Learn what an LLC is and why a business owner may form one.
Definition and Example of an LLC
A limited liability company (LLC) is a kind of business entity that offers its owners liability protection without the complexities that come with setting up and operating a corporation.
Acronym: LLC
For example, if a business owner wants to set up shop, they generally have three choices: a corporation, a partnership, or an LLC. A corporation provides very strong liability protection. However, it generally costs more to form than other business entities, and has more stringent maintenance requirements. A partnership, on the other hand, may be easier to establish and often offers more flexibility in terms of allocating profits and losses among its owners. However, it may not have as strong liability protections as a corporation. This is especially the case with general partners, who are personally liable for the partnership’s obligations. An LLC presents the best of both worlds—limited liability to all of its owners like a corporation, while being relatively easy to set up and maintain, as well as to flexibly allocate profits like a partnership.
How Does an LLC Work?
By default, a solo business owner’s endeavor could be considered a sole proprietorship. While a sole proprietorship is easy to form—all you have to do is start doing business—there are some drawbacks. For example, a sole proprietorship’s business debts are legally the debts of the sole proprietor; without a business entity, there is no legal distinction between the business and the business owner. For some business owners, this may be optimal for their tax situation; for others, however, running their business as an S corporation or C corporation for tax purposes may be ideal. To protect your personal assets from business obligations and vice versa, as well as to accomplish more complex tax planning strategies, you may find that setting up a legal entity for your business operations is the best option. An LLC offers its owners liability protection as well as flexible tax planning opportunities. For example, if you’re a solo entrepreneur, you can form an LLC and continue to operate as a sole proprietorship for tax purposes—reporting all income and expenses on Schedule C—but still have assurance of the liability protection offered by the LLC. Alternately, your LLC can elect to be taxed as an S corporation or a C corporation, depending on what is optimal for your situation. Explore all your options and consult with an accountant to determine if an LLC is the best entity for your business initiative.
Types of LLCs
There are two types of LLCs in terms of ownership: single member (only one owner) and multi-member (multiple owners). Similarly, an LLC can be member managed or manager managed. You may have to make this designation on the LLC’s formation documents submitted to the state. If an LLC is member managed, all the owners of the LLC can make decisions on behalf of the LLC. If an LLC is manager managed, one or more managers of the LLC—who may or may not be LLC members—can make decisions on behalf of the LLC.
How Are LLCs Taxed?
How an LLC is taxed depends on the LLC’s number of owners as well as if it has made any special tax elections to be taxed as a corporation. Here’s an overview:
Single-Member LLCs
By default, a single-member LLC is treated as a disregarded entity for tax purposes. This means that for federal tax purposes, a single-member LLC does not have to file a tax return, nor is it taxed on its income. Instead, the income is reported and taxed on its owner’s tax return as though the LLC did not exist.
Multi-Member LLCs
By default, multi-member LLCs are treated as partnerships for tax purposes. Partnerships generally do not pay federal income taxes, but they do file partnership tax returns to allocate their income and deduction amounts to their partners based on their respective ownership percentages or some other allocation method. The partners then report their share of the partnership’s income on their personal tax returns.
S Corporation
If an LLC elects to be taxed as an S corporation, it will file an S corporation tax return and allocate all income and deduction amounts to its owners based on their ownership percentages. S corporations generally do not pay any federal income tax. However, they may be subject to state-level S corporation taxes.
C Corporation
If an LLC elects to be taxed as a C corporation, it will file a C corporation tax return and pay income at the corporate tax rates in effect for the year. The current federal corporate tax rate is 21%. Its shareholders are then taxed on any dividends they receive from the corporation.
How To Start an LLC
LLCs are governed by state law, so setting up an LLC will look and cost different depending on which state you set yours up in. For example, in California, setting up an LLC involves filing two forms: one with a $70 fee, another with $20 within 90 days of the second form submission. In New York, on the other hand, there’s one form to file, but the fee is $200. You can find the information on how to set up an LLC on your state’s Secretary of State website. To form an LLC, you’ll need to have a registered agent in your state who must be available during normal business hours at a given address to receive legal documents for your LLC. You could serve as your own registered agent, or you could hire an individual or business to function in this role. Beyond the initial setup of your LLC, you will also need to maintain your LLC according to your state’s guidelines. These requirements vary by state and can include:
Filing an annual or biennial reportPaying an annual or biennial feePaying an annual franchise tax
title: “What Is A Limited Liability Company Llc " ShowToc: true date: “2023-01-27” author: “Salvador Adams”
What Is a Limited Liability Company?
