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What is an LLC and How Does it Work?
LLC stands for Limited Liability Company. An LLC is a type of US business structure that combines the features of Corporations, Sole Proprietorships, and Partnerships. An LLC offers limited personal liability protection, similar to that of a Corporation, as well as the pass-through taxation that Sole Proprietorships and Partnerships provide.
Forming your business as an LLC is the most straightforward way to ensure your personal assets are protected if your business is sued. In addition to liability protection, LLCs offer three different taxation options. These are the main reasons why LLCs are the most common formal business structure in the US, according to the National Small Business Association (NSBA).
LLCs are very flexible entities, which is another reason why they are such a preferred option for many new business owners. An LLC can have one or more owners, which are referred to as “members”. Members of the LLC may choose to actively be involved with the day-to-day management of the business. These types of LLC are referred to as “member-managed LLCs”. For owners who prefer to be hands-off, they can also choose to select non-member individuals to run their business day-to-day, which are known as “manager-managed LLCs”. For more on the management structures of an LLC, check out our guide: Member-Managed vs. Manager-Managed LLCs.
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Benefits of an LLC
If you’re wondering, “Should I form an LLC?” you have come to the right place. If you’re already running a business as a sole proprietor or partnership or just getting started, an LLC can be a great business structure choice. An LLC can benefit nearly every business type because it combines liability protection and tax status options. Thus, they have a level of flexibility that other types of business structures lack. This is how an LLC can work great for a local small business just as well as it works for huge, multi-national businesses like Pepsi (Pepsi Cola Decatur LLC) and Amazon (Amazon.com LLC).
Advantages that LLCs provide:
- Limited Liability Protection for Owners
- Tax Status Flexibility
- Simple to Manage
- Ownership Flexibility
- Easier Access to Funding
Limited Liability Protection for Owners
One of the primary advantages that an LLC provides is personal asset protection for members if the business is sued or files for bankruptcy. This protection shields the LLC members from personal responsibility for any debts or other business liabilities. Thus, the owner’s personal assets such as their bank accounts, home vehicles cannot be (typically) viewed as company assets.
Tax Status Flexibility
The other most important benefit that an LLC provides is its flexibility regarding taxation. By default, LLCs are treated as a pass-through taxation entity, similar to Sole Proprietorships and Partnerships’ tax status. With pass-through taxation, a business set up as an LLC has its profits or losses passed directly onto its owner. This means that any profits are taxed only once and are not subject to the “double taxation” that Corporations are by default. In addition to this, LLCs also can elect for C-Corporation or S-Corporation tax status. This flexibility allows business owners to choose the tax status that will work best for their business.
Simple to Manage
Managing an LLC is relatively easy and involves very little paperwork. Unlike Corporations, LLCs don’t need to assign officers formally. Also, LLCs are not required to complete the same level of record-keeping, such as holding annual meetings or recording company minutes like a Corporation is required to do. This makes the ongoing management of an LLC much more streamlined, simple, and less time-consuming than their Corporation counterparts.
Ownership Flexibility
LLCs offer flexibility when it comes to ownership and management of a business. LLCs can have one owner, which is known as a single-member LLC, or have two or more members, which is known as a multi-member LLC. In addition to being able to have multiple owners, LLCs can also be run day-to-day by the members, which is known as member-managed LLC, or they can designate a manager to run day-to-day operations, which are known as manager-managed LLCs.
Easier Access to Funding and Financing
Forming an LLC allows you to start to build business credit history and can demonstrate that your business is separate from you as an individual. As a result, this can help increase the likelihood of getting business loans, lines of credit, and other outside funding. Your financing options include but are not limited to Bank loans, SBA Loans, Unsecured Loans, Invoice factoring, Business lines of Credit, and Merchant Cash Advances.
Disadvantages of an LLC
While there are many benefits to forming your business as an LLC, there are few areas where an LLC is at a disadvantage:
- Limited Outside Investment Potential: As a result of being a pass-through entity by default, LLCs cannot easily take on new owners. Without the ability to issue stock, LLCs have limited ability to obtain significant outside investments from new owners or angel investors. In this aspect, Corporations can attract investors more easily as they can issue stock.
- Higher Startup Costs: While forming an LLC is cheaper than forming a Corporation in most cases, LLCs do still require an initial filing fee and may require additional on-going fees (this varies from state to state). When considering the initial cost, starting as a Sole Proprietor or Partnership is cheaper as they do not require the formal filing of paperwork. However, keep in mind that while starting as a Sole Proprietor or Partnership may be more affordable, they lack the liability protections provided by an LLC.
LLC Taxes: How are LLCs Taxed?
Limited Liability Companies (LLCs) are a newer type of business structure; thus, they are treated differently from other business structures by the IRS. By default, LLCs are treated as a Sole Proprietorship or “Disregarded Entity” if there is only one member. Single-member LLCs do not pay taxes themselves or file a separate return with the IRS. Single-member LLCs report all profits (or losses) of the LLC on Schedule C and submit this with their regular 1040 tax return. If you’d like to learn more about the similarities and differences, read our LLC vs sole proprietorship comparison guide.
If it is a multi-member LLC, the IRS treats the business as a Partnership for tax purposes. Like single-member LLCs, multi-member LLCs do not pay taxes directly. Instead, a multi-member LLC has any profits (or losses) distributed to the owners according to their ownership percentage, as outlined in their LLC operating agreement. Any taxes are paid on each owner’s individual personal income tax returns, with a Schedule E attached. Also, multi-member LLCs file an information return known as Form 1065 with the IRS. This return ensures that all LLC members are reporting their income correctly. For more information on the critical differences between the two, you can read our guide on LLCs vs partnerships.
