Key Takeaways

  • A limited liability company (LLC) combines the liability protection of a corporation with the flexibility and tax simplicity of a partnership or sole proprietorship.
  • Understanding how LLC works involves knowing its formation process, structure, liability protections, taxation options, and ongoing compliance obligations.
  • LLCs offer flexibility in management, allowing owners (members) to decide between member-managed and manager-managed structures.
  • Pass-through taxation lets profits flow directly to owners’ personal tax returns, but LLCs can also elect corporate taxation.
  • Drafting a thorough operating agreement and maintaining separation between business and personal finances are crucial for preserving liability protection.
  • LLCs can be used for a variety of businesses — from single-member ventures to multi-member enterprises — and can enhance credibility with clients and investors.

Understanding LLC is as simple as weighing the advantages and disadvantages of this business structure for your company. You might be starting a new business or have a partnership or sole proprietorship that could benefit from being registered as a limited liability company (LLC). An LLC is a relatively new form of business entity that was established in the 1970s. LLC formation initially had slow growth due to its uncertain tax treatment with the IRS.

To be able to enjoy the benefits of pass-through taxation that this business structure can provide, your LLC must have at least two members. Because of its tax benefits, electing for LLC designation is popular among real estate holdings as well as small businesses.

Why LLCs Are Popular

There are many reasons business owners might elect to form their businesses as LLCs. Some of the most popular reasons for choosing an LLC include:

  • They can be formed with a single member.
  • They are easy to form.
  • They offer pass-through taxation for multiple-member LLCs.
  • Members can enjoy the protection of their personal assets from business debts and suits or legal claims against the business.
  • There are fewer filing and meeting requirements when compared to corporations.
  • They have more flexibility when structuring management.
  • They are simple to maintain.

If forming an LLC with your spouse as the additional member, you will be classified as a "disregarded tax entity" and have taxes pass through the company to your personal tax returns.

How LLC Formation Works

Understanding how LLC works starts with its formation. Creating an LLC is relatively straightforward compared to forming a corporation, but it still involves several key legal steps:

  1. Choose a Business Name: The name must be unique in your state and usually include “LLC” or “Limited Liability Company.”
  2. File Articles of Organization: This foundational document, also called a Certificate of Formation in some states, is submitted to the Secretary of State’s office and officially establishes your LLC as a legal entity.
  3. Appoint a Registered Agent: Every LLC must designate an agent to receive legal documents on behalf of the company.
  4. Create an Operating Agreement: While not always legally required, this internal document defines ownership, management structure, voting rights, profit distribution, and procedures for adding or removing members.
  5. Obtain an EIN: The IRS issues an Employer Identification Number (EIN) for tax purposes, required if you have employees or multiple members.
  6. Comply with Ongoing Requirements: Most states require annual reports, franchise taxes, or renewal filings to keep the LLC in good standing.

Following these steps ensures your LLC is legally recognized and positioned to take advantage of its tax and liability benefits.

Personal Liability Protection of an LLC

Limited