Understanding LLCs: What They Are and How They Operate

An LLC is a legal entity you can create when you own a business.

LLCs are popular because they provide the business owner with limited liability and personal asset protection like a corporation. But they avoid double taxation and are simpler to manage than a corporation.

What is an LLC?

An LLC is a way to structure your business to provide limited liability protection and tax advantages. An LLC can have an unlimited number of owners who are called members.

Who should form an LLC?

Anyone starting a new business or running a sole proprietorship or partnership should consider forming an LLC. This is essential if you’re concerned with limiting your personal liability.

LLCs can be used to run almost any kind of business. But if you’re planning at some point to raise money from outside investors, an LLC might not be the best option. The LLC’s pass-through taxation and flexible governance can be a turn-off to outside investors.

What are the benefits of an LLC?

An LLC provides its members with personal liability protection, pass-through taxation, and simplicity.

• Personal liability protection: One of the most significant advantages of an LLC is that it protects its owners’ personal assets should the business have legal troubles. Your liability is limited to your investment in the business. There are exceptions though. If you personally guarantee a business debt or are negligent in operating your business, your personal assets won’t be protected.
• Pass-through taxation: Another key benefit of an LLC is that it avoids double taxation. The company’s profits aren’t taxed at the corporate level and instead pass-through to the owners’ personal income tax return.
• Flexible membership: LLCs provide flexibility in ownership. There are no minimum or maximum number of owners.
• Ease in filing taxes: Because LLCs aren’t taxed at the federal level, there are no corporate tax returns to file.
• Little bureaucracy: An LLC is the simplest form of business entity for small business owners. Unlike corporations, there are no officers, board of directors, or shareholders. This makes managing the business easier.
• Brand protection: It’s easier to protect a corporate brand when a company owns it. And you can provide additional brand protection if your brand and LLC’s name are the same.
• Management: Management of an LLC is generally informal. There are no required meetings, and one member can be designated the managing member who makes all the business decisions.
• Credibility: Forming an LLC lets your customers know you’re running a real business and enhances your credibility.

What are the disadvantages of an LLC?

Even with all the benefits of an LLC, there are a few disadvantages.

1. Cost: State registration fees and legal fees to establish an LLC are generally more expensive than forming a sole proprietor. LLCs don’t file a federal tax return. But partnerships need to pay a tax professional to prepare and file an annual tax return on Form 1065.

2. Transferable ownership: A member’s ownership in an LLC can’t be quickly sold like shares of a corporation can be. This makes LLCs less attractive to outside investors.

3. Renewal fees: Renewal of state registrations and annual report filing fees can be more costly than operating as a sole proprietor. And if your LLC uses a registered agent service, you’ll need to consider their annual fees.

How does an LLC compare to other business structures?

There are other business structures besides an LLC. These include:

• Sole proprietorship
• Partnership
• C-corporation

We highlight the significant differences between each in the following tables.

LLC vs. Sole proprietorship

LLC vs. Partnership

LLC vs. C-corporation

Different types of LLCs

There are four different types of LLCs. Choosing the correct one to fit your small business is critical.

Domestic LLC: A domestic LLC is the most common type, and it’s for businesses operating in the state where it was formed.

Foreign LLC: If a business wants to operate in more than its original state, it will need to register in the other state(s) as a foreign LLC. Contrary to what the name may imply, foreign LLCs are for US companies.

Professional LLC: Some states require businesses owned by certain licensed professionals like lawyers, doctors, and accountants to form professional LLCs. These businesses must have their organizational documents approved by the state’s licensing board before the company can be registered with the state.

Series LLC: For series LLCs, the member forms an LLC that allows its assets and operations to be broken down into independent sections called series. Series LLCs are most common in real estate when investors own multiple properties. Each property is an independent series that’s protected from the liabilities of the other properties. But not all states allow series LLCs.

LLC taxation

LLC members need to be aware of both federal and state tax consequences.

Federal taxes

An LLC’s initial tax status assigned by the IRS is based on its number of members.

LLCs with more than one member are called multi-member LLCs. And for tax purposes, they’re taxed as partnerships.

Both of these classifications are pass-through taxation methods. That means the company’s profits flow through and are only taxed on the owners’ personal tax returns.

Certain LLCs will qualify for a tax deduction not available to corporations. The qualified business income deduction (QBI) allows up to 20% of the qualified business income to be taken as a tax deduction on the member’s personal tax return.

Some LLCs may elect a special tax classification called an S-corporation (S-corp). An LLC electing to be taxed as an S-corp enjoys even more tax advantages, but it comes with more work. Discussing the details of an S-corp is beyond the scope of this article.

State taxes

LLCs may need to pay state taxes. Income taxes, franchise taxes, and business profits tax may be charged in your state. Be sure to investigate if the state where you’ll form your LLC has any state taxes.

Employment taxes

If an LLC has employees, federal and state payroll taxes need to be paid.

But if you hire an employee, the LLC needs to pay federal and state payroll taxes.

Commonly asked questions: