One of the most popular business entities to form when starting a business today is a limited liability company, or “LLC” for short. At its basic level, an LLC is somewhat of cross between a partnership and a corporation. It provides the tax benefits of a partnership while giving all members the liability protection of a corporation.
Here is an example of how an LLC works in practice:
Let’s say that Katherine and Peter decide to start a lawn care company in Clarksville. Katherine will do the mowing and Peter will weed eat and edge the sidewalks. They intend to buy two vehicles and a trailer in their business.Katherine and Peter know that starting off they will have about 50 customers across Clarksville and a few in Springfield, so there will be a good bit of travel associated with the business. Because of the nature of their business, there is a substantial amount of liability – operating lawn equipment is inherently dangerous and and travel across Montgomery and Robertson Counties exposes employees to accidents.
If Katherine and Peter operated the business as a general partnership, both would be 100% liable for any accident either one of the them have. There would be no liability shield. Due to that risk, they want to form a business entity that provides them protection for their personal assets. They do not want to lose their house, cash, or other assets should an accident occur they be held liable. Katherine and Peter know that a corporation could provide them with that liability protection, but they do not want to pay a corporate tax and then be taxed again on any distributions from the corporation to themselves. They would rather just be taxed based upon their personal income tax rate. The type of business entity that works best for Katherine and Peter would be an LLC.
Key Points of an LLC
- Great Liability Protection. An LLC provides as much liability protection as a corporation but avoids the corporate tax that a corporation has to pay.
- Favorable Taxation. Unless it elects otherwise, profits generated by the LLC are taxed at the personal income tax rate of its individual members. This means that the owners of the LLC are taxed at a lower rate than a corporation.
Due to the hybrid nature of an LLC (halfway between a partnership and a corporation) it is probably the most popular way of starting a new business in Tennessee and across the country.
Starting an LLC in Clarksville, Tennessee
Due to the complex nature of starting an LLC we highly recommend having an business lawyer guide you through the process of setting up the company and preparing operating agreements. Here are the steps that a business lawyer will take that are required to get your business up and running:
Pick a name for your LLC
When considering what name you want to call your LLC, go to the the Tennessee Secretary of State’s website and do a business search to make sure that the name you want to use has not been taken. If it has been taken by another business, unfortunately it may be unavailable and you may have to pick a new name for the LLC.
Decide the Structure of the LLC
Before you register your LLC with the state you will need to determine what type of LLC you want to create. As discussed below, in Tennessee there are three types of LLCs – member managed, manager managed, and director managed. The most common and simplest LLC is a member managed LLC. This entity allows all members to have a say in the day-to-day operations of the LLC and a share in the profits and losses, unless otherwise agreed.
File and Register your LLC’s Articles of Organization
The next step in creating your LLC is to file the Articles of Organization with the Tennessee Secretary of State. The Articles of Organization set forth who the members of the LLC are, who the registered agent is, and the primary location of the business. The Articles of Organization is not the same thing as an Operating Agreement so don’t confuse the two.
Obtain an Employment Identification Number (EIN)
At the time you form and register your LLC, you should obtain an employment identification number or “EIN”. This number is essentially the social security number for the business and how the business is identified for tax purposes. An EIN is required to open up bank accounts for the LLC. Note however, if the LLC is a single member LLC, meaning just you, you can use your social security number for the LLC.
Prepare and Execute the LLC’s Operating Agreement
Although Tennessee law does not require LLCs to have an operating agreement, it is a critical that your LLC have one. The operating agreement sets forth:
- The purpose of the business
- How the profits and losses of the LLC are divided
- Restrictions on the transfer of member’s interest
- The admittance of new members
- How LLCs interests are handled at the death of a member
- How the LLC is dissolved
Submit Your Business License Application with Montgomery County and the City of Clarksville
Most businesses will need to register with Montgomery County and/or the City of Clarksville to obtain their business licenses. There is a $15.00 filing fee for each registration. Some business are exempt from obtaining business licenses with the county or city, check with each entity
What are the Types of LLCs in Tennessee
Tennessee allows the creation of three different types of LLCs:
Member Managed
The member managed LLC is the most common type of LLC. Unless the members otherwise agree, each member has the right to:
- Manage the company
- Share in the profits and losses of the business
- Make decisions regarding the business
Most all single single member LLCs, meaning you are the sole owner of the business, are member managed LLCs. If you are going to be the only member in the company, it does not make sense to have a manager managed or director managed LLC.