In addition to these default designations, an LLC can choose to elect to be treated as a Corporation by filing IRS Form 8832, Entity Classification Election. An LLC can also elect S-Corp taxation by filing IRS Form 2553, Election by a Small Business Corporation.
How to Form an LLC
The process for forming an LLC varies from state to state, however generally speaking there are 6 basic steps in every state.
You may want to consider using a professional filing service to form your LLC for peace of mind. Using a filing provider ensures that your formation paperwork is submitted correctly without errors and can help if any issues arise in the formation process. Check out our list of the Top 5 Best LLC Formation Services.
Six Basic Steps to Forming an LLC
- Select your State of Formation
- Choose your LLC Name
- Choose a Registered Agent
- File your Articles of Organization
- Create an Operating Agreement
- Obtain a Federal Tax ID (EIN)
1. Select your State of Formation
To start, you’ll want to choose the state where your LLC will be legally formed. In almost all cases, a new business should be formed in the state where the owners reside and where the company will operate. If you choose to start your LLC in a state other than where your business will operate, you could face fines, penalties, and fees by not being properly registered.
2. Choose your LLC Name
Next, you will need to choose the legal name of your LLC. Your LLC name must be unique and distinguishable from all registered businesses in the state where you’re forming your LLC. Generally speaking, your name must not include any unapproved words or phrases that could confuse the business with a government or regulatory body. Also, the name must end with “Limited Liability Company”, “LLC”, “L.L.C.” or other approved name to denote that the business is legally formed as an LLC. As a result, the name cannot include words like “Corp”, “Inc”, “Corporation” or “Incorporated” as this could cause confusion about the legal structure of your business. Keep in mind these are general rules and what words are permitted in your state may vary.
3. Choose a Registered Agent
You will need to designate a registered agent to accept legal documents, tax notifications, and other official correspondence from the state on your LLCs behalf. A registered agent can be an individual who lives in the state or a commercial registered agent. The registered agent will be required to be listed on your Articles of Organization.
4. File your Articles of Organization
To officially form your LLC you will need to submit Articles of Organization and pay a fee to state. The formation document is also known as a Certificate of Organization or Certificate of Formation in some states.
5. Create an Operating Agreement
An LLC operating agreement is the legal document that details the LLC members’ ownership percentages and duties. As a result, the operating agreement is a vital document for every LLC. Having an operating agreement ensures that your limited liability status is protected and helps to avoid any potential issues in the future should they arise.
6. Obtain a Federal Tax ID (EIN)
A Federal Tax ID (EIN) is also known as an Employer Identification Number or Federal Employer ID Number (FEIN). EINs are issued by the Internal Revenue Service (IRS) to identify businesses and other entities. EINs are used in a similar way to a Social Security Number is for an individual. EINs are used to identify your business on tax returns and are also required to open a business bank account. For more information, visit our article How to Get an EIN for an LLC.
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Want a more in-depth guide to starting an LLC? Check out our ultimate step-by-step guide:
How to Start an LLC: A Step-by-Step Guide to Forming an LLC
LLC Frequently Asked Questions (FAQs)
What is the downside to an LLC?
The main downsides to an LLC is the upfront filing cost and that LLC members must pay taxes on their share of income, regardless of if they received a distribution or not. Even with these downsides LLC’s are a great option for business owners who want liability protection but want to avoid the “double taxation” that Corporations are subject to.
What is an LLC used for?
An LLC or Limited Liability Company is a legal business structure that provide some legal and financial protection for the members (owners) of the business. An LLC must be legally formed, and this formation varies state by state.
What does LLC stand for?
LLC is an acronym for Limited Liability Company.
What is the difference between a business license and an LLC?
The term “business license” is a general term that refers to variety of different types of registrations controlled by federal, state and local government agencies. This can include things such as Sales Tax Permitting and Wittholding IDs for employers among many others.
An LLC on the other hand refers to a specific legal business structure, referred to as a Limited Liability Company. If you choose to form your business as an LLC you will also need to register with the relevant federal, state and local agencies for all applicable licenses and permits for your business. When filing for a business license you’ll need to provide your business name, thus you will want to complete your LLC formation prior to applying for business licenses.
Is an LLC really necessary?
An LLC is not required to start a business, however, the advantages and benefits an LLC provides such as liability protection and taxation flexibility often outweigh the upfront cost and time it takes to form an LLC.
What does an LLC do for you?
An LLC protects its owners’ assets by separating them from business assets and liabilities. This does not protect you if you a personally liable for your own negligence or wrongdoing even when providing duties related to your business.
What is the difference between an LLC and an S corporation?
An LLC is a legal business structure. An S corporation is a taxation classification that can be used by either LLC or corporations. In most cases, an LLC will file taxes under the default “pass-through” taxation where all profits are taxed to the members, and no taxes are paid directly by the business. The S corporation taxation may be used if the following are true.
1. The business can pay the owners a reasonable salary
2. There is substantial distribution year over year
3. There is a positive return on investment for payroll service costs
4. The business meet S corporation requirements
Who should consider an LLC for their business?
If you have multiple owners or have employees, you may wish to form an LLC to protect and separate your personal assets from those of the business. You may also wish to consider an LLC if the business has significant risks and need or want to separate your personal finances from those of the business.