What Is an LLC?
Updated · Apr 06, 2022
An LLC is one of the most popular legal structures for your company, preferred by many entrepreneurs. Here are the essentials you should know about it.
In this article, I’ll explain exactly what an LLC is and how it’s different from other business entities. We will cover:
- LLC registration
- LLCs vs. partnerships and corporations
- The benefits of an LLC
- Downsides of LLCs
- LLC taxation and profit distribution
Read on to learn more!
What Is an LLC?
LLC stands for limited liability company where an owner’s personal assets are protected if the business racks up debt.
Besides financial liability insurance, these companies also get pass-through taxation, which prevents double taxation for owners and proprietors.
This makes LLCs a hybrid between:
- corporations, which benefit from limited liability
- and sole proprietorships and partnerships, which get pass-through taxation
Business owners choose to create an LLC over other legal entity options because of these double perks. However, not every organization can be an LLC.
As per the IRS, the LLC definition is:
“A Limited Liability Company (LLC) is a business structure allowed by state statute.”
In other words, different states have different rules about LLCs. In most places, banks and insurance companies don’t qualify.
In some states like Texas, professional-license-requiring services providers (like medical practices) can’t be LLCs either.
You can learn about the specific requirements from your state's corporate filing office, which is also where you file your documents to get an LLC. In most places, this filing office is the Secretary of State.
The Main Advantages of LLC
Why do business owners apply for LLC over other options? These are the main LLC advantages that draw people in:
- Limited liability, meaning that your personal assets can’t be seized even if your company is in debt. Essentially, LLCs are treated as separate entities from their owners. Piercing the corporate veil is very difficult (except in select cases of suspected fraud).
- Pass-through taxation where the income is treated like the owner or member’s personal income.
While corporations are taxed twice (once as an entity and once when the profits get to the investors), LLCs are treated as sole proprietorships or partnerships instead.
- Tax flexibility allows certain variability in the LLC tax requirements—the owners can choose whether they want to be treated as a sole proprietor, partnership, S corporation, or C corporation.
- Easier administration with no mandatory board meetings, corporate minutes, or annual reports.
- Cash accounting—corporations can only use accrual accounting (the revenue is recorded when the transaction occurs). LCCs can use cash accounting, where the income only counts when you receive the amount.
- Profit allocation flexibility, which means investors can distribute profits as they wish. LLCs can share it depending on each member’s stake, but they are not obliged to do that—they are free to choose another allocation option instead.
Setting up a limited company offers additional perks like placing membership interests into a living trust, unrestricted number of owners and owner nationality, and no unemployment insurance taxes on the owner’s salary.
The Main Disadvantages of LLC
Before you run to your Secretary of State office to register an LLC, these are the downsides you need to know about:
- Social security and medicare taxes—with the pass-through taxation, the LLC profits and salaries are essentially treated like personal income. As such, they are subject to self-employment taxes, which are currently at 15.3%.
While you’re not taxed twice, you might end up paying more than you would as a corporation (where only salaries are taxed this way).
- Renewal costs and unexpected fees—it doesn’t cost much to set up an LLC, but in some states, the renewal fees might be higher than expected. Certain states also ask you to publish an LLC formation notice in newspapers—that can be quite expensive in places like New York.
- Fringe benefits are taxable income—Your employees’ fringe benefits (medical insurance, retirement benefits, bonuses) are treated as taxable income. This is not the case for C corporations, where the benefits do not have to be reported.
- Franchise tax or capital values tax—some states (including Texas and California) will have you pay a franchise fee for the benefit of forming a limited liability company. You are essentially paying for the privilege of limited liability and that amount might change depending on profits.
- Difficult membership transfer—it’s easy to buy, sell, or transfer corporate stocks. But the LLC membership transfer is a complicated procedure, which can become a problem if one of the members opts out.
Even with these downsides, forming an LLC is an excellent choice for new business owners, especially those looking to save on taxes. Here’s what you need to know about LLC taxation:
How Are LLCs Taxed?
LLCs are pass-through entities by default. This means that any profits you make go directly to the owner or the investors.
Let’s say you create your own LLC and you are the only owner. You do not file taxes for the LLC—instead, the profits or the losses go on Schedule C of your individual tax return.
What if you have multiple members? For tax purposes, you will be treated as a partnership.
After the LLC creation, the business must report profits on IRS Form 1065. Every year, investors get form K-1, which reports their share of the income or loss. Then, that amount goes on their individual tax returns.
Although this is the default regime, LLCs can also choose to be taxed as either an S or a C corporation. Choosing the former means you can save on self-employment taxes without the formalities of running a corporation.
LLC vs. Partnership
The main difference between starting a business LLC and a partnership is the liability.
In a partnership, each member is responsible for debts incurred by the organization. This does include their personal assets—so in case your company can’t pay its creditors, they might be allowed to seize your property.
LLCs, on the other hand, are protected from personal liability. A member’s personal finances can’t be seized to cover company debts.
LLC vs. Corporation
Flexibility and pass-through taxation are the main perks of establishing an LLC—they are also what differentiates it from a corporation.
There are a lot more formalities involved in starting and running a corporation. Management and recordkeeping are a lot more rigid for this type of company than for LLCs, which are member-managed.
C corporations have to pay a corporate income tax on their profits, which LLCs and S corporations can avoid. Once a C-corp passes the income to its shareholders, they also get taxed on the profits—also known as double taxation.
Becoming an LLC rather than incorporating can be tempting considering these advantages. However, corporations have one significant advantage—corporate ownership.
They are owned by shareholders. Each one of them is free to buy, sell, or transfer shares quickly. If an owner wants to leave, they can simply sell their shares.
LLCs, on the other hand, are member-owned—each one has a certain percentage of the company. But transferring that percentage is much more complicated than transferring shares.
This is why corporations can exist in perpetuity and why venture capitalists and other investors often prefer to put their money in them.
How to Start an LLC
Now that you weighed the LLC benefits and downsides, here is how to make an LLC:
- Choose a name—Different states have different requirements for your business name and its style. For instance, an LLC in Florida must include “Limited Liability Company, LLC or L.L.C.; OR Chartered, Professional Limited Liability Company, P.L.L.C. or PLLC.”
- Pick your business formation service—We at HostingTribunal have a full review of the best LLC formation services to help you choose. If you decide to file an LLC yourself, you’ll still need a registered agent at the very least.
- Create your Articles of Organization—This document provides basic information about your company, like your name and the nature of your business.
- Write your Operating Agreement—The operating agreement is not a must for everyone. Some states allow LLC setup without them. Still, it’s a good idea to get them in writing, as this is the document that describes how you do business.
- Get your EIN—Your Employer Identification Number is like a social security number for your company. It’s free to get from the IRS and you need it to open a company bank account or hire employees.
- Apply for licenses and permits—Finally, you’ll need local licenses and permits to start operating. Depending on your area of business, the requirements will differ.
We have a complete guide on how to create an LLC where you can learn more about the process.
What is an LLC?
It’s a limited liability company, which benefits from pass-through taxation, as well as increased flexibility and minimal formalities.
LLCs are popular legal entities combining the perks of corporations and partnerships. But they are not without disadvantages, so make sure you consider all your options before making a choice.