A Limited Liability Company (LLC) is a type of business entity that combines the best parts of corporations, sole proprietorships, and partnerships into one to offer owners (also known as members) liability protection, flexible management structure, and tax advantages.
Forming an LLC is the simplest way of structuring your business to protect your personal assets in the event your company faces a lawsuit. LLCs can be owned by one or more people, known as LLC members.
One owner LLC is known as a single-member LLC while an LLC with more than one owner is a multi-member LLC.
What is an LLC?
LLC stands for “limited liability company” and is a type of legal entity that can be formed to own and operate a business. LLCs are very popular among small businesses as they provide the same limited liability as a corporation, but are easier and cheaper to create and manage.
Though the regulations surrounding LLCs vary from state to state, many states don’t restrict ownership, meaning anyone can be a member including individuals, corporations, foreigners, foreign entities, and even other LLCs.
However, some entities such as banks and insurance companies cannot form LLCs.
Simply put, to answer what is an LLC, it is a formal partnership arrangement between members that requires articles of organization to be filed with the state. Not only is an LLC much easier to set up than a corporation, but it also provides more flexibility and protection.
Who Should Form An LLC?
Any person starting a new business, or is currently running a business as a sole proprietor, should consider forming an LLC. This is especially true if you want to limit your personal legal liability as much as possible. Forming your business as a limited liability company (LLC) will help you by:
- Protecting you against lawsuits
- Reducing paperwork compared to those of corporations and other legal entity types
- Preventing double taxation
- Make your business appear more credible to customers and creditors
LLCs can be used to own and run almost any type of business. However, some types of professions will require special professional LLCs to operate. Other than that, an LLC can be used for a business of any size – from a single owner operation to businesses with many co-owners. LLC is also the most common legal entity used in the rental and commercial property industry.
Benefits of Forming a Limited Liability Company (LLC)
There are many reasons to start an LLC and some of the benefits of an LLC include the following:
Personal Asset Protection – An LLC provides its members with limited liability, meaning that the owners or members are not personally liable for any debts incurred by the LLC business or business-related lawsuits. Since you’re not personally liable, creditors or those who file lawsuits against your LLC cannot collect payment in the form of personal assets like your personal bank accounts, car, or property.
Pass-Through Taxation – LLC owners can opt for their pass-through taxation where profits and losses incurred are passed through the business into the owner’s personal tax return. Such profits are then taxed as personal tax rates instead of corporate level.
In terms of taxation, single-member LLCs (SMLLCs) are usually treated the same as sole proprietorships in the sense that the owner will report the LLC’s profits, losses, and deductions on IRS Schedule C and files it together with his or her personal return.
An LLC with two or more members will be treated as a partnership. Similarly, the LLC profits and losses are reported on the owners’ personal returns and taxed at their personal rates.
Since LLCs are pass-through entities, LLC owners can qualify for the special pass-through tax deduction that took into effect in 2018. This act allows an income deduction of up to 20% of net business income earned by pass-through businesses.
Simplicity – An LLC is one of the simplest and easiest business entities to form and operate. Unlike a corporation, an LLC does not require officers and directors, board or shareholder meetings, or other administrative burdens of having a corporation.
Flexibility – An LLC provides a ton of flexibility in terms of ownership, management, and taxation. There’s no minimum or a maximum number of members required to form an LLC. Many LLCs only have one member while some can go up to five, ten, or even hundreds of members.
An LLC can be managed by its members – meaning, all the owners share the responsibility in handling day-to-day business operations or members can also opt to designate one or more managers to run the business. These managers can be members, non-members, or a combination of both.
As a limited liability company (LLC), you also get to choose how you want to be taxed, either as sole proprietorships or partnerships. However, SMLLCs and multi-member LLCs have the additional advantage of choosing to be taxed like a corporation simply by filing a document called an election with the IRS.
Here, LLC businesses can choose to be taxed as a C corporation or an S corporation. Either way, LLC owners will be treated as normal employees of the corporations.
