What is an LLC? [Full Breakdown]
If you’re dreaming of starting a new business, you may be wondering what sort of business entity to form. There are plenty to choose from — the United States gives businesses options to incorporate under S or C status, launch as a sole proprietorship, form an LLC, and more.
An LLC, in particular, is popular with small businesses because it offers many of the best aspects of a corporation without the onerous tax responsibilities or extra paperwork. In this article, we’ll dive into what an LLC is, what limited liability means, and walk through the pros and cons of forming an LLC.
We’ll also look at LLC vs. other legal entity types and walk you through the process of forming an LLC.
What is an LLC?
An LLC, or limited liability company, is a legal entity, or a business structure, that’s a way to organize your company. LLCs are referred to as a “hybrid” legal entity because they offer some of the characteristics of a corporation and some of the characteristics of a sole proprietorship. (More on corporations and sole proprietorships to come later on.)
While LLCs aren’t recognized as corporations in the United States, they do offer limited liability like a corporation does. They also allow pass-through income taxation, a huge benefit for many small businesses.
Understanding Limited Liability Protection
Limited liability means that an LLC’s owners, called LLC members, can’t have their personal assets seized in the event the company takes on business debts. This asset protection is possible because, under an LLC, business assets and personal assets are separate.
If a company owes money, for example, a creditor could seize the company’s equipment, real estate, or other assets. But the owners would have personal liability protection — if your business fails, creditors can’t come after your house.
This is also true for litigation. Any legal rulings against your company would be against the company, and your personal assets would be off-limits in that ruling.
Pros and Cons of an LLC
There are great reasons to form an LLC when starting your small business but some downsides as well. Let’s dive into the pros and cons of LLCs.
The two biggest benefits of forming an LLC are that it provides you liability protection and it makes filing taxes simpler.
LLCs let owners choose what system of tax filing they can use. If you form an LLC, you can tell the IRS you’d like to be taxed like a corporation or as a sole proprietor or partnership. Choosing to be taxed as a sole proprietor means LLC owners get access to “pass-through” taxation, where taxes on the business’s earnings are passed through to their personal tax returns.
Having business taxes passed through means you can combine your tax responsibilities all in one place. It also eliminates double taxation. An LLC owner can simply pay a self-employment tax and taxes on their earnings all in one place, instead of having to pay taxes on the corporation’s earnings and then again on a personal income tax on what the corporation pays you.
The other big perk is with liability. LLC members (remember that’s the owners of an LLC) are not liable for debts of the company or any acts that could be litigated against. This provides security and protection that a sole proprietorship doesn’t. With a sole proprietorship, the company and the individual are legally one and the same, meaning any debts or litigation facing the company can be directed toward the owner with no protections.
LLCs are easier to form than C Corporations or S Corporations and much cheaper. This allows you to set up a business easily, or for some businesses — like real estate — you can set up different LLCs for each building so not all of your portfolio is liable if one investment goes bad.
For very small businesses, LLCs do cost a bit to set up, and you need to keep a separate bank account. If you’re setting up a simple caregiving business or other freelancing business, it might be easier to forego the legal costs and just operate as a sole proprietorship.
Another negative is that many states charge a franchise tax to LLCs. This can be a flat fee, as in Delaware, or based on revenue. The tax can be very small in some places, but in a state like California, all foreign LLCs and domestic LLCs, as well as any corporation, must pay at least $800 annually to their Franchise Tax Board. Some states also have renewal fees to maintain an LLC, and some require owners to file an annual report.
If you do business abroad, the odds are that countries won’t recognize the tax status of your LLC and will force you to file taxes as a corporation. Canada and many other countries don’t have an LLC business distinction, so you’ll end up paying the corporate rate whether or not you’re actually incorporated.
How LLCs Differ From Other Legal Entities
LLCs are just one type of business entity available to anyone forming a new company. Let’s dive into what’s out there and what each option offers.
Starting a sole proprietorship is the simplest way to launch a business and, in many states, requires you to simply pick a name and register your business, often at no cost. A sole proprietorship is a legal distinction but offers few protections from liability. It does allow pass-through taxation, so you can simply process business taxes with your personal income tax form.
A C corp is more expensive and complicated to form than an LLC, and pass-through taxation is not allowed. Also, a C corporation requires a ton more administrative work and record-keeping compared to an LLC.
Its biggest benefits are with liability protection and the ability to scale. C corps can issue stock and bring on new capital and shareholders for rapid expansion.
An S corporation offers many of the perks of a corporation — liability protection being the biggest one, plus the ability to bring on additional shareholders more easily than an LLC. Unlike C corps, S corps also allow pass-through taxation. The biggest setback with S corporations is that they limit growth. S corps can only have up to 100 stockholders, and all of those stockholders must be U.S. tax residents. LLCs and C corps are not limited in their number of members, and there’s no citizenship requirement.
How to Form an LLC
Forming an LLC varies widely by state, but no matter where you are, we do recommend that you bring on an attorney to help you with the process. Luckily, there are plenty of online legal services that will walk you through the process and do it affordably.
State laws differ, but the basic steps you’ll need to follow are as follows:
File Articles of Organization
Owners of an LLC (known as LLC members) must first pick a business name, and then file the Articles of Organization (sometimes called a Statement of Information), essentially a statement that the business is forming. This is usually done through your secretary of state’s website or your state’s registrar. Only one person in your company? No worries. Many states allow a single-member LLC.
Write an LLC Operating Agreement
An LLC Operating Agreement denotes how your business is organized and how it plans to function. This document should lay out ownership stakes for all members and make clear the business’s intent and basic strategy to turn a profit.
Obtain Any Licenses or Permits Needed
If your state requires you to get special licenses or permits, you will need to do this to get started. Check out your state’s secretary of state website to learn more.
File an Annual Report
LLC members usually have to file an annual report with the state. These should coincide with annual meetings held by your company to assess profits and losses, and the overall direction the company is headed in.
Pay Any Fees
Starting your LLC will likely cost you a little bit of money. There are LLC filing fees, which vary by state but range anywhere from $40 up to several hundred dollars in some jurisdictions.
Filing legal documents as part of the business formation requires some investment, though LLC formation is a standard practice at many affordable online legal websites.
In some states, acquiring a business license requires paying a fee. Some states have an annual franchise tax as well or a fee to file your annual report. It’s hard to go into too many specifics when states have such different laws and regulations around LLCs, but this website is a good resource.
Choosing the Right Entity for Your Business
For many small business owners, an LLC is a fantastic choice. With liability protection and pass-through taxation, it offers the security business owners want without the complications or cost of double taxation. While companies looking for massive scale may want to check out C corp status, for most small businesses, forming an LLC is a smart, safe way to start a company.