Key Takeaways

  • A Limited Liability Company (LLC) combines liability protection of a corporation with tax flexibility of a partnership.
  • LLCs can choose how they are taxed—sole proprietorship, partnership, C corporation, or S corporation.
  • Owners (members) have limited liability, protecting personal assets from business debts and claims.
  • LLCs are easier to form and manage than corporations, but they still require annual filings and fees.
  • LLCs offer flexible management, allowing member-managed or manager-managed structures.
  • Some drawbacks include self-employment taxes and varying state filing fees and requirements.

To give an LLC overview, you will have to understand a few things:

  • What is an LLC?
  • Why do LLCs exist?
  • Who should consider an LLC structure?

Formed in the 1970's, LLCs are a relatively new business formation type.

What is an LLC

A Limited Liability Company is a business structure first recognized by the IRS in 1980. In the 1970s, Wyoming and Florida introduced the LLC structure, and most of the other states enacted it soon after that. An LLC blends benefits of a corporation and a partnership or sole proprietorship. Like a corporation, members (LLC owners) have limited liability protection while avoiding double-taxation. Instead, they have pass-through taxation like a partnership or sole proprietorship.

This business formation exists to allow business owners to operate their business without some of the red tape associated with corporations while having protection for their assets from business debt. While partnerships and sole proprietorships are pass-through entities and do not pay taxes at the entity level, the owners do not have limited liability protection.

Likewise, though a corporation features limited liability protection for its shareholders, it is subject to double taxation. A corporation can experience pass-through benefits through an S Corporation election; however, it does not get the same tax treatment as an LLC. LLC members have flexibility in how they run the company. The members can manage it, or they can appoint someone to manage business operations. Depending on what way the members decide, the LLC is either member-managed or manager-managed.

To form an LLC, a business owner must file Articles of Organization with the Secretary of State. LLC members have flexibility when implementing their management structure. The operating agreement outlines essential member guidelines such as:

  • Outlining whether the LLC is member-managed or manager-managed.
  • Specifying member rights and compensation.
  • Communicating ownership percentage for each member.
  • Conveying profit and loss distribution among its members.    
  • Laying out rules for transferring ownership

If an LLC does not have an operating agreement or if the agreement does not address specific factors, then the state's provisions prevail. Compared to the corporate structure, LLC formations are straightforward.

How LLCs Are Taxed

An important aspect of understanding what to know about LLC formation is taxation. The Internal Revenue Service (IRS) does not recognize LLCs as a separate tax classification. Instead, the LLC can choose how it will be taxed:

  • Single-member LLCs are automatically taxed as sole proprietorships. The owner reports profits and losses on their personal income tax return (Form 1040, Schedule C).
  • Multi-member LLCs are treated as partnerships by default. Each member reports their share of profits and losses on their personal return using Schedule K-1.
  • LLCs may elect corporate taxation by filing Form 8832 (for C corporation taxation) or Form 2553 (for S corporation taxation). This flexibility allows owners to choose the most favorable tax structure based on business income and future growth.

In addition to federal taxes, LLCs may owe state-level income taxes, franchise taxes, or annual report fees depending on their formation state. Understanding these obligations ensures ongoing compliance and prevents penalties.

Advantages of an LLC

An LLC has several advantages.

  1. LLC members enjoy limited liability protection, like that of a shareholder in a corporation.
  2. LLC members share in the profits and the tax deductions, however; they receive protection from company liabilities and each other's debt.
  3. LLCs offer a relatively flexible management structure.
  4. LLCs pass-through profits and losses to their members. Corporate structures are taxed at the entity level and employee level. For instance, an employee-shareholder is subject to payroll tax (as an employee) and dividend tax (as a shareholder). LLC members report profits and losses when they file their taxes.  
  5. Members of an LLC have flexibility in dividing the profits and losses.

Flexibility in Management and Ownership

One of the top advantages of an LLC is its structural flexibility. Unlike corporations that require a formal board of directors and officers, an LLC can be:

  • Member-managed, where all owners actively participate in daily operations.
  • Manager-managed, where members appoint one or more managers to oversee business affairs.

This flexibility makes LLCs ideal for both small businesses and growing startups. Ownership can include individuals, corporations, foreign entities, and even other LLCs, offering significant versatility not typically available to S corporations.

LLCs can also customize their profit distribution. Members are not required to distribute profits strictly in proportion to ownership percentage—allowing more strategic financial planning.

Disadvantages of an LLC

LLCs have several small business advantages; however, there are disadvantages to forming an LLC. When evaluating your business requirements, analyze both the pros and the cons.

  1. Limited liability companies are typically more complicated to form compared to a sole proprietorship or the general partnership. However, LLC formation process is not as complicated as creating a corporation. Each year a limited liability company must pay a filing fee to the Secretary of State to upkeep their LLCs, file informational returns to the IRS, and filing of a state tax return.
  2. In certain jurisdictions, single-member LLCs may not get the same level of limited liability protection as that of a corporate entity.
  3. In many states, if you have a company that renders professional services, you cannot set up an LLC because the limited liability does not extend to those types of companies. Instead, you must set up a Professional LLC (PLLC). PLLC structures do not benefit from liability protection. For instance, doctors do not benefit from this liability shield due to opposition primarily from the trial lawyers.
  4. LLC profits may be subject to self-employment taxes. This can be a disadvantage depending on your income bracket.

LLCs are suitable for many small business owners. Still, you need to consider all the nuances that come with an LLC and make sure it is a structure that fits your business needs.

State Requirements and Ongoing Obligations

LLCs are easier to form than corporations, but they still have continuing obligations. Most states require:

  1. Annual or biennial reports to maintain good standing.
  2. Annual fees or franchise taxes that vary by jurisdiction (for example, California’s minimum franchise tax or Florida’s annual report fee).
  3. Registered agent maintenance, requiring a designated person or entity to receive legal documents.

Failure to meet these requirements can result in administrative dissolution or penalties. Some states also restrict certain professions—like doctors, accountants, and architects—to Professional LLCs (PLLCs) for compliance reasons.

Additionally, self-employment taxes may reduce the overall tax benefit for some members, particularly those earning high income. Consulting a tax professional before formation can help determine if an LLC or another structure (like an S corporation) is better suited to your goals.

Steps to Form an LLC

For entrepreneurs learning what to know about LLC creation, formation typically involves the following steps:

  1. Choose a business name that meets state naming requirements and includes “LLC” or “Limited Liability Company.”
  2. Select a registered agent to receive service of process and official state correspondence.
  3. File Articles of Organization with the Secretary of State (or equivalent agency).
  4. Draft an Operating Agreement detailing ownership, management, and member rights.
  5. Obtain an EIN (Employer Identification Number) from the IRS for tax purposes.
  6. Register for state and local taxes, if required.
  7. Maintain compliance through annual filings and updated records.

Each state may impose different fees or documentation standards, so checking local requirements before filing is crucial.

Frequently Asked Questions

1. How is an LLC different from a corporation?

An LLC offers limited liability protection like a corporation but is simpler to manage and provides flexible taxation options.

2. Do LLC owners pay self-employment taxes?

Yes, unless the LLC elects S corporation taxation, members typically pay self-employment taxes on business income.

3. Can a single person form an LLC?

Yes. Single-member LLCs are common and provide the same liability protection as multi-member LLCs.

4. Do LLCs have to file taxes every year?

Yes. LLCs must file taxes annually at the federal level and may have state filing or reporting obligations.

5. Is an Operating Agreement required for an LLC?

It depends on the state, but even where not required, it’s highly recommended to prevent disputes and clarify management roles.

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