Key Takeaways

  • An LLC (limited liability company) combines corporate liability protection with partnership-style flexibility.
  • Owners, called members, are shielded from personal liability for most business debts.
  • LLCs can be managed by members or appointed managers.
  • Profits and losses usually pass through to members’ tax returns, avoiding double taxation.
  • LLCs offer flexible ownership, fewer compliance requirements, and wide usage across industries.
  • Downsides include self-employment taxes, varying state rules, and limited access to venture funding.
  • Forming an LLC typically involves state filing, naming requirements, and appointing a registered agent.

To understand how an LLC works, you'll have to know how the business is managed and taxed. You should be familiar with how the business handles profits and losses and who runs day-to-day operations.

How Does a Limited Liability Company Work?

Many small business owners prefer the limited liability company (LLC) structure because it gives them the liability protection that corporations enjoy but without all the formalities and the double taxation.

LLCs are often cast as a simple and quick alternative to incorporation. They're also viewed as a safe alternative to partnerships and sole proprietorships. It's still very important to understand how LLCs work before forming one.

You can form an LLC by filing formation documents with your state. In your documents, you and any other owners, or members, will specify how your company will be managed. You may choose "member-managed," where the members manage the business. You might also select “manager-managed,” where one or more people — inside or outside of the company — will be chosen to manage the business.

In member-managed LLCs, all of the business's owners can take part in daily operations. In a manager-managed LLC, only the appointed managers take part in the day-to-day business operations.

Similar to a corporation's charter, an LLC has an Articles of Organization. This document establishes the company as a separate legal entity. It also contains important information about the LLC, such as the following:

  • The owners
  • The business address
  • The managers
  • The sole proprietorships and partnerships to stop operating, but the dissolution of LLCs can be more complicated. The operating agreement will outline what happens in the case of dissolution, including details for the following:
    • How to distribute the business's assets among members
    • How to compensate members for any business debts they personally guaranteed
    • How to return capital contributions

How to Form an LLC

Forming an LLC is generally straightforward, though the exact process depends on the state. Typical steps include:

  1. Choose a Name: The name must be unique within your state and often must include “LLC” or “Limited Liability Company.”
  2. File Articles of Organization: This is the primary formation document filed with the Secretary of State or similar agency.
  3. Appoint a Registered Agent: An individual or company designated to receive legal and official correspondence.
  4. Create an Operating Agreement: Although not always required, this document outlines management structure, member roles, profit-sharing, and dissolution procedures.
  5. Obtain an EIN (Employer Identification Number): Required for taxes, banking, and hiring employees.
  6. Comply with State Requirements: Some states require initial reports, publication of formation, or annual fees.

Following these steps officially establishes the LLC as a separate legal entity.

Main Features of an LLC

Until the LLC business structure was created, business owners were personally responsible for business debts unless they incorporated. LLC owners have personal liability protection against business debts, such as legal settlements or court judgments. Business owners are only at risk of losing the amount of money they put into the business to start it. This doesn't apply, however, if an owner personally guarantees a loan, in which case the owner is personally liable for that debt.

LLCs are generally treated like partnerships for tax purposes, and this applies to how profits and losses are handled. Like a partnership, an LLC is considered a “pass-through” entity by the IRS. However, you may choose to be taxed differently. Some LLC owners choose to be taxed like corporations because it results in lower taxes.

If you don't elect corporate tax treatment, your business's profits or losses are not taxed at the business level. Instead, they pass through the business to the individual members. Members then report and pay taxes on their share on their personal tax return.

LLCs are considered the easiest business structure to form. Many people can set up an LLC in a very short period of time, and it's possible to do it without an attorney. If, however, you need assistance understanding all of the guidelines in setting up an LLC, you should consider consulting with legal and tax professionals to ensure you meet all the necessary requirements.

Common Uses of LLCs

LLCs are highly versatile and used across many industries and business types, including:

  • Small Businesses and Startups: Due to ease of formation and protection against personal liability.
  • Family-Owned Businesses: Allows flexible management and succession planning.
  • Real Estate Holdings: Popular for property ownership to limit personal risk and simplify asset transfer.
  • Professional Services: Doctors, lawyers, and consultants often use PLLCs (professional LLCs) for liability protection.
  • Joint Ventures: Two or more companies may create an LLC to manage shared projects without forming a full corporation.

Disadvantages of an LLC

Despite the benefits, LLCs are not always the best choice for every business. Key drawbacks include:

  • Self-Employment Taxes: Members may need to pay self-employment tax on all profits, which can be higher than corporate tax rates.
  • Varying State Rules: Laws governing LLCs differ significantly by state, including fees, reporting, and compliance obligations.
  • Limited Growth Potential: Some investors, especially venture capitalists, prefer corporations due to stock structure and ease of issuing shares.
  • Conversion Costs: Converting an LLC to a corporation later can be complex and costly.
  • Shorter Legal History: Compared to corporations, LLCs are a relatively newer entity type, and in some contexts may face uncertainty in interpretation.

Advantages of an LLC

LLCs are popular because they combine favorable aspects of corporations and partnerships:

  • Personal Liability Protection: Members are not personally responsible for most business debts or lawsuits.
  • Pass-Through Taxation: Business income is usually reported only once, on members’ tax returns, avoiding corporate double taxation.
  • Flexible Ownership: LLCs can have one member or multiple, including individuals, corporations, or other LLCs.
  • Fewer Formalities: Unlike corporations, LLCs do not require annual shareholder meetings or extensive recordkeeping.
  • Management Flexibility: Members can choose member-managed or manager-managed structures.
  • Business Credibility: Having “LLC” in the name often conveys professionalism to partners, lenders, and customers.

Frequently Asked Questions

  1. What is an LLC and how does it work?
    An LLC is a legal business entity that protects owners from personal liability while allowing profits and losses to pass through to personal tax returns.
  2. How do you form an LLC?
    Forming an LLC usually requires filing Articles of Organization with your state, appointing a registered agent, and creating an operating agreement.
  3. What are the advantages of an LLC?
    LLCs provide liability protection, flexible management, pass-through taxation, and fewer compliance requirements compared to corporations.
  4. Are there disadvantages to an LLC?
    Yes. LLCs may face self-employment taxes, varying state requirements, and limited investor appeal compared to corporations.
  5. Who should consider an LLC?
    Entrepreneurs, small business owners, and professionals looking for liability protection and tax flexibility often find LLCs ideal.

If you need help understanding LLCs, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.