What is an LLC
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What is an LLC? (Meaning + Explanation)

What is an LLC, and what does it do?

Choosing the proper business structure for your small business can be challenging. And understanding what an LLC is essential to help you make the correct choice.

What is an LLC? A limited liability company (LLC) is a popular way to structure a business that combines the best parts of corporations and sole proprietorships.

LLCs are flexible to manage, provide several options on how they’re taxed, and allow an unlimited number of owners. Perhaps the biggest perk is their ability to limit personal liability if your business has legal or financial troubles.

LLCs are recognized business structures under state laws in all 50 states. So opening business bank accounts and obtaining employer identification numbers shouldn’t be an issue.

What is an LLC, and what does it do?

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 in simple terms?

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.

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.

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.

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. sole proprietorship
LLCSole proprietorship
TaxationNo corporate taxation

Company profits flow through to members

No corporate taxation

Company profits flow through to the owner

Liability protectionMembers have limited liabilityOwner has unlimited liability
Cost of formationRegistration fees

Legal fees

Minimal
Ongoing costsAnnual reports

Registration renewals

Minimal

LLC vs. partnership

LLC vs. partnership
LLCPartnership
TaxationNo corporate taxation

Company profits flow through to members

No corporate taxation

Company profits flow through to partners

Liability protectionMembers have limited liabilityPartners generally have unlimited liability
Cost of formationRegistration fees

Legal fees

Registration fees

Legal fees

Ongoing costsAnnual reports

Registration renewals

Registration fees

Legal fees

Annual tax return preparation

LLC vs. C-corporation

LLC vs. C-corporation
LLCC-corporation
TaxationNo corporate taxation

Company profits flow through to members

Company profits taxed twice:

Liability protectionMembers have limited liabilityShareholders have limited liability
Cost of formationRegistration fees

Legal fees

Registration fees

Legal fees

Ongoing costsAnnual reports

Registration renewals

Registration fees

Legal fees

Annual tax return preparation

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 taxation
Photo by Nataliya Vaitkevich from Pexels.

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.

Single-member LLCs by default are taxed as sole proprietorships.

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

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.

LLC members are not employees and aren’t paid salaries.

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

Federal payroll taxes
TaxAmount
FICA (Social Security and Medicare)Up to 7.65% of wages per year
Federal unemployment taxUp to $420 per employee per year

 

State payroll taxes
TaxAmount
State unemployment taxVaries
Headcount, occupational privilege, and other miscellaneous state payroll taxesVaries

Where should I form an LLC?

LLCs are usually formed in the state where the business is located. There’s generally no significant benefit to forming an LLC in a different state.

How to form an LLC

Forming an LLC involves a few steps.

1. Choose a state

Decide if you’ll form the LLC in the business’s home state or not. Once a state is selected, review the Secretary of State’s website for formation instructions.

2. Choose a name

Select a name for your LLC that’s not already taken in your state.

Here’s an example from Florida where you can search for businesses by name to see if a name is available.

Business name lookup Business name lookup Florida Department of State Sunbiz
Source: Florida Department of State.

Business name generators can help you come up with something unique.

Choosing a name that’s also your brand or describes what you do can help with marketing. For example, a business named Orlando Plumbing lets people know you’re a plumber in Orlando.

3. Select a registered agent

An LLC needs a registered agent to accept legal and business documents on its behalf. The registered agent can be one of the LLC’s members or an independent party.

4. Prepare an LLC operating agreement

LLCs should have an operating agreement that lays out the ownership, rules, and guidelines for managing the LLC. Templates are available online, or you could hire an attorney to draft it.

5. Register your LLC with your state

File Articles of Organization or other required documents with your state to officially register your business.

Key takeaways

  • LLCs offer personal asset protection and limited liability. But they are more expensive to set up and maintain than sole proprietorships.
  • Anyone starting or operating a business can form an LLC.
  • You generally don’t need an attorney to form an LLC.
  • Owners, also called members, of LLCs pay tax on their personal tax returns for their share of company profits.
  • LLCs don’t pay federal income tax.

LLC FAQs (frequently asked questions)

LLC FAQs
Photo by Pixabay from Pexels.

1. Should I form an LLC? Do I even need an LLC?

Forming an LLC isn’t necessary to operate a business. However, it offers personal liability protection that you won’t get when you work as a sole proprietorship.

Existing businesses can easily convert to LLCs. It usually requires filing a notice of intent to convert with your state.

2. How much does it cost to form an LLC?

Costs vary from state to state. But you can expect to spend at least a few hundred dollars to form an LLC.

3. How are LLCs taxed?

LLC’s enjoy the advantages of pass-through taxation. This means company profits aren’t taxed at the corporate level. Instead, profits flow through to their members, who pay taxes on their share of the company’s profits.

Members pay tax on their share of profits even if the profits aren’t distributed.

For example, assume a single-member LLC has an annual profit of $50,000. But the member reinvests all of the profit back into the company to buy new equipment. Even though the member didn’t receive any cash from the business, he’ll still have to pay tax on the $50,000 profit.

4. What are LLCs used for?

LLCs are used to structure a business and provide their members with limited personal liability. This protects the members’ personal assets from the company’s creditors.

5. What’s better: an LLC or a corporation?

An LLC provides many of the same benefits as a corporation but with less administrative burden. LLCs have fewer regulatory requirements to meet than corporations. And unlike corporations that are taxed on their profits, LLCs aren’t.

6. Do I need a lawyer to form an LLC?

A lawyer generally isn’t necessary to form an LLC. There are free resources available to help you. But, if you’re creating a professional LLC, consulting a lawyer would be wise.

7. How long does it take to form an LLC?

As with costs, how long it takes to form an LLC varies from state to state. You should expect the state to take two to four weeks to process your documents. Some states may offer expedited processing for an extra fee.

Article by:

Melissa Pedigo

CPA

Melissa Pedigo is a US CPA with more than 20 years of experience. She’s worked at Big 4 firms, for the government, and internationally. Now a full-time writer, she enjoys translating complex financial and tax topics into plain English. When she’s not keeping current reading IRS rules or tax legislation, you’ll find her studying foreign languages or playing tennis.

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