C corporation taxation, the LLC will pay taxes on business profits at the corporate tax rate that’s 21$ much lower than most individual rates. S corporations, on the other hand, allow the LLC to remain as a pass-through entity with profits being passed through the business to the owners to be taxed at individual tax rates.
However, these distributions are not subjected to Social Security and Medicare taxes, hence resulting in tax savings.
Credibility – Forming an LLC to own and run your business can actually boost your credibility as it reassures customers that you’re a real business. An LLC is recognized as a more formal business structure compared to a sole proprietorship or partnership. Additionally, you also have an official business name to use.
Access to Business Loans – Once you have formed an LLC, your business can begin building a credit history, which will help with your business access loans and lines of credit.
Disadvantages of Forming an LLC
Cost – Forming an LLC and operating it generally costs more than running a sole proprietor or partnership business. You’ll need to pay filing fees to legally establish an LLC. Although it’s not legally required, it is highly recommended for an LLC to adopt a written LLC operating agreement to lay out how the LLC will be governed.
Once you form an LLC, you’ll also need to pay all annuals fees and taxes to the state. The amount will vary from state to state, but it can get up to $800 per year or more for highly profitable LLCs.
Investment – An LLC is not an ideal choice for owners looking to seek outside investors, especially if you’re looking for funding from venture capitalists, who ordinarily will only fund corporations.
Corporations are best for outside investments since they offer stocks that can be issued in exchange for investors’ money. This is not to say that outside investors cannot invest in LLCs.
Though outsiders can invest in LLCs and receive LLC ownership interests, it can be a very complicated process.
Limited Liability Company vs Partnership
The primary difference between a partnership and an LLC is that an LLC separates the company assets of the company from personal assets. This will protect LLC members from the company’s debts and liabilities.
An LLC functions the same way a partnership does in the sense that the company’s profits get passed through to the tax returns of its members. Losses can also be used to offset other income but only up to the total amount invested by the member.
In the event of a sale or transfer of business, a business continuation agreement needs to be established to ensure a smooth transfer of interests when one of the owners decides to leave or dies. Without a business continuation agreement, the remaining partners must dissolve the LLC and create a new one in the event where one partner files for bankruptcy or passes away.
How Do I Form an LLC?
Now you understand what is an LLC, the process of forming an LLC is fairly simple. We have a super in-depth article on how to create an LLC, but generally, these are the steps that you’ll need to follow in order to form an LLC.
Name your LLC.
When picking an LLC name, you need to make sure that the current LLC name isn’t used by any other business in your state. And often, you’re also required to add the term “Limited Liability Company” or its abbreviation “LLC” to your name for others to know the type of business it is.
File Articles of Organization.
This is a basic document that will identify your business name, address, as well as other entity information. It is best to check with your Department of State to see if they already have a form that’s easy to fill out.
Identify a Registered Agent to represent your LLC.
Next, you need to identify and assign a registered agent to receive any legal documents. A registered agent can be a member, yourself, or even a third-party business, so long as they’re a person, above 18 years of age, and have a physical address in the state you’re running.
Pay your state’s required fees.
Initial filing fees vary by state. You may also need to pay an annual fee to form an LLC.
A notice of intent to form an LLC.
Some states require business owners to publish a notice in your local newspaper to announce your intent. The newspaper staff can easily guide you on what to do with this. However, you may also need to be prepared to file an affidavit of publication with your state.
Create an LLC operating agreement.
An LLC operating agreement is required by most states and works to prevent possible issues that may occur between LLC members. An operating agreement is a written document that details the responsibility of each member, distribution of profits and losses as well as other important information linked to the operation of the LLC.
Frequently Asked Questions about LLCs
How much does it cost to form an LLC?
The cost to form an LLC varies from state to state but generally will cost approximately $100 to $200 if you file it yourself. Most of the cost will go into the filing fee of your articles of organization. The incurred costs will be more if you decide to hire a lawyer.
How are LLCs taxed?
