Key Takeaways

  • An LLC (limited liability company) provides personal asset protection and pass-through taxation.
  • LLCs can be formed by individuals, corporations, and other entities, with no maximum number of members.
  • Formation requires choosing a business name, appointing a registered agent, filing articles of organization, and possibly drafting an operating agreement.
  • LLCs offer flexibility in taxation, management, and ownership but may face higher self-employment taxes and complex state compliance requirements.
  • Comparing LLCs to sole proprietorships, partnerships, and corporations can help determine the best structure for a business.

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. 

LLC Members

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. 

LLC Management

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. 

State-Specific Rules and Requirements

Each state has unique requirements for forming and maintaining an LLC. These may include:

  • Formation fees: Initial filing fees can range from $50 to $500 or more depending on the state.
  • Annual reports and franchise taxes: Many states require yearly reports and ongoing fees to maintain good standing.
  • Foreign qualification: If your LLC operates in multiple states, you may need to register as a foreign LLC in those additional states.
  • Publication requirements: A few states, like New York and Arizona, mandate publishing a notice of LLC formation in a local newspaper​​.

For detailed state-specific rules, consult your state’s Secretary of State website or use UpCounsel to connect with a business attorney.

LLC Voting

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. 

LLC Transferability

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.

LLC Taxation

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. 

LLC Advantages and Disadvantages

Advantages of an LLC include:

  • Limited liability protection: Members are not personally liable for business debts or lawsuits.
  • Flexible taxation: LLCs can choose to be taxed as sole proprietorships, partnerships, or corporations.
  • Pass-through taxation: Profits and losses pass directly to members’ personal tax returns, avoiding double taxation.
  • Flexible ownership: Members can include individuals, corporations, other LLCs, or foreign entities.
  • Fewer compliance requirements: LLCs typically have less paperwork and fewer formalities than corporations.
  • Credibility: Operating as an LLC can increase business legitimacy with customers, vendors, and lenders​.

Disadvantages of an LLC include:

  • Self-employment taxes: Members typically must pay self-employment taxes on business income.
  • Varying state rules: Formation fees, ongoing requirements, and tax obligations differ by state.
  • Limited investor appeal: Some investors prefer corporations due to stock issuance and structural clarity.
  • Transfer restrictions: Selling ownership interest may require consent from other members​.

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. 

Steps to Form an LLC

Forming an LLC typically involves the following steps:

  1. Choose a Business Name
    The name must be unique and comply with your state’s LLC naming requirements. Avoid restricted terms like “bank” or “insurance” unless properly licensed.
  2. Designate a Registered Agent
    This person or entity is responsible for receiving legal documents on behalf of the LLC. Many states allow a member to serve in this role, though their address becomes public record.
  3. File Articles of Organization
    Also known as a Certificate of Formation, this document is submitted to the state and includes your LLC’s name, address, management structure, and other basic information.
  4. Create an Operating Agreement
    While optional in many states, this document outlines how the LLC is run, including profit-sharing, voting rights, and member duties.
  5. Apply for an EIN (Employer Identification Number)
    Required for tax filings and opening a business bank account.
  6. Register for State Taxes and Permits
    Depending on your location and business type, you may need to register for state taxes, obtain a sales tax ID, or apply for local business licenses​​.

Frequently Asked Questions

1. What is an LLC and how does it work? An LLC is a flexible business structure that combines personal asset protection with pass-through taxation. It’s formed by filing articles of organization with the state and is governed by an operating agreement.

2. How is an LLC different from a corporation? LLCs are generally easier to form and maintain, offer flexible management and tax treatment, and don’t require the same formalities as corporations.

3. Can a single person form an LLC? Yes. Many states allow single-member LLCs, which are treated as sole proprietorships for tax purposes unless otherwise elected.

4. Do I need an attorney to form an LLC? While not required, hiring an attorney can help ensure your documents are complete and compliant with state law.

5. Does an LLC protect my personal assets? Yes, as long as the LLC is properly maintained and not used to commit fraud, members are generally not personally liable for business debts.

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