What is an LLC?

Learn what a Limited Liability Company is, how it works, and the pros and cons of an LLC.

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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’ve probably realized that there are precautions to take in business. At the very least, you’ve learned that you can protect yourself from personal 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, keep your personal and business resources separate, and save money on taxes? Many entrepreneurs select a limited liability company, or LLC. In fact, about 90% of our customers choose to form an LLC over a corporation. 

What is a limited liability company? 

An LLC is a legal business entity that provides limited liability protection, meaning that the owners (who are called “members” in an LLC) are usually protected from the business’s liabilities and debts. That simply means that if someone sues the business or the business goes into debt, the personal assets of the LLC members are usually protected. 

Corporations also have liability protection for their owners (“shareholders”), but corporations usually have to deal with “double taxation.” Basically, when the corporation makes a profit, the corporation itself is taxed on the profits. Then, when the profits are distributed to the individual shareholders, the profits are taxed a second time. 

LLC members, though, can avoid this double taxation by being taxed as a sole proprietorship or general partnership. In that case, the LLC itself isn’t taxed on profits; the members only pay those taxes on their individual tax returns. This is called “pass-through” taxation.

What’s more, LLCs also have the option to be taxed as a corporation if they prefer. This can sometimes be advantageous for larger LLCs.

This flexibility in taxing also carries over to how LLC members can organize and run their business. The law requires corporations to have extensive record keeping, operational processes, and reporting. LLCs have far fewer requirements.

Advantages and Disadvantages of an LLC

Pros

We’ve already discussed a couple of the advantages of having an LLC, but let’s outline all the benefits here:  

  1. Protects your personal assets: Members are usually protected from the LLC’s debts and claims (for example, lawsuits or claims for compensation, payments, etc.) should something happen to the company.
  1. Avoids double taxation: The LLC members only pay taxes on the profits they individually receive from the business on their personal tax return without the business itself first being taxed. 
  1. Flexible organization structure: LLCs aren’t required to have the same formal business structure as corporations. Corporations must meet annually to elect a board of directors to oversee company policies, appoint officers to run the business, and contend with more regulations. But LLCs have much more flexibility in how they operate and make decisions for the business, which is outlined in their operating agreement.
  1. No ownership restrictions: LLCs share an advantage with C-corporations in that there are no restrictions on the number and types of owners it can have. S-corporations, though, have restrictions such as not being able to have foreign shareholders or have more than 100 shareholders.
  1. 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 according to the percentage of the business that someone owns. 
  1. Less red tape: You’ll encounter less red tape when running an LLC as opposed to a corporation. Although legal requirements for reporting and bookkeeping vary from state to state, generally speaking, LLCs have fewer requirements than corporations. 

Cons of an LLC

Forming an LLC isn’t entirely without disadvantages, though, such as:

  1. Not internationally recognized: Unlike corporations, LLCs are not recognized outside the U.S. That means doing business in other countries can be more problematic.
  1. Difficult to raise capital: 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.
  1. Having an LLC means registering with your state, which does mean filing fees and paperwork to stay in compliance. At the very least, this means filing Articles of Organization (or your state’s equivalent) with the state and paying the associated fee. This is more than you’d have to pay for or contend with as a sole proprietorship or general partnership, but it’s still less than what’s required for corporations.

How are LLCs taxed?

LLCs have great flexibility regarding how they’re taxed. By default, a single-member LLC is taxed as a sole proprietorship, while a multi-member LLC is taxed as a general partnership. As we mentioned, for most LLCs, this will probably save the most on taxes.

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. Some LLCs actually find this beneficial, depending on their circumstances.

C Corporations

A C corporation is the most common form of corporation and what most people are referring to when they say “corporation.” It refers to Subchapter C of the Internal Revenue Code.

Although having your LLC taxed as a C corporation will mean double taxation, for certain LLCs, there could be some benefits that would outweigh the disadvantages. For example, C corporations have the widest range of tax deductions, including health insurance premiums.

In the final analysis, some of the C corporation benefits could mean that an LLC would pay less in taxes by being taxed that way. This is where you really need a tax professional to run the numbers for you before you make a decision.

S Corporations

An S corporation is actually a tax entity rather than a separate legal business entity type. In fact, an LLC or C corporation can be taxed as an S corporation if they fill out the right form (Form 2553) with the IRS and meet the requirements, which include having:

Like most LLCs, S corporations have pass-through taxation. But one of the main reasons an LLC would choose to be taxed as an S corporation is to save money on self-employment taxes.

LLC owners normally pay self-employment taxes (about 15.3%) on all profits. This is more than the taxes they’d pay when working for someone else because their employer would pay part of them.

Instead of paying self-employment taxes on all their profits, owners of an S corporation can pay themselves a salary and only pay self-employment taxes on that salary; the business owners then avoid paying self-employment taxes on the remaining profits. 

This can save the S corp owners a substantial amount of money. However, the IRS expects you to pay yourself at least a “reasonable” salary so that you’ll still pay something in self-employment taxes.

Again, an accountant can help you run the numbers to see if this strategy makes sense for your business.

Operating Agreements 

An extremely important component (and advantage) of having an LLC is the operating agreement. This document provides guidelines as to how your LLC will be run. This not only minimizes disputes and misunderstandings that could crop up among members, but it also allows you to establish rules that, in their absence, would default to state law. 

A major perk of having an LLC over a corporation is the flexibility it gives you. An LLC operating agreement lets you exercise that flexibility to decide how you want to set up the profit and ownership structure, among other things. The corporation’s equivalent, corporate bylaws, don’t have as much flexibility under the law.

Let’s say, for example, that one LLC member puts in only 10% of the initial investment and the other puts in 90%. Maybe the majority owner is willing to take only 50% of the LLC profits in exchange for having a greater say in the management or having to do less work in the daily operation of the company. You can use the operating agreement to have it your way. 

Despite its obvious importance, most states don’t require LLCs to have an operating agreement in place. However, once you and the other members draw one up and sign it, it’s still a legally binding document.

Should you form an LLC?

Now that you have a better idea of what an LLC is, maybe you can decide if it’s the right type of business entity for you. If it is, we can help you get started. With our LLC formation service, our business experts can take you through the process and put you on the path to your dream business. And, if you want help meeting the state’s compliance requirements, we can help you with that, too, with our Worry-Free Compliance service. Contact us today to learn more.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

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