To understand how LLC works, you'll first need to know how Limited Liability Companies (LLCs) differ from other business entity types. Basically, they offer the legal protection for owners that a corporation offers, but with the taxation practices of a sole proprietorship.

LLC Basics

Before the LLC entity structure came about, business owners had to choose between either forming a corporation or a sole proprietorship. LLCs sort of take the best characteristics of each of those entity types and puts them into one. Since LLCs were introduced, they have become increasingly popular with entrepreneurs. They tend to be easier to operate and maintain than other business types.

Some states require an LLC to have a minimum of two owners, or they will be considered a sole proprietorship, however, they will usually allow spouses to act as the second owner. Other states allow for single-owner LLCs and multiple-owner LLCs.

Establishing an LLC in most states is quite simple and inexpensive. You'll need to contact the Secretary of State office in the state in which you plan to conduct business to find out what exactly is required to file a business in that state.

There are several important aspects of LLCs to consider:

  • Limited liability
  • Management structure
  • Taxation
  • Income distribution

Limited Liability

The limited liability part of the LLC name refers to the fact that the owners (also called members) of the business are protected from any financial or legal responsibilities should the company run into issues or dissolve.

Sometimes LLC members can be at risk of losing their capital contributions, but otherwise, their assets are protected. Members of LLCs can, however, be held liable if they co-sign any loans for the company.

Management Structure

Another appealing part of the LLC setup is the flexibility allowed for management structure. LLCs can either be member-managed or manager-managed.

A member-managed LLC will hold the members of the business responsible for running the daily operations of the business. This is ideal for small businesses, especially when they are family-owned.

A manager-managed LLC can either appoint one of the members to act as manager, or they can hire a third party individual or company to manage the LLC.

Entity types like corporations don't offer this sort of management flexibility. Corporations are required to have a board of directors with certain offices. The directors and shareholders must have different responsibilities when it comes to major company decisions. Corporations are also required to hold regular meetings, whereas LLCs are not.


LLCs have a few options when it comes to their classification in the eyes of the IRS. They may elect to be taxed as a corporation, partnership, or disregarded entity.

Unless they choose to be taxed as a corporation, the LLC will benefit from the pass-through taxation treatment. This means that the income of the business is passed through to the owners and reported on their personal tax returns. The LLC itself is not taxed. Without this pass-through treatment, the company can experience double taxation like a corporation. Double taxation means that the business income is taxed at the company level and again at the individual level through the income taxes of shareholders who report their dividends.

Income Distribution

Members of an LLC have a bit of freedom when it comes to distributing the company profits and losses. Some business structures require income distribution percentages to mirror the capital contributions of the members. LLCs can decide on distribution percentages in whatever way they see fit. Members who had a smaller capital contribution might get a higher profit distribution because of their management role with the company.

Corporate rules for income distribution are the most strict, while the rules for partnerships are the least strict. Income distribution rules for companies with S-Corp status are somewhere in the middle. ;

LLC Formation

Forming an LLC is done through the appropriate state agency. This could be the Secretary of State or a business or corporate division of some sort. You'll need to research the requirements within the particular state you plan to do business.

You need to file articles of organization (or whatever name your state has for formation documents), pay the required fees, choose your LLC names, and obtain an EIN. Usually, LLCs are also required to choose a registered agent, and some states require operating agreements as well.

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