An LLC is a type of business in which the owners are called members. The business entity is separate from the members so only the entity may be held liable if the company is sued or fails to pay its debts. An LLC contains elements of a sole proprietorship, a partnership, and a corporation. State laws determine the types of organizations that can create LLCs. Generally, most types of businesses can form an LLC, other than banks and insurance companies. Some states limit the types of services LLCs can offer. California, for example, prohibits LLCs that provide professional services like accounting and law firms, pharmacies, and doctors’ offices. State laws also determine who may be a member of an LLC, and the number of members the entity may have. In most states, members may include individuals, corporations, other LLCs, and foreign entities. Many states permit LLCs that have only one member.
How Does a Limited Liability Company Work?
All LLCs should have an operating agreement, which is essentially the rules and regulations for how the company will work. The agreement should describe who will manage the firm, how membership changes will be handled, and how profits and losses will be distributed. To protect members from liability, the operating agreement should state that the entity is separate from the members. Ownership changes will occur if existing members die or leave the firm or new members are added. The operating agreement should address these potential changes. For instance, it might outline a procedure for valuing and then selling a departing member’s share. If the LLC has only one member, the agreement should state how the firm will be dissolved if the owner dies. If membership changes occur at an LLC that has multiple members but no operating agreement, state laws might require the firm to dissolve and re-form. Besides management and membership changes, the operating agreement should address profits, losses, and taxes. Most LLCs are pass-through organizations. This means the company’s profits and losses are passed through to the members, who report them on their personal tax returns. The Internal Revenue Service (IRS) will normally tax a single-member LLC as a sole proprietorship. If an LLC has two or more members, the IRS will tax it as a partnership. The members of any LLC (including single-member entities) can choose to have their firm taxed as a corporation by filing Form 8832, titled Entity Classification Election, with the IRS.
How to Form a Limited Liability Company
The first step in creating an LLC is to choose a name for your firm that meets your state’s requirements. Some states require the words “LLC,” “Limited Liability Company,” or a variation thereof in the company name. Next, you’ll need to select a registered agent who resides in your state. Your registered agent will be responsible for receiving official documents (like lawsuits and subpoenas) on your firm’s behalf and forwarding them to your firm’s management. The agent may be a member or manager of your LLC or someone outside the firm. The next step is to draft your company’s operating agreement. You can hire an attorney to write your agreement or draft one yourself using a template you’ve obtained online. Once your agreement is completed, you can create your articles of organization by filling out a form provided by your state’s Office of the Secretary of State. Here are some of the details you’ll be asked to provide:
Your firm’s name and addressYour firm’s business purposeYour registered agent’s name and addressNames of the individuals or company that will manage your firm
Once you’ve completed your articles of organization, you’ll need to sign the form, submit it, and pay the required fees.
Pros and Cons of a Limited Liability Company
Pros of a Limited Liability Company Explained
Flexibility
A key advantage of an LLC is its flexibility. Members can decide how they want the firm to be managed and taxed.
Protection From Liability
Except in cases such as fraud, LLC members are generally protected from liability arising from lawsuits against the firm or debts the company assumes. If the LLC is the subject of a third-party suit or a claim for an unpaid debt, the members’ assets cannot be used to pay damages or the debt.
Pass-Through Entity
In an LLC, profits and losses are passed through to members, who include them on their personal income taxes. LLC members may be eligible for a 20% pass-through deduction under the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA allows non-corporate taxpayers to deduct up to 20% of their qualified business income (QBI). QBI means income earned from a U.S. trade or business, and excludes capital gains and losses, certain dividends, and interest income. In 2020, the deduction was allowed only for individuals whose income didn’t exceed $163,300 for single filers or $326,600 for those who are married and filing jointly.
Cons of a Limited Liability Company Explained
Self-Employment Tax
Members must pay their own self-employment tax (for Social Security and Medicare), which has a rate of 15.3%. Members may deduct half of this amount as a business expense.
Other Taxes and Fees
A second disadvantage is that an LLC may be subject to an annual state tax, an annual fee, or both. In New Hampshire, for instance, LLCs are included in the definition of “business organizations” and are therefore subject to the state’s business enterprise tax (BET) and business profits tax (BPT) if gross business receipts exceed $150,000 or the enterprise value tax base was greater than $75,000, respectively. Meanwhile, in California, an LLC must pay $800 to the state whether or not it’s conducting any business. If the firm’s annual income exceeds $250,000, it must also pay an annual fee that ranges from $900 to $11,790.
Banking Restrictions and Fees
When it comes to banking, any check made out to an LLC cannot be cashed, but instead deposited into a separate corporate account. Some banks also have higher fees just for businesses that are incorporated.
