest of a departing member be valued?

How do you want to be taxed?

Normally, when it comes to the federal income tax, an LLC is taxed like a sole proprietorship or a partnership: A member’s share of the business’s income is reported on the member’s personal tax return.

You have an option, however. You can elect to have the LLC itself taxed. Check with a tax pro. Then, if you and your co-owners decide that this optional method is best for your LLC, file IRS Form 8832, Entity Classification Election, within 75 days after you form your LLC.

Be aware, though, that only a small percentage of LLCs will find that it’s beneficial to elect the optional taxation method.