How Does An LLC Work: Everything You Need to Know
How does an LLC work? An LLC (limited liability company) works as a type of business entity that provides both liability protection for owners and members and pass-through taxation. 4 min read
2. LLC Members
3. LLC Management
4. LLC Voting
5. LLC Transferability
6. LLC Taxation
7. How It All Works
Updated July 8, 2020:
How does an LLC work? An LLC (limited liability company) works as a type of business entity that provides both liability protection for owners and members and pass-through taxation.
What Is an LLC?
An LLC is a type of business structure that treats owners like partners but gives them the choice to be taxed like a corporation. This form of business allows for flexibility in ownership and management.
Once the owners have decided how they would like to be taxed, managed, and organized, they will spell it all out in an operating agreement.
Most new business owners will choose the LLC form of business in order to protect their personal assets from liability in case the business fails and to benefit from being taxed as a disregarded entity. Some, however, will choose a corporate structure instead.
The owners of an LLC are also called its members. These members share in all of the profits and losses of the company as the owners of a partnership would. If two people started an LLC, both investing at 50 percent of the company, each would get 50 percent of the profits, and so on.
Operating agreements are not required in order to start an LLC in most states, but they are beneficial documents to the founding of a successful business. These agreements outline the benefits, responsibilities (financial and otherwise), and percent of investment of each member.
Unlike S-corporations, LLCs do not have to distribute payouts equal to the percent of member investments. If the owners have spelled out a specific type of distribution in their operating agreement, they may follow that. If there is no profit distribution plan written out in an agreement, the state provides a fallback plan that distributes monies proportionally to investments.
Management styles within LLCs will look different depending on the size and structure of a company. The following may act as management for an LLC:
- All members
- A hired manager (non-member)
- A management committee (made up of members)
Members are allowed to act as passive investors in the company, in which case their only involvement in the company is financial.
Sometimes the profit distribution percentages are based on the management roles of the members rather than simply their principle investment amounts.
LLC owners will frequently decide on voting rights based on the members' capital investment amounts. For instance, if a member holds a 25-percent interest in the company, but another holds 50 percent, the vote of the member with 50-percent interest will count twice as much as the one with 25-percent interest.
If voting rights are not laid out in an operating agreement, the LLC must follow the voting rules provided by the state in which the LLC is formed.
Unlike some other business structures, a member of an LLC can sell or give their interest in the company to another person. All other members first have to vote and reach majority approval before this can happen.
LLC transfer rules will also be outlined in the operating agreement, but if they aren't, the state provides fallback rules. Usually, states allow members to sell or give their shares away but still maintain voting rights, unless the operating agreement says otherwise.
LLCs are taxed as pass-through entities like partnerships and sole proprietorships unless they've opted for C-corp or S-corp status. Certain regulations apply in order for an LLC to qualify for S Corp taxation status.
Pass-through entities, like partnerships, pass all of the company's profits and losses through the to members according to their interest percentages. The profits are therefore taxed through the personal income taxes of the members, not as company income. This avoids the double taxation that happens with certain corporate structures.
How It All Works
As one of the newest business structures, LLCs are very popular among business owners today. Although they may seem like a no-brainer to an entrepreneur, it's important to learn how they work before jumping in.
The articles of organization include the following information about the entity:
- Names of all owners (members) and manager(s)
- Name and address of registered agent
- Company name and address
The articles of organization also lay out the business's plan, purpose, and structure.
Similar to articles of organization, the operating agreement is a document that the members of the LLC form and agree on together. This document is not required by the state, but it helps a company run well and avoid disputes.
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