What is an LLC?

by Team ZenBusiness

- November 19, 2018 11:00 am

At some point, inspiration struck you to go into business for yourself.  You had a vision of building customized birdhouses or catering vegan events or running a cosplay cleaning service…whatever it was, endless paperwork and corporate meetings were probably not a big part of your vision.

You have probably realized that there are precautions to take in business. At the very least you’ve been made aware that you can protect yourself from liability—that is, legal and/or financial obligations such as lawsuits and debt collectors—by making your company a separate legal entity as opposed to a simple sole proprietorship or partnership.

So, how do you avoid the red tape of becoming a corporation while still keeping your personal and business resources separate? Most entrepreneurs select a limited liability company, or LLC. In fact, 90% of ZenBusiness customers choose to form an LLC over a corporation.

Legal Entity and Tax Entity

To best explain what an LLC is, as opposed to other business entities (such as a corporation, limited partnership, etc.), it helps to know the difference between a legal entity and a tax entity. The legal entity refers to how the courts, state, and others view your business, while the tax entity refers to how the business is taxed.

Legal Entities

You may know that a corporation is a legal entity separate from the people who form and own it. As a separate entity, the corporation itself pays taxes and can be held liable for its actions, and this separation protects owners from personal liability. But corporations require extensive record keeping, operational processes, and reporting.

Limited liability companies were first introduced in the 1970s, and the concept has attracted many business owners because they offer liability protection, flexibility in taxation and management, a more relaxed and flexible management structure, and minimal record keeping. An LLC is a legal entity that provides limited liability protection, meaning owners are protected from the LLC’s debts and claims (i.e., assertions by claimants for compensation, payments, or reimbursements for losses) should something happen to the company. They also allow their members to avoid corporate tax. Speaking of which, let’s talk about how LLCs are taxed as opposed to other businesses.

Tax Entities

LLCs have great flexibility in terms of how they are taxed. By default, a single-member LLC is taxed as a sole proprietorship while a multi-member LLC is taxed as a partnership. However, by filing an additional form with the IRS, you do also have the option of having your LLC taxed as an S-corporation or C-corporation.

But the reason that approximately 90% of ZenBusiness’s clients choose LLCs over corporations is to avoid double taxation (being taxed twice). As a tax entity, a corporation can be either a C-corporation or an S-corporation. A C-corporation is taxed twice: once for the corporation’s profits (corporate tax) and again when profits go to the corporation’s owners, or “shareholders” (individual tax). A corporation can avoid this double taxation if it qualifies to be an S-corporation, which allows the corporate tax to be circumvented so that only the individual tax is paid by the shareholders. The S-corporation status also allows shareholders to avoid self-employment taxes. However, the IRS imposes strict guidelines for qualifying to be an S-corporation, and the additional paperwork can be daunting.

Similar to the S-corporation, an LLC is a “pass-through entity,” meaning that profits or losses are able to be passed through to your personal income without facing corporate taxes, similar to sole proprietorships and general partnerships. However, owners of the LLC are considered self-employed and are subject to self-employment tax. LLCs are not their own tax entities.

There are some instances in which, for tax purposes, it may make sense for an LLC to be taxed as an S-corporation or even a C-corporation. In those cases, an LLC can file IRS Form 2553 to be taxed as an S-corporation or Form 8832 to be taxed as a C-corporation.

What is an LLC?

So, from the above, you can see why many business owners consider an LLC to be the best of both worlds. From a liability standpoint, they can avoid losing their shirts if someone slips in their place of business and decides to sue. From a taxation standpoint, they can avoid paying the government taxes twice and only pay as individuals, as opposed to corporation shareholders who must first pay their corporate taxes and then pay taxes on the income they make as individuals.

To further define LLCs, it helps to compare them to other business types, as in the following chart:

Benefits of an LLC

We already discussed the first two main advantages of having an LLC protecting your personal assets from liability and avoiding double taxation but let’s outline all the benefits here again for review.  

    • Protects Your Personal Assets – As with a corporation, an LLC’s owners are protected from the LLC’s debts and claims (e.g., lawsuits or claims for compensation, payments, etc.) should something happen to the company. Those wishing to sue or collect debts from your company will be coming after the corporation or the LLC, not you as a person.
    • Separates Business from Personal – Both LLCs and corporations keep your income and losses and your business’s income and losses separate.  If you’re saving for Susie to attend dental school or veterinary school so she can become a dentist or veterinarian or horse dentist, you don’t have to worry about the business’s debts eating into that money.
    • Establishes an Official Business – With an LLC (as well as a corporation), your company becomes a state-recognized entity.  Not only is that distinction important on an official government level, but you’ll likely find clients and others more willing to take you seriously when you have that “LLC” behind your company’s name.
    • Avoids Double TaxationLLC owners don’t have to pay government taxes twice and only pay as individuals, as opposed to corporation shareholders who must first pay their corporate taxes and then pay taxes on the income they make as individuals.
    • Offers Flexible Management Structure – LLCs aren’t required to have the same formal structure as corporations. Corporations must meet annually to elect a board of directors to oversee company policies and officers to run the business. But LLCs have much more flexibility in how they operate and make decisions for the business.
    • Provides Tailored Ownership Options – An LLC treats its ownership as a percentage owned by each owner, called a “member.” LLC members are free to determine ownership percentages among members as they wish, without regard to how much capital each member contributed.
    • Requires Less Reporting – Although legal requirements for reporting and bookkeeping vary from state to state, generally speaking, LLCs have fewer requirements for both than corporations. And let’s be real: When you dreamed up starting a business, how much of that involved doing the red tape and bureaucracy?
Disadvantages of an LLC

There are a few reasons why business owners may be hesitant to form their business as an LLC.

    • Is Not Recognized Outside the USA – Unlike corporations, LLCs are not recognized outside the US. That means doing business in other countries would be more difficult.
    • Does Not Allow Stock to Be Issued – LLCs have a hard time raising capital for the growth of a business because the owners can’t issue shares of stock to attract investors. Many investors are more likely to be attracted to investing in the more familiar form of corporations. It’s also not possible to do an IPO with an LLC.
Other Considerations

There are a few other things you will need to keep in mind when forming your new LLC.

        • Operating Agreements – An operating agreement can provide guidelines as to how your LLC will be run. This can not only minimize disputes and misunderstandings that could crop up, but it allows you to establish rules that, in their absence, would default to state law.
        • No Profit Restrictions – LLCs also have more options for how large a share each owner takes. Unlike corporate profits, LLC profits don’t have restrictions such as having to be divided equally or according to the percentage of the business that someone owns.
        • Membership Certificates – Similar to stock certificates, an LLC may issue membership certificates. These certificates may be used to indicate ownership or voting right percentages.
        • Corporate Indicators – When you pick the name for your company, you must add what is called a “corporate indicator” to the name. For LLCs you have the choice of adding (depending on your state’s guidelines) LLC, L.L.C., or Limited Liability Company to your name, and it will appear as such on all official paperwork.
        • Tax Entity – Taxes, of course, are a top consideration in the business world. Consequently, it’s wise to research what kind of tax entity best fits with your business and saves it the most from the IRS. Fortunately, you can get detailed information by going to the LLC page on the IRS website to learn more.

    Now that you have a better idea of what an LLC is, maybe you can decide if that’s the right business entity for your cosplay cleaning service for vegan events and customized birdhouses.

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