What is an LLC?
Limited Liability Companies (LLCs) have become increasingly popular among entrepreneurs and small business owners because of their flexibility and liability protection. If you’re considering starting a business or restructuring an existing one, understanding the key aspects of an LLC is essential. In this article, we will cover everything you need to know about LLCs, including their definition, benefits, formation process, and management structure.
LLC Defined
An LLC is a legal business structure that combines elements of both a corporation and a partnership. It offers limited liability protection to its owners (referred to as members) while allowing for flexible management and taxation options.
What are LLCs best used for?
LLC can be used for multiple purposes, but the most common reasons for forming an LLC are to:
- Own real estate, either residential or commercial.
- Operate a company of almost any kind. Some states prohibit an LLC structure for a Professional Corporation.
- Own cars, boats, and other assets.
- Own other (multiple) LLCs, either as a series LLCs or non-series LLCs.
LLC Asset and Liability Protection
The main benefit of an LLC is its limited liability or asset protection. That means the other assets of the LLC owners are projected against liabilities of the LLC itself. For example, if you own a business through an LLC and the business gets sued, your personal assets (i.e. home, bank accounts, and other unrelated LLCs) are shielded from the lawsuit.
Piercing the Corporate Veil
Piercing the corporate veil is when an LLC (or corporation) loses its liability protection. The LLC must be properly structured and maintained to provide you personal asset protection and shield you from the liabilities/debts of the LLC. Just having an LLC without the appropriate structure will expose you to risk. The LLC must be treated as a separate entity. Here are some common reasons why an LLC may lose its liability protection:
- Commingling personal and LLC assets. For example, using the LLC to pay for personal expenses.
- The LLC does not actually own the asset (i.e. real estate, business, etc.) you wish to protect because the title was never transferred.
- Personally guaranteeing a debt of the LLC.
- Not maintaining proper books and records.
- Not having a separate business bank account for the LLC.
- Inadequate capital to pay debts.
- Engaging in fraudulent or illegal activities.
- Not paying payroll taxes deducted from employee paychecks.
How to form an LLC
LLCs are not formed through the IRS, they formed at the state level. Forming an LLC involves several steps, which may vary slightly depending on the state. Here are the general steps involved:
- Choose a Name: Select a unique and distinguishable name for your LLC that complies with your state’s naming requirements.
- File Articles of Organization: Prepare and file the required documents, usually called the Articles of Organization, with the appropriate state agency. These documents typically include basic information about the company, such as its name, address, purpose, and management structure.
- Choose a registered agent (aka: agent for service of process). A registered agent is an individual or entity designated to receive legal documents and official communications on behalf of a business or organization. The purpose of having a registered agent is to ensure that there is a reliable and official point of contact for legal matters related to the entity.
- Operating Agreement. Although not always required, it is highly recommended to have an operating agreement in place. This document outlines the ownership structure, member responsibilities, decision-making processes, and other important provisions.
- Obtain Licenses and Permits: Depending on your industry and location, you may need to obtain specific licenses or permits to operate legally. Research the requirements and ensure compliance.
- Get an Employer Identification Number (EIN): An EIN is a unique identification number issued by the IRS for tax purposes. It is required for hiring employees, opening business bank accounts, and filing tax returns.
Management Structure of an LLC
LLCs offer flexibility in their management structure. There are two main types of LLC structures :
- Member-Managed LLC: In a member-managed LLC, all members participate in the company’s day-to-day operations and decision-making. This structure is common in small businesses and startups.
- Manager-Managed LLC: In a manager-managed LLC, the members appoint one or more managers to handle the company’s operations. This structure is often preferred when members want to play a more passive role or when there are multiple owners who are not involved in the daily operations.
It’s important to specify the management structure in the operating agreement to avoid confusion and conflicts among the members.
LLC Ownership
An LLC ownership depends on how the LLC elects to be taxed. For example, an LLC taxed as an S-Corporation has restrictions on the type of shareholders whereas an LLC taxed as a C-Corporation or Partnership has few shareholder restrictions. An LLC has members whereas a partnership has partners and a corporation has shareholders.
Taxation of LLC
An LLC is a hybrid structure that can choose to be treated for tax purposes as either a C-Corporation, S-Corporation, Partnership, or Single Member LLC.
