One of the key decisions you'll need to make when starting your business is choosing the right business structure. While there are several options available, LLCs have gained popularity due to their flexibility, liability protection, and tax advantages.
But what is the true definition of an LLC, how does an LLC work, and what types of pros and cons can you expect as an LLC owner? We're here to give you the information you need so you can make the best choice for your business.
What Is an LLC (Simple Definition)?
A Limited Liability Company, commonly referred to as an LLC, is a type of business entity that combines the straightforward taxation of a sole proprietorship with the legal protection of a C Corporation. An LLC offers limited liability protection to its owners, shielding their personal assets from business debts and liabilities.
Put simply, this means that if the LLC encounters financial or legal trouble, the owners' savings, homes, cars, and other assets aren't at risk.
That's because an LLC is a legal entity that is completely distinct from its owners, also called members. This allows the LLC to enter into contracts, own property, and engage in business activities independently. The members of an LLC can be individuals, corporations, other LLCs, or even foreign entities, making it a highly versatile and very popular business structure.
How an LLC Works
To understand what it's like to own an LLC, you'll need to learn how a limited liability company works.
To form an LLC, you'll need to complete the following steps:
Step 1: Choose a business name that's available in your state (use our Business Name Search Tool to find out if your preferred name is available).
Step 2: File Articles of Organization with the appropriate state agency (usually your Secretary of State).
Step 3: Pay the required fees.
Articles of Organization will typically include your LLC's name and business address, your name and address (along with the names and addresses of any other members), and the contact details of your Registered Agent. Some states may have additional requirements, so it's essential to check your state's unique rules.
Creating an Operating Agreement
Once your LLC is established, write an operating agreement, an important document outlining the rights, responsibilities, and ownership percentages of each member.
Your state may not strictly require an operating agreement — however, we strongly recommend creating one. An operating agreement can be instrumental in preventing potential disputes among members and can provide a clear roadmap for your company's operations.
LLCs have a flexible management structure, which means members can choose to manage the company themselves or appoint managers to run the day-to-day operations. This flexibility allows an LLC to adapt to the preferences and expertise of its members.
In other words, if you want to run your LLC entirely on your own, you can. But if you want to hire a team of managers to handle most of the daily work, you can do that, too.
When tax season rolls around, LLCs don't have to pay corporate taxes. Instead, they're subject to pass-through taxation, which means their profits are simply "passed through" to their owners' personal income tax returns.
Translation? No costly double taxation and less complex paperwork. And if you want to save even more money on taxes as your business grows, you can consider having your LLC taxed as an S Corp.
What Are the Pros and Cons of Having an LLC?
There's a lot to love about LLCs, but like every other business entity type, their advantages are also accompanied by some drawbacks:
Pro #1: Limited Liability
One of the most important advantages of having an LLC is the limited liability protection it offers. In an LLC, members' personal assets are separate from the company's debts, reducing the risk of personal financial ruin in the event of business-related issues.
Pro #2: Flexibility
While corporations are bound to a rigid management structure, LLCs are generally free to have just about any management structure their owners' want.
Pro #3: Relatively Simple Upkeep
On the flip side, although your state's LLC requirements and fees may not be ideal, maintaining an LLC is generally much simpler than running a corporation. There are far fewer paperwork, oversight, and administrative tasks involved. And if you've formed your LLC with Incfile, our lifetime company alerts mean you'll always be notified of upcoming deadlines.
Pro #4: Pass-Through Taxation
As we explained earlier, pass-through taxation is an especially beneficial part of owning an LLC. With it, you won't have to file separate tax returns for your business — instead, your business earnings will be reflected on your personal tax return.
Con #1: Self-Employment Tax
When you own an LLC, you must pay self-employment tax, which has a rate of 15.3%. If you're an employee working for an employer, on the other hand, you and your employer split the cost of self-employment tax.
Con #2: State Requirements and Fees
Each state has its own regulations and fees for forming and maintaining an LLC. In California, for instance, LLCs must pay a minimum annual franchise tax of $800, even if they generate no revenue. Additionally, most states require LLCs to file annual reports.
These costs and requirements can add up, and failure to comply with them may result in penalties or, in the most severe cases, involuntary dissolution of your company.
Con #3: Transferring Ownership May Be Inconvenient
In a corporation, ownership can be transferred through the sale and purchase of a company's shares. But in an LLC, the terms of transfer must be clearly laid out in the operating agreement. Otherwise, all the LLC members will have to vote on the addition of any new members.
FAQs About LLCs
Starting an LLC of your own is no small feat, so you probably still need answers. Here are some common questions:
What Are the Benefits of Having an LLC?
LLCs come with a wealth of benefits that other business structures don't offer. The key advantages of an LLC include personal asset protection, pass-through taxation, flexibility, credibility to customers, and relatively simple maintenance.
Why Should You Put Everything Under an LLC?
We've already established that one of the main perks of an LLC is its limited liability. Because of that, any debts or obligations you put under an LLC will be legally separated from your name.
It's important to note, however, that forming an LLC does not automatically give you complete legal protection. In order to minimize your liability, you must obtain business insurance.
What Is an Example of a Business Purpose for an LLC?
The flexibility of LLCs allows them to be used for various business purposes. For instance, a group of investors may form a real estate investment LLC to acquire and manage rental properties. By doing this, they can limit personal liability, pool their resources for property acquisition, and manage properties under one company.
In another example, an individual may start an LLC with the purpose of creating and selling consumer goods. As a result, they can protect their personal assets from business creditors and lawsuits, gain a more professional appearance, and achieve greater separation between their business and personal finances.
What Is the Difference Between a Corporation and an LLC?
While corporations and LLCs both offer limited liability protection for their owners, they have distinct differences in terms of structure, taxation, and compliance:
Structure: Corporations have a more rigid management structure that features a board of directors, officers, and shareholders. On the other hand, LLCs are typically managed by their members or hired managers. And since LLCs don't sell shares on the stock market, there are no shareholders necessary.
Taxation: In a corporation, profits are taxed both when they're earned and when they're distributed to shareholders as dividends — this is known as a double tax. LLCs, on the other hand, enjoy pass-through taxation, and their profits are only taxed once.
Compliance: Corporations are required to hold regular shareholder meetings and maintain exhaustive corporate records, while LLCs have fewer regulations and less rigorous record-keeping requirements.
So if you want to start a large company and sell shares on the public stock market, a corporation may be the best choice for you. But if you want to reap the benefits of pass-through taxation and fewer compliance rules and regulations, an LLC could be ideal for your needs.
What's the Difference Between a Single-Member and Multi-Member LLC?
The distinction between a single-member vs. multi-member LLC comes down to the number of owners it has. If an LLC has only one owner, it's known as a single-member LLC. But if it has two or more owners, it qualifies as a multi-member LLC.
Understand LLCs to Help Your Business Thrive
It's not hard to see why LLCs are so popular with small business owners. With their liability protection, tax benefits, and adaptable management options, they can provide the convenient taxation of sole proprietorships and the robust legal protection of corporations.
By learning the definition of an LLC, evaluating its pros and cons, grasping the ins and outs of its operations, and carefully considering your own wants and needs, you can determine if an LLC is the right business structure for you.
And if you do, our $0 LLC service makes it possible to start your LLC for free — just pay your state's required fees and we'll handle the rest.
Carrie Buchholz-Powers is a Colorado-based writer who’s been creating content since 2013. From digital marketing to ecommerce to land conservation, she has experience in a wide range of fields and loves learning about them all. Carrie is fond of history, animals and beauty in equal measure. In her free time, she enjoys knitting, playing video games and exploring Colorado's prairies and mountains with her husband.