Choosing the right business entity can be tricky, but understanding what an LLC is can help you make the best choice.
- LLC stands for limited liability company, and it can protect the personal assets of a business owner from lawsuits.
- An LLC can be taxed as a sole proprietorship, an S Corporation or a partnership.
- An LLC can have an unlimited number of members unlike an S-corp, which is limited to 100 shareholders.
- This article is for entrepreneurs who want to know if an LLC is the right structure for their new business.
One of the more popular structures for forming a business is a limited liability company, commonly known as an LLC. An LLC is flexible, giving you options for how your business is taxed and the number of owners it allows, but its most compelling quality is its ability to limit your personal liability if your business is sued or files for bankruptcy. Read on to learn more about this business structure and how to form it.
What is an LLC?
LLCs are a hybrid type of legal entity that has characteristics of a corporation, partnership or sole proprietorship.
"LLCs are just another entity type to protect the business owners," said Ryan Gordon, an attorney at the Lyda Law Firm.
According to LegalZoom, under most circumstances, there are many advantages for business owners. "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."
It's for these reasons that LLCs are one of the more popular and flexible types of business legal structures, especially for small companies and startups.
Key takeaway: LLC stands for limited liability company, which is a business entity that helps shield business owners' personal assets from the business's debt and lawsuits.
What are the benefits of an LLC?
The biggest benefit of an LLC is that it protects its owners' personal assets should the business face any legal issues. Suppose your business is hit with a lawsuit. If your business is structured as an LLC, your assets are protected from any judgments that are imposed on the business. If your business can't afford to pay the judgment, you, as a business owner, won't be forced to pay the money from your personal finances.
Flexibility in how the business's management team is structured is another key benefit. LLCs 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 running of the business. LLCs don't limit how many owners a business can have, and they allow you to see how profits are divided among the owners, based on the operating agreement.
"The LLC's operating agreement provides the framework for how the company will be run, the relationships between the managers and members of the company, the plan for allocating profits, and other critical information pertaining to the operations of the LLC," said Paolo De Jesus Jr., managing partner at Romano Law.
Also, if you're not a big fan of paperwork, an LLC is worth considering because it requires much less documentation and administrative procedures than other business structures.
Key takeaway: The benefits of filing as an LLC include liability protection, management flexibility and a simple filing process.
How are LLCs taxed?
The federal government references LLCs as a "disregarded entity." When you choose this particular business structure, you are taxed by the IRS as a sole proprietorship (if you're a single-member LLC), a partnership (if you have more than one member) or a corporation (either as an S corporation or a C corporation, if that's what you elect). Once this selection is made, the business calculates taxes based on those tax rules for the IRS and then prepares an LLC return for the state in which they do business.
The benefit of this is that LLCs are not subject to separate federal taxes, unless the LLC is a C-corp, because the LLC's profits and losses are passed on to each owner, who then submits that info with their personal income tax return. This "flow-through" structure avoids the double taxation that corporations experience, where the business pays taxes on profits, which are then taxed again when the business owner pays personal income tax on them.
However, business owners must pay self-employment taxes, and they may also find themselves in a higher tax bracket. In such instances, they may be able to save money by electing to be taxed as an S-corp.
"It is actually possible for an LLC to also be an S-corp for the purposes of taxation," Gordon said. "LLCs may also be taxed as partnerships, and partnership taxation is actually the default classification of an LLC for tax purposes."
What is the difference between an LLC, an S-corp or a partnership?
A common question many new business owners have when they're choosing their legal structure is, "What's the difference between an LLC, an S corporation or a partnership?"
First, let's address the common root of confusion, which usually comes from using these terms to talk about a legal entity's structure when you're talking about the way it is taxed. An S-corp is a tax classification.
"There is no such thing as 'LLC tax,'" said Heather Harmon Kennedy, owner of Harmon Kennedy Law. "So even though you may have an LLC as your entity structure, you might be taxed as a sole proprietor, partnership, S-corp or C-corp."
If your LLC consists of only you – one member – the IRS treats the LLC as a sole proprietorship. If you have multiple members, though, the LLC will be taxed as a partnership. Then, depending on your specific tax situation, you may elect to be taxed as an S-corp.
With an S-corp, business owners may be able to reduce their personal tax burden, as the business pays them a salary and their payroll taxes – which means they do not pay self-employment taxes. But, S-corps have some additional restrictions that you want to be aware pf. For instance, non-U.S. citizens cannot be owners in an S-corp, but they can in LLCs.
Compared to an S-corp, an LLC is more flexible and generally less restrictive, said Xavier Morales, CEO and founder of Secure Your Trademark.
"For example, an LLC can have unlimited members while an S-corp can have no more than 100 shareholders or owners," said Morales. [Read related article: Should You Set Up Your Business as an LLC or S Corporation?]
Key takeaway: An LLC can be taxed as a sole proprietorship or partnership. An LLC can choose, though, to be taxed as an S corporation. S-corps restrict the number of shareholders and require business owners to take a salary.
Do LLC laws vary by state?
In many states, the types of businesses that can be formed via LLC are restricted. For instance, many states prohibit businesses in the financial services industry from forming a limited liability company.
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)," said Henderson. "This flexibility could also include deciphering which members should pay Social Security tax on income and who doesn't. However, state laws vary greatly regarding LLCs, so you need to be aware of the tax situation specific to your state to determine if this is to your advantage."
Key takeaway: LLC laws vary by state; check the laws of your business's the state where the business was founded before choosing this structure for your business.
How do you start an LLC?
For business owners looking to pursue the LLC route, here's what you need to do to get set up. Remember, the requirements vary based on the state, but the following are general rules that apply wherever you are located.
1. Choose an available name for your business.
You won't be allowed to use a name that is already taken, and several states offer a way to determine if the name is still available.
"It is important to be original and unique when choosing a name in order to avoid confusion and potential trademark infringement claims," said De Jesus. "If you have chosen a name that is available, but you are not yet ready to file the LLC documents, you may want to reserve the name you have chosen to ensure it is not taken before you file. The length of the reservation period will vary from state to state."
2. Choose a registered agent.
A registered agent is an individual or company in the state you're filing that receives your official documents on behalf of your LLC. A registered agent is basically a go-between that passes information along to you. This is a requirement in most states.
3. Prepare the LLC operating agreement.
Even though this may not be required in some states, De Jesus suggests drafting one anyway because it's important to have an outline of how your LLC will run.
The operating agreement includes details about the
- Organization of the business
- Board of managers
- Voting requirements
- Restrictions on transferring and selling shares
- Division of company profits and losses
- Dissolution of the company, if needed
[Read related article: Your Small Business Guide to LLC Operating Agreements]
4. File articles of organization with the state.
LLCs are formed by filing articles of organization with the secretary of state's office. To fill out this form, you will need the name, address and purpose of your LLC. Depending on the state, the filing fee varies, and the articles of organization may be referred to as a different name, like the certificate of formation.
Online services like LegalZoom and NOLO offer methods to initiate this process. You can also check with a local accountancy firm or attorney for help forming your LLC. [Read related article: How to Start an LLC: A Step-by-Step Guide]
Key takeaway: Establishing an LLC can be done by choosing an available name for your business, filing the articles of organization, creating an LLC operating agreement, and obtaining the necessary licenses and permits required by your state.
Additional reporting by Derek Walter. Some source interviews were conducted for a previous version of this article.