What Is an LLC?
According to a report done by the National Small Business Association, more than a third of small businesses are structured as a limited liability company (LLC).
Want to know what is an LLC and how does it work? For a comprehensive breakdown of LLCs and the opportunities they can afford your business, read on.
What is an LLC Company?
While there are many different types of business ownerships, an LLC is among the top entities used today. An LLC is one of the most popular legal business entities in the U.S—and for good reason.
It’s a U.S.-specific variation of a private limited company, granting an organization the pass-through taxation incentives of a partnership or sole proprietorship, with the limited liability of a corporation. As a hybrid legal entity, it takes the best aspects of other popular legal business structures, granting its owners greater flexibility.
Typically, it’s owned by one or more individuals, who are then referred to as “members.” That said, there are single-member LLCS. So, if you’re a sole proprietor who’s looking to expand your business, an LLC is often the next step. This corporate structure provides the same limited liability of corporations, but is easier to get started and cheaper to run.
But to really see if an LLC is the right entity for your business, it’s important to consider LLCs through the lens of the following factors:
- Liability protection
- Paperwork & Overhead
One of the most appealing draws of an LLC is its limited liability status, which grants the owners personal asset protection. For businesses, liabilities are commonly:
- Non-payments of debts leading to bankruptcy. The liability falls on the person responsible for paying the debts.
- Mismanagement of fiduciary duties. The liability falls on the leadership in charge of handling the business’ finances.
With limited liability, the business owner’s liability—in other words, their responsibility to pay back debts and obligations—is limited to the amount that they invested in the business.
That doesn’t mean that they have zero liability. There are circumstances where a business owner can be held liable; however, in the event of a bankruptcy or legal dispute, the owners’ personal assets (home, wealth, investments, etc.) can’t be taken, since they’re not considered company assets. In fact, per NOLO:
“Because you’re not personally liable, creditors or people who file lawsuits against your LLC can’t collect against your personal assets...They are limited to collecting from your LLC’s assets, like your LLC’s bank account.”
However, there are extenuating factors that can strip an LLC of its limited liability status. This is what’s known as “piercing the corporate veil,” which according to Cornell Law, “refers to a situation in which courts put aside limited liability and hold a corporation's shareholders or directors personally liable for the corporation’s actions or debts.”
Common reasons for this liability protection to be broken include:
- Misuse of business funds (i.e. personal use)
- Conflict of interest
- Criminal action
- Personal guarantees
If you go through the effort to establish a LLC, you want to ensure that you take precautions not to break the corporate veil.
Another benefit of LLC status is the ease with which you can file taxes and the amount of savings you can garner. For single-member LLCs, taxes are not only simple to file, the IRS also treats you as a sole proprietor, meaning that the business profits are only taxed once. Tax liability “passes” through to your personal tax returns, so you don’t get double taxed (unless you’re taxed as a C corp).
An LLC is considered by the government as a “disregarded entity.” So, you have a say in how you will be taxed by the IRS. It’s partly up to you to decide whether you want to be taxed like a:
- Proprietor (single-member LLC)
- Partnership (one or more member)
- Corporation (either a S corp or C corp)
Once you decide, the business taxes are calculated according to those rules. For LLCs, all of the LLC member’s shares of the profits and losses are known as the distributive share. The IRS expects this to be reported annually. Additionally, multi-owner LLCs must file a Form 1065.
For LLCs, all of the LLC member’s shares of the profits and losses are known as the distributive share. The IRS expects this to be reported annually. Additionally, multi-owner LLCs must file a Form 1065.
Once an LLC is formed, its members are expected to manage the business, establish the requirements for membership, and decide the conditions on withdrawal or transfer of a member’s ownership interest.
LLCs have no limit to the total number of owners allowed. However, having owners outside of the U.S. can complicate matters. Owning an LLC may expose non-residents to complicated tax situations where they’re obligated to file both US taxes and domestic taxes on their income.
It’s also worth noting that LLCs allow for processes such as vesting or employee ownership, whereby founders or employees earn ownership over time.
One of the drawbacks of an LLC is that it’s more difficult to raise investment for the business. The vast majority of professional investors prefer to invest in a C corporation as opposed to an LLC.
Related: C Corp vs. LLC: What's the Difference?
For the investment to be worthwhile, investors must perform significant legal due diligence to ensure that they’re actually buying what they were promised. And, as Stripe notes, “Many investors do not want to do substantial expensive legal work as a condition of making an investment; they prefer to make investments in standardized companies under standardized terms. C corporations are much better suited to this preference.”
With a corporation, stock can easily be issued in exchange for the capital infusion. But with LLCs, changing ownership becomes much more complicated. As a result, it’s common for LLCs to convert to C corps or for investors to request that they make the conversion as an obligation for investment.
Paperwork & Overhead
Like any legal entity, LLCs require a certain amount of paperwork to be filed initially (and throughout its lifespan) to remain legitimate under state law. There are two major documents that must be completed in order to make the LLC legitimate.
Article of Organization
LLCs are formed by filing articles of organization with your state’s Secretary of State office.
This outlines the basic details about the business. Once filed, the LLC is considered official. Each state has different requirements, but common elements include:
- Name of the company
- Description of the business
- Mailing address for the business location
- Name and address of the registered agent
- Information about company owners, managers, and officers
- A filing fee
An operating agreement is the primary documents LLCs use. According to the SBA, “it outlines the business' financial and functional decisions including rules, regulations and provisions. The purpose of the document is to govern the internal operations of the business in a way that suits the specific needs of the business owners.”
After the members have signed the operating agreement, the document is legally binding.
Is an LLC Right for You?
Choosing a business structure is about finding the right balance between responsibilities and protections—do LLCs give you the balance you want?
As we’ve discussed the major benefits of an LLC include:
- Limited personal liability
- Easy tax filing and tax advantages
- Ownership and management flexibility
- Flexible distribution of profits and ownership
The most significant issue for LLCs involves taking outside investment. But by the time you reach this stage, it’s relatively simple to transition the business into a C corp.
Although it depends on your industry and location of operation, most startups are ideally suited to be formed as LLCs. That said, it’s wise to speak with your attorney before determining what structure is best for your situation.
No Matter Your Business Structure, Expense Management Matters
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