The default tax regime for single-member LLC is to be taxed as a sole proprietorship, while multi-member LLCs are taxed like partnerships. However, LLC business owners also have the option of having their LLC taxed as a C corporation or S corp by filing an election with the internal revenue service (IRS).
Where should I form an LLC?
It is normally recommended for you to form your LLC in the state where your business is located as there are ordinarily no great advantages to forming your LLC in any other state.
Do I need a lawyer to form an LLC?
No, you don’t need a lawyer to form your LLC business. You can form your LLC yourself.
What’s the difference between a corporation and an LLC?
Both corporations and LLCs provide their owners with limited liability. But LLCs are taxed like sole proprietorships or partnerships by default. In addition, LLC owners also do not need to work as employees of the LLC as they are considered as self-employed small business owners.
Corporate shareholders who work for the corporation must be treated as employees of the corporation. In terms of taxation, S corporations are pass-through entities where profits pass through the business and are taxed at the shareholders’ individual rates called pass-through taxation while C corporations act as separate taxpaying entities with a low 21% tax rate.
What’s the difference between a sole proprietorship and an LLC?
A sole proprietor personally owns a business as well as all its assets with no separate business entity involved. In this case, the sole proprietor is personally liable for all business debts and lawsuits incurred by the company. This means that creditors or lawsuit plaintiffs can reach the proprietor’s personal assets in order to satisfy a debt.
An LLC, on the other hand, acts as a separate business entity. The LLC owns the business and all its assets without involving the LLC members’ personal assets, hence are not personally liable for LLC debts and lawsuits.
What is a professional LLC?
In some states, individuals in certain types of professional practices are not allowed to form regular LLCs. Instead, they need to form professional LLCs which are specially designed for licensed professionals like lawyers, doctors, architects, engineers, accountants, etc.
The main difference between a professional and a regular LLC is that all the members of a professional LLC must hold a professional license.
What is a Series LLC?
A series LLC is a company whose articles of formation or articles of organization allows for unlimited segregation of membership interests, assets, and operations into independent series.
Each series operates as a separate entity with a unique name, a bank account with separate books and records. Series LLCs are often used by real estate investors with multiple properties as each series isolates and protects its properties from the liabilities of the properties in other series.
Limited liability companies with different profit centers can also use series LLCs to segregate and protect each business operation. However, you need to take note that only certain states allow the formation of series LLCs.
What is a domestic LLC?
A domestic LLC is an LLC that’s conducting business in the state in which it was formed.
What is a foreign LLC?
A foreign LLC is when an existing LLC decides to open offices or have other kinds of physical presence in a new state. For example, if an LLC “organized” in texas opens a business establishment in Michigan, then your Texas LLC will need to also form a foreign LLC in Michigan.
Are there any age requirements for forming an LLC?
No, there’s nothing preventing a minor from being a member of an LLC. However, some states have LLC laws that prohibit minors under the age of 18 from serving as organizers to form the LLC.
Who will manage the LLC?
Generally, an LLC is managed by its members, known as member-managed. However, in some cases, members will appoint a manager to help handle the LLC’s daily operations and this is called manager-managed.
The membership of an LLC and the way it will be run are usually laid out in an operating agreement, which is an internal agreement among all the members of the LLC.
Do I need insurance for an LLC?
Though you do not need insurance for an LLC, it is highly recommended to have one. A good liability insurance policy can shield your personal assets when limited liability protection does not.
One such example is if you’re a massage therapist and accidentally injure a client’s back, your liability insurance policy should cover you as well as your personal assets in this scenario should your limited liability status be ignored by a court.
In addition to protecting personal assets, insurance can also protect the LLC’s assets from lawsuits and claims. However, your LLC won’t be protected if it doesn’t pay its bills as commercial insurance does not protect personal or corporate assets from unpaid business debts.
Starting a business correctly doesn’t have to be difficult. With over 15 years of experience consulting new businesses and start ups, Matthew is probably the best person to help you set a strong foundation for your business.