What Is an LLC?

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What Is an LLC?

Updated on April 18, 2022

What Is an LLC?

Step By Step

If you are thinking about starting a business or in the process of doing so, you will soon need to decide which business entity to choose. One of the more popular entities these days is a limited liability corporation, or LLC.

This guide lays out exactly what an LLC is, its advantages and disadvantages, and how to create one, to help you decide if this is the right entity for you and your business.

LLC Defined

An LLC is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes. The LLC itself does not pay taxes. As a “pass-through” entity, income passes through the business to the owner or owners, who report it on their personal tax returns. An LLC is created by filing paperwork with your state, and nominal fees are involved. 

An LLC offers its owner or owners, who are called members, considerable flexibility in terms of management. You can choose your management and operational structure and decide how you want to be taxed.

Your LLC can have a single member or multiple members, all of whom have personal liability protection, meaning your personal assets are not at risk if you cannot pay business debts or are involved in a lawsuit.

LLC Limited Liability Company

Advantages of Forming an LLC

1. Simple to Form and Maintain

An LLC is simple to form, requiring much less paperwork than a corporation.

You only need to file Articles of Organization and have an Operating Agreement to define ownership and roles and responsibilities.

There’s no annual meeting or reporting requirements, as with a corporation, and you don’t need a board of directors. In some states, however, you do have to file an annual report for an LLC. It’s also less expensive to form an LLC.

Corporations and partnerships are best formed with the assistance of an attorney, which is expensive. It is a good idea, however, to have your LLC’s operating agreement reviewed by an attorney. Corporations also pay fees for their required annual filings.

2. Better Control of Your Business

In an LLC, you can be the only owner just like a sole proprietorship so that you have full control of the business. If you have more than one owner, you can structure the management any way you choose with your operating agreement. You don’t have to answer to a board of directors or anyone else. You have more freedom to make decisions than you do in another type of business structure, other than a sole proprietorship.

3. Limited Personal Liability

Unlike a sole proprietorship, an LLC is considered a legal entity that is separate from you, as the owner. Just as in a corporation, your personal assets are protected because you are not personally liable for the company’s debts or legal liabilities.

In a sole proprietorship or general partnership, your personal assets such as your home are at risk if there are unpaid debts or legal liabilities. There are some instances in which an LLC owner, however, could have personal risk. For example, if you are asked to personally guarantee a business loan, you are personally liable for the debt.

4. Tax Advantages

An LLC is considered a “pass through” entity, meaning income passes through the business to the owners for tax purposes. The LLC is not a taxable entity, so all income is reported on the tax return of the owner or owners and taxed at their personal income tax rate. In the case of corporations, the corporation is taxed as well as the dividends shareholders receive, which is sometimes referred to as double taxation.

LLC owners also may be eligible for the 20% pass-through deduction that was part of the Tax Cuts and Jobs Act, meaning they can deduct up to 20% of business income. An LLC, however, can choose to be taxed as a corporation or partnership if it is deemed to be beneficial for the company.

5. Profit Sharing Flexibility

Most businesses split profits based on the capital contributions of owners. In a partnership, profits are generally divided equally. Corporations pay dividends based on the ownership percentage of the shareholders.

In an LLC, in the operating agreement the owners can specify any profit-sharing plan that they choose. One owner can take a percentage share of profits greater than their ownership interest, while other owners take less. This may be done in a case in which one owner is more involved in the operations of the business than others. 

6. Credibility

An LLC has the advantage of having more credibility to customers and vendors than a sole proprietorship. As a matter of perception, people tend to see an LLC more as a more established company, as opposed to a one-person show.

Disadvantages of Forming an LLC

There are also some drawbacks to forming a business as an LLC. 

1. High Cost of Forming an LLC

Creating an LLC costs more than having a sole proprietorship since there is nothing to file for a sole proprietorship. You must pay filing fees to form an LLC which vary by state and range from $40 to $500. 

2. Annual Taxes and Fees Could be High

Once the company officially forms as an LLC, the entity must pay annual taxes and fees to the state. The amounts of these fees and taxes differ by state. Entrepreneurs should be aware that these costs have the potential to be $800 or even more per year.

3. Self-employment Tax

As an LLC owner, you will probably have to pay self-employment taxes unless you choose an S Corp tax status. Corporation shareholders (owners) do not pay self-employment taxes. 

4. Not Good for Investors

Another meaningful drawback to forming a business as an LLC is it is not the optimal business structure for a company that will obtain funding from outside investors. A business owner in need of venture capital will find such lenders and investors generally only fund corporations.

