What Is a Limited Liability Company (LLC)?
A limited liability company (LLC) is a business structure in the U.S. that protects the assets of its owners from lawsuits and creditors concerned with the company's business debts.
Limited liability companies are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship.
While the limited liability feature is similar to that of a corporation, the availability of pass-through taxation to the members of an LLC is a feature of a partnership rather than an LLC.
Key Takeaways
- The limited liability company (LLC) is a corporate structure that protects its owners from being personally pursued for repayment of the company's debts or liabilities.
- Regulation of LLCs varies from state to state.
- Any entity or individual can be a member of an LLC with the notable exceptions of banks and insurance companies.
- LLCs do not pay taxes on their profits directly.
- Their profits and losses are passed through to members, who report them on their individual tax returns.
Understanding a Limited Liability Company (LLC)
Limited liability companies are permitted under state statutes, and the regulations governing them vary from state to state. Generally, LLC owners are called members.
Many states don't restrict ownership, which means that anyone can be a member. That includes individuals, corporations, foreigners, foreign entities, and even other LLCs. Some entities, such as banks and insurance companies, are prohibited from forming LLCs.
An LLC is a formal business arrangement that requires articles of organization to be filed with the state. An LLC is easier to set up than a corporation and provides more flexibility and protection for its investors.
LLCs may elect not to pay federal taxes directly. Instead, their profits and losses can be reported on the personal tax returns of the owners. Or, the LLC may choose to be classified as a corporation for tax purposes.
If fraud is detected or if an LLC fails to meet its legal and reporting requirements, creditors may be able to go after the members.
LLCs should not be confused with an Unlimited Liability Corporation (ULC), which is a corporate structure allowed in certain countries and in some Canadian provinces.
The wages paid to LLC members are deemed operating expenses and are deducted from the company's revenue.
Forming an LLC
1. Although the requirements for LLCs vary by state, there are generally some commonalities. The very first thing owners or members must do is to choose a name.
2. Then, articles of organization can be completed and filed with the state to establish the LLC. This document can provide basic information about the LLC, the names and addresses of the LLC members, the name of the LLC's registered agent, and the statement of purpose for the business.
The articles of organization are filed with the state in which the LLC is formed, along with a fee paid directly to the state. Paperwork and additional fees must also be submitted at the federal level to obtain an employer identification number (EIN).
3. An LLC operating agreement will lay out the operational and financial decision-making roles and duties of members. It will state just how profits are to be distributed.
It is the contract between all members of the LLC and provides all details about the LLC's structure and important business functions.
Normally, this internal document remains with the LLC and isn't distributed externally.
A registered agent is a company that an LLC hires to manage the various legal and government correspondence sent to the LLC so that it can be sure to comply with state regulations.
Benefits of an LLC
- An LLC provides its members with limited personal liability relating to the company's business debts.
- It is fairly easy to organize and get up and running.
- It offers the flexibility to opt for pass-through taxation or to elect corporate taxation (as an S Corporation or C Corporation).
- Its pass-through taxation prevents double taxation—that is, paying taxes twice, once on LLC profits and then again, on profits that individual members receive.
- Many business expenses can be written off as business deductions, thus lowering taxable income; these deductions are taken on the LLC or personal return (depending on the taxation method chosen, corporate or pass-through).
- An LLC can be run by its members or members can hire a manager to handle day-to-day affairs. Some members may choose to be more or less involved than others.
- The LLC designation can lend greater credibility to a sole proprietorship or partnership.
- Less record-keeping is required compared to corporations, which means greater focus can be maintained on the goals of the business.
Drawbacks of an LLC
- Depending on state law, an LLC may have to be dissolved upon the death or bankruptcy of a member. A corporation can exist in perpetuity.
- If the LLC opts for pass-through taxation, members must pay self-employment taxes in addition to personal income taxes.
- Unless the Operating Agreement is properly conceived, executed, and understood by all, there's the risk that roles and responsibilities may not be clearly understood.
- There can be penalties, as stated in the Operating Agreement, for failing to make capital contributions.
An LLC may not be a suitable option if the founder'sultimate objectiveis tolaunch a publicly traded company.
LLC vs. Partnership
The primary difference between a partnershipand an LLC is that an LLC separates the business assets of the company from the personal assets of the owners, insulatingthe owners from the LLC's debts and liabilities.
Both LLCs and partnerships are allowed to pass through their profits, along with the responsibility for paying the taxes on them, to their owners. Their losses can be used to offset other income but only up to the amount invested by a member.
If the LLC has organized as a partnership, it must file Form 1065. (If members have elected to be treated as a corporation, Form 1120 is filed).
With an LLC, a business continuation agreement can be used to ensure the smooth transfer of interests when one of the owners leaves or dies. Without such an agreement in place, the remaining partners must dissolve the LLC and create a new one.
What Is a Limited Liability Company?
A limited liability company, commonly referred to as an LLC, is a type of business structure commonly used in the U.S. LLCs can be seen as a hybrid structure that combines features of both a corporation and a partnership. Like a corporation, LLCs provide their owners with limited liability in the event the business fails. But like a partnership, LLCs pass their profits to members so that they are taxed as part of each member’s personal income.
What Are LLCs Used for?
The LLC has two main advantages:
- It prevents its owners from being held personally responsible for the debts of the company. If the company goes bankrupt or is sued, the personal assets of its owner-investors cannot be pursued.
- It allows all profits to be passed directly to those owners to be taxed as personal income. This prevents the double taxation of both the company and its individual owners.
What Are Some Examples of LLCs?
LLCs are more common than many realize. Alphabet, the parent company of Google, is an LLC, as are PepsiCo Inc., Exxon Mobil Corp., and Johnson & Johnson.
LLCs can include sole proprietorship LLCs, family LLCs, and member-managed LLCs.
Many physicians' groups are registered as LLCs. This helps protect the individual doctors from personal liability for medical malpractice awards.
Are Limited Liability Companies Taxed Differently Than Corporations?
Yes. In the case of a corporation, profits are first taxed at the corporate level and then taxed a second time once those profits are distributed to the individual shareholders. This double taxation is decried by many businesses and investors.
Limited liability companies, on the other hand, allow the profits to be passed directly to the investors so that they are taxed only once, as part of the investors’ personal income.
The Bottom Line
LLCs are important legal structures for forming a business. Limited liability means that the assets and debts of the business remain separate from the personal assets and debts of the LLC's owners.
In most cases, if an LLC goes bankrupt, creditors can only go after the assets of the business and not of the owners.
LLCs also have several other beneficial features including simplified taxation and a relatively straightforward formation process. This is part of the reason why LLCs are the most common type of business in the U.S.