Manager Managed
In manager managed LLCs, the members get together and decide on a select few to run the business. The manager managed LLC is useful in two primary situations:
- There are many members and there needs to be a few primary leaders of the business.
- Parents want to add their children as owners of the business but not necessarily give them immediate control over the day-to-day operations of the business.
Director Managed
The director managed LLC is most useful when a corporate type structure is needed. Director managed LLCs are managed by board of directors. These directors are the only members that can bind the company to any certain action taken on behalf of the LLC. So for example, if the LLC wants to enter into a new agreement with a supplier for certain goods, the members that make up the board of directors are the only members that can vote to approve such a measure.
What Are the Advantages of an LLC?
There is a reason why LLCs are the most popular business entities to create today. Here are the primary advantages of an LLC:
- Favorable Income Taxation. Income earned from the LLC is taxed at your personal tax rate, unless you elect for the business to be taxed itself. For most entrepreneurs, it makes complete sense for the income of the business to be taxed at your personal tax rate.
- Liability Shield. If someone files suit against the LLC your personal assets are shielded from liability. The only assets that the defendant could recover are those assets inside the LLC. Nonetheless, be aware that under certain circumstances, owners of LLCs do have liability exposure. The process of reaching beyond the shield of the LLC and accessing the personal assets of the LLC is called piercing the corporate veil.
- Prestige. For some people, having the initials LLC behind the company name gives it automatic prominence and stature. It tells the customer that the business is established and is not a fly-by-night operation.
What are the Disadvantages of an LLC?
While LLCs are a great business entities on many levels there are some drawbacks for their use in Tennessee. Here are some of the disadvantages of LLCs:
- Tennessee Franchise and Excise Tax. Under most circumstances, an LLC must pay both franchise and excise tax every year. Both the franchise tax and the excise tax are taxes on the “privilege of doing business in Tennessee.” The franchise tax rate is .25% (one quarter percent) of the net worth or the book value, whichever calculation is greater. The excise tax is 6.5% of the net taxable income of the business earned in Tennessee. Note, however, that there are exceptions to the franchise and excise tax:
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- If 66% of the activities of the LLC are farming or possessing personal residences where at least one member resides on the property.
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- If 95% of the LLC is owned by family and two-thirds (2/3rds) of the revenue of the business is passive income, such as renal income, or is farming.
- Self Employment Tax. Self employment tax is the combination of the Social Security tax of 12.4% and Medicare tax of 2.9%. If the LLC is earning ordinary income such as income from selling goods or services, the members must pay self employment tax on their income. However, if the income is passive income, such as rental income or farming income, the self-employment tax can be avoided. Additionally, under many circumstances the self-employment tax can be limited if the LLC elects to be taxed as an Chapter S corporation.
- Annual Reports. Each year, an LLC must file an annual report and a filing fee with the Tennessee Secretary of State. Currently, the cost for filing your annual report is $300.00 per year. This is an added business expense that entities such as sole proprietors and general partnerships do not incur.
What is the Difference Between an LLC and a Corporation?
There are important differences between LLCs and Corporations. An LLC is very much a cross between a partnership and a corporation. LLCs are provided the favorable tax benefits that a partnership receives but also the liability shield of a corporation.
Conversely, a corporation is a business entity that has great liability protection, but the business itself must pay tax on its income. That income is then taxed again when distributed to the shareholders. Due to that issue, most small business owners should be hesitant when considering corporations. However, please note that if you create a corporation and tell the IRS that you wish to be treated as a Chapter-S corporation, this double taxation does not apply and you will be taxed individually for your share of the business income.