What is an LLC (Limited Liability Company)?

Written by Steven Tennies on May 6, 2013 at 7:23 pm

The limited liability company or LLC is the new kid on the block and combines some of the most significant advantages of partnerships and corporations into one. The first LLC was formed in Wyoming in 1977. But LLCs caught on like wildfire due to the personal asset protection and tax flexibility they offered their owners.

LLC-2Limited liability company defined

An LLC is a hybrid business entity, combining many of the positive characteristics of both a corporation and a partnership, presumably giving them the best of both worlds.

Like a corporation, an LLC is a legally distinct entity, separate from its owners. It has the power to sue and be sued, just like a corporation. It provides similar limited liability protection as that of a corporation, but has the pass-through tax benefits of a sole-proprietorship and partnership.

How to form an LLC

An LLC comes into existence when prospective members file a charter document with a state’s business entities department, which is usually the Secretary of State. The owners of an LLC are called members and membership units represent a member’s ownership interest.

An LLC can have one or more members.

LLC management

LLCs offer a flexible management structure. LLCs can be either member-managed or manager-managed. In a member-managed LLC each member has an equal voice in the decision-making processes of the company, much like partners in a partnership. Most LLCs are member-managed. In a manager-managed LLC the members specifically designate a manager or managers, who may or may not also be members, to manage the company, much like officers in a corporation.

LLCs and the IRS

By default, the IRS treats single-member LLCs as a sole proprietorship and multiple-member LLCs as partnerships, meaning that they are initially treated as pass-through entities. The company itself does not pay income tax. Profits are taxed to the members at their personal income tax rates.

However, if the members of the LLC believe it to be advantageous, the LLC can elect to be taxed as either a “C” or “S” corporation by filing form 8832 with the IRS.

Advantages of an LLC

Limited liability protection—the foremost benefit of an LLC is the limited liability protection afforded its owners. The members cannot be held liable for company losses, or debts and business credit, and they don’t have to give up personal assets, such as a house or a car, to satisfy those business obligations.

No double taxation—by default LLCs are not subject to double taxation like corporations. An LLC is treated as a pass-through entity, meaning that the company itself will not be taxed unless it elects to be taxed as a corporation. The individual members report all business profits, losses, and expenses on their individual income tax returns.

Fewer operational formalities—LLCs require far less paperwork and recordkeeping than a corporation. Most states don’t even require an operating agreement, though it is still a good idea to create one so that you can choose the specific rules that will govern your company. If you do not create an operating agreement, your company will, by default, be governed by the LLC statutes of your state. Most states also do not require LLCs to hold formal annual meetings that are required of corporations.

Flexibility—members can choose to have profits distributed any way they would like. This means whatever percentage of the profits they want to give each member, they have the flexibility to do so regardless of their specific ownership interest.

Enhanced credibility—an LLC lends credibility to your business by showing your potential customers, employees, vendors and partners that you have made a formal commitment to your business.

Disadvantages of an LLC

Limited legal precedent—LLC law is not as developed as corporate law and many issues remain to be decided.

Restricted transferability—it is more difficult to transfer your ownership interests.

Difficulty raising capital—it is more difficult to raise capital for an LLC. Many investors and venture capital firms will only invest in corporations.

Industry restrictions—not every business can become an LLC. Some specific businesses, such as banks or insurance companies are not allowed to form an LLC. And in many states, if you are a licensed professional, such as an accountant or attorney, you cannot form an LLC.