Corporations are the ideal business structure for luring outside investment as the company can easily issue stock in exchange for investor funds. Though it is possible for those outside of an LLC to invest in the LLC and obtain ownership interest, doing so without a corporation will prove challenging.

How Are LLCs Taxed?

LLCs are unique in the context of taxation as its owners can choose how the company is taxed. Typically, an LLC is taxed like a sole proprietorship if it has one member, and a partnership if it has more than one member. However, LLCs can also be choose to be taxed as a corporation.

Electing to be taxed as a corporation is accomplished by filing a document, referred to as an election, with the Internal Revenue Services (IRS). An LLC can also be taxed as a S corporation or a C corporation.

C Corp taxes are applicable to the company profits at the tax rate for corporations. The tax rate for C Corp is 21%. This tax rate is significantly lower than the typical individual taxpayer rate. 

S Corp taxation considers the LLC as a pass-through entity, in which profits pass through the company and into the hands of the owners. At this point, the taxes are applied at the same rate as those of individual taxpayers. 

However, taxes for Medicare and Social Security are not applicable to these financial distributions.  In the end, the S Corp tax structure is likely to result in considerable tax savings for the LLC, in comparison to C Corp.

How to Form an LLC

1. Choose Your State

The first step is to choose the state in which you plan to do business. LLC processes and requirements vary by state, so visit your state’s website for details. Generally, you can form your LLC with an online application. If you plan to have physical locations in more than one state, you will need to register a foreign LLC in the states where you will do business other than your home state.

2. Choose Your LLC Name

Your business name is extremely important. It should reflect the brand you plan to build, tell customers what you do, and be memorable. Once you’ve chosen a name, you’ll need to make sure that it’s not already taken. You can do a search on your state’s website, and on other state websites if you are doing business in more than one state. You should also check the US Patent and Trademark Office to make sure the name hasn’t been trademarked.  

3. Choose a Registered Agent

A registered agent is the person or company that sends and receives legal documents on behalf of your LLC. The registered agent can be a member of the LLC, or you can choose a third party such as an attorney, or a company that offers registered agent services. Most states require you to have a registered agent. The agent must be a resident of the state where you do business, or a corporation authorized to do business in your state.

4. Determine Your Management Structure

There are two types of management structures:

  • A Member-Managed LLC is managed by the members of the LLC. This is usually chosen by smaller LLCs with few members who will be involved in various management roles. 
  • A Manager-Managed LLC is managed by people who are not members of the LLC and are employees of the business. This structure is often used when an LLC is larger and has multiple members.

5. File Articles of Organization

The articles of organization is the form you file to create your LLC. These forms vary by state but can generally be filed online. You’ll need to fill out the LLC name, the name and address of the registered agent, the names of the LLC owners, and in some states, the way the LLC will be managed. Fees are generally around $100.

6. Draft an Operating Agreement

An operating agreement is not usually required but is highly recommended. The operating agreement should clearly define the following:

  • The percentage of each member’s interests in the LLC
  • How profits and losses will be allocated to each member
  • Each member’s rights and responsibilities
  • The management structure and management roles of members
  • The voting rights of each member
  • Rules for meetings and voting
  • What happens when a member sells their interest, becomes disabled, or dies

It’s a good idea to have an attorney’s help when creating your operating agreement so that you can be sure you’re covering all bases to protect all members and avoid future issues.

7. Apply for Business Licenses

It’s important to make sure you’re in compliance with all laws at the local, state, and federal levels. It’s likely, depending on your location and type of business, that you’ll need business licenses and permits. Do some research to determine which licenses you need. At the very least you’ll need a sales tax permit to sell products and collect sales tax. 

8. Obtain an EIN

EIN stands for Employer Identification Number and is like a social security number for your business, allowing the IRS to identify your business easily. It is also known as a Federal Tax Identification Number (FTIN), or sometimes for corporations a Tax Identification Number (TIN). An EIN is required if your LLC has more than one member, if you plan to hire employees, or if you choose to have your LLC taxed as a corporation. The application is free and can be found on the IRS website. The application is form SS-4, and it can be mailed to the IRS or submitted electronically, and once your information on the application has been validated, the EIN is assigned immediately.

After Forming an LLC

Your state may require you to file annual reports for your LLC, which may involve a fee. Check your state for requirements.

You should now be ready to form your own an LLC! And if you decide against it, that’s fine too – other entities offer advantages as well.