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What Is an LLC?

image for fizkes / Getty Images
fizkes / Getty Images

One of the popular structures for forming a business is a limited liability company, commonly known as an LLC. This legal structure provides protections to its owners, ensuring they have limited liability when it comes to the debts and obligations of the company.

LLCs are a hybrid type of entity that has characteristics of a corporation, partnership or sole proprietorship. A key benefit is that owners have limited liability when it comes to the debts and obligations of the organization.

LLCs are formed by filing articles of organization with your secretary of state's office where your business will be located. Given that details vary by state, the owners will need to be aware of the rules and regulations of forming an LLC in the state where they plan to operate.

According to details offered by LegalZoom, this means that under most circumstances, there are many advantages for business owners who want this type of protection and structure.

"LLCs aren't bound by the same rigid rules of corporations, but this doesn't stop them from being just as useful," states the company's website. "It doesn't matter if you're a one-man business or if you have hundreds of employees, an LLC keeps protecting you while allowing for expansion and growth. With an LLC, there's no requirement for special meetings, extensive corporate records, or many other formalities."

Susan Henderson, senior tax manager with California-based Hudson Henderson and Company Inc., said there are tax matters to consider, particularly with the variance in different state tax laws.

"For some businesses, an LLC makes sense, as it allows for the operation of a business with lots of investors and, potentially, the flexibility to distribute income however they deem appropriate from a year-to-year basis (assuming they have adopted the partnership tax treatment for the IRS)," she said. "This flexibility could also include deciphering which members should pay Social Security tax on income and who doesn't. However, state laws vary greatly in regard to LLCs, so you need to be aware of the tax situation specific to your state to determine if this is to your advantage."

The federal government references LLCs as a "disregarded entity." This means that when you choose this particular business structure, you have to elect to be taxed by the IRS as either a partnership or a corporation (either as an S corp or C corp). Once this selection is made, the business calculates tax based on partnership or corporate tax rules for the IRS and then prepares an LLC return for the state in which they do business.

Another large benefit is that LLCs are not subject to federal taxes. Instead, profits and losses of the business are passed on to each owner, who then pays personal income taxes. This avoids double taxation and gives owners a better opportunity to keep as much of the profits as possible.

Management of the business is another key benefit. The business can either be member-managed, which means the day-to-day responsibilities are handled by the owners themselves, or manager-managed, meaning the owners bring in someone from the outside to handle the daily needs of the business.

As indicated, a key point to consider is the higher self-employment tax owners are subjected to, and that in many states, the types of businesses that can be formed via LLC are restricted. Many states prohibit businesses in the financial services industry from forming an LLC.

For those who want to go this route, establishing an LLC can be done by following a few key steps. Generally, you'll need to choose the name for your business (several states offer a way to determine if the name is available), file the articles or organization, create an operating agreement, and get the right licenses and permits.

Online services like LegalZoom and NOLO offer methods to initiate this process. Also, you can check with a local accountancy firm and attorney to get the ball moving.