An LLC taxed as a partnership will file federal income tax form 1065; an LLC taxed as a C-Corporation will file federal income tax form 1120; and LLC taxed as an S-Corporation will file federal income tax form 1120-S; and a SMLLC will file taxes on the owners individual income tax return on either form Schedule C or Schedule E.
Single Member LLC (SMLLC)
A Single-Member Limited Liability Company (SMLLC) is a type of limited liability company that has only one owner, commonly referred to as the single member. The key characteristic of an SMLLC is that it is owned and operated by a single individual or entity, rather than multiple owners or members.
How to withdraw money from an LLC
At some point, you will want to start taking distributions (get paid) from your LLCs. First your LLC should have its own business bank account. You can withdraw money from you LLC in the following ways.
- Write yourself a check
- ATM withdrawal
- Wire transfer from your business LLC account to your personal account
- ACH or Electronic Funds Transfer money from your business LLC account to your personal account
- Run payroll for yourself.
- Use a peer to peer (P2P) digital payment system like Zelle, Venmo, or PayPal.
Taxation of LLC withdrawals/distributions
The taxation of withdrawals (distributions) from your LLC depends on several factors.The first factor is how your LLC is taxed. Since an LLC has the choice to be taxed as either a C-Corporation, S-Corporation, Partnership, or Single Member LLC, the tax implications of withdrawals vary by the entity type.
Main advantages of an LLC
Limited liability
Owners are protected and not liable for the debts of the LLC.
Easy to create and maintain
There is minimal paperwork required to start and maintain an LLC.
Flexible ownership and management structure
Unlike a corporation, LLCs owners can have ownership that is disproportionate to their invested capital. For example, you can form an equal (50/50) ownership LLC with a friend even if one of you does not provide 50 percent of the initial capital.
Pass-through entity taxation
LLCs are pass-through-entities which means the entity itself does not pay federal taxes. Instead, the income of the LLCs flows through to each of its owners and the owners pay tax on the income based on their LLC ownership percentages. LLCs taxed as a C-Corporation are not pass-through entities.
Professional image
LLCs convey a professional image among customers and vendors versus a sole proprietorship.
Disadvantages of an LLC
Illiquid
Ownership shares/interests in LLCs are not easily transferable, especially if the LLC operating agreement imposes limitations or requires member approval. This can restrict the ability of members to sell or transfer their ownership interests, making it harder to exit or bring in new investors.
State-Specific Regulations
States may impose minimum LLC taxes and/or fees. Each state has its own set of laws governing LLCs, and these laws can vary significantly. This can lead to additional complexities when operating across multiple states or if you need to change your LLC’s location. Complying with different state requirements can be time-consuming and costly.
Self-Employment Taxes
Single Member LLCs or members of LLCs taxed as a partnership are subject to self-employment taxes on their share of the company’s profits. Net profits of LLCs taxed as a corporation are not subject to self-employment taxes.
Limited Life
In many jurisdictions, an LLC has a limited life span. If a member leaves the LLC or dies, it can trigger its dissolution unless the operating agreement specifies otherwise. This can lead to complications in long-term business continuity and succession planning.
Difficulty in Raising Capital
Compared to corporations, LLCs may face challenges when it comes to raising capital. LLCs cannot issue stock and are generally limited to raising funds through personal investments, loans, or bringing in new members. This limited access to capital can make it harder to fund growth or attract larger investors.
LLC FAQs
Q: Is an LLC better than a corporation?
A: An LLC is a hybrid entity meaning it can choose to be taxed as a corporation, while still maintaining the flexibility of an LLC.
Q: Is an LLC a pass-through-entity (PTE)?
A: It depends on how the LLC is taxed. An LLC taxed as a C-Corporation is not a pass-through-entity, but an LLC taxed as a partnership, S-Corporation, or SMLLC is a pass-through entity.
Q: Does an LLC need an EIN?
A: Yes, an LLC, regardless of how it elects to be taxed and the number of owners, must have its own EIN.
Q: Is there a downside to an LLC?
A: Forming an LLC has start up and maintenance costs that are not incurred if you are a sole proprietor.