A limited liability company (LLC) is a legal entity that offers its owners both liability protection similar to a corporation, as well as the administrative simplicity and flexibility of a partnership.
Learn what an LLC is and why a business owner may form one.
Definition and Example of an LLC
A limited liability company (LLC) is a kind of business entity that offers its owners liability protection without the complexities that come with setting up and operating a corporation.
- Acronym: LLC
For example, if a business owner wants to set up shop, they generally have three choices: a corporation, a partnership, or an LLC.
A corporation provides very strong liability protection. However, it generally costs more to form than other business entities, and has more stringent maintenance requirements.
A partnership, on the other hand, may be easier to establish and often offers more flexibility in terms of allocating profits and losses among its owners. However, it may not have as strong liability protections as a corporation. This is especially the case with general partners, who are personally liable for the partnership’s obligations.
There is such an option as a limited liability partnership (LLP), which provides—you guessed it—limited liability to all partners. However, these are generally restricted in certain states to specific professions, such as attorneys, architects, and accountants.
An LLC presents the best of both worlds—limited liability to all of its owners like a corporation, while being relatively easy to set up and maintain, as well as to flexibly allocate profits like a partnership.
How Does an LLC Work?
By default, a solo business owner’s endeavor could be considered a sole proprietorship.
While a sole proprietorship is easy to form—all you have to do is start doing business—there are some drawbacks. For example, a sole proprietorship’s business debts are legally the debts of the sole proprietor; without a business entity, there is no legal distinction between the business and the business owner.
For some business owners, this may be optimal for their tax situation; for others, however, running their business as an S corporation or C corporation for tax purposes may be ideal.
To protect your personal assets from business obligations and vice versa, as well as to accomplish more complex tax planning strategies, you may find that setting up a legal entity for your business operations is the best option. An LLC offers its owners liability protection as well as flexible tax planning opportunities.
For example, if you’re a solo entrepreneur, you can form an LLC and continue to operate as a sole proprietorship for tax purposes—reporting all income and expenses on Schedule C—but still have assurance of the liability protection offered by the LLC. Alternately, your LLC can elect to be taxed as an S corporation or a C corporation, depending on what is optimal for your situation.
Explore all your options and consult with an accountant to determine if an LLC is the best entity for your business initiative.
Types of LLCs
There are two types of LLCs in terms of ownership: single member (only one owner) and multi-member (multiple owners). Similarly, an LLC can be member managed or manager managed. You may have to make this designation on the LLC’s formation documents submitted to the state.
If an LLC is member managed, all the owners of the LLC can make decisions on behalf of the LLC. If an LLC is manager managed, one or more managers of the LLC—who may or may not be LLC members—can make decisions on behalf of the LLC.
How Are LLCs Taxed?
How an LLC is taxed depends on the LLC’s number of owners as well as if it has made any special tax elections to be taxed as a corporation. Here’s an overview:
By default, a single-member LLC is treated as a disregarded entity for tax purposes. This means that for federal tax purposes, a single-member LLC does not have to file a tax return, nor is it taxed on its income. Instead, the income is reported and taxed on its owner’s tax return as though the LLC did not exist.
Some states impose taxes on all LLCs, whether they are single member or multi-member. In California, for example, any LLC that is conducting business or is organized in the state must pay an annual tax of $800.
By default, multi-member LLCs are treated as partnerships for tax purposes. Partnerships generally do not pay federal income taxes, but they do file partnership tax returns to allocate their income and deduction amounts to their partners based on their respective ownership percentages or some other allocation method. The partners then report their share of the partnership’s income on their personal tax returns.
If an LLC elects to be taxed as an S corporation, it will file an S corporation tax return and allocate all income and deduction amounts to its owners based on their ownership percentages. S corporations generally do not pay any federal income tax. However, they may be subject to state-level S corporation taxes.
If an LLC elects to be taxed as a C corporation, it will file a C corporation tax return and pay income at the corporate tax rates in effect for the year. The current federal corporate tax rate is 21%. Its shareholders are then taxed on any dividends they receive from the corporation.
How To Start an LLC
LLCs are governed by state law, so setting up an LLC will look and cost different depending on which state you set yours up in.
For example, in California, setting up an LLC involves filing two forms: one with a $70 fee, another with $20 within 90 days of the second form submission. In New York, on the other hand, there’s one form to file, but the fee is $200.
You can find the information on how to set up an LLC on your state’s Secretary of State website.
To form an LLC, you’ll need to have a registered agent in your state who must be available during normal business hours at a given address to receive legal documents for your LLC. You could serve as your own registered agent, or you could hire an individual or business to function in this role.
You can hire someone to set up an LLC on your behalf. This could be a streamlined LLC formation service provider or a business attorney.
Beyond the initial setup of your LLC, you will also need to maintain your LLC according to your state’s guidelines. These requirements vary by state and can include:
- Filing an annual or biennial report
- Paying an annual or biennial fee
- Paying an annual franchise tax
- An LLC is a business entity that offers both liability protection and flexibility with respect to taxation and profit sharing.
- Depending on their number of owners and whether they have made any special tax elections, LLCs are treated as either sole proprietorships, partnerships, S corporations, or C corporations for federal income tax purposes.
- Because LLCs are created at the state level, business owners looking to start an LLC will need to determine their state’s requirements for setting one up, or pay a professional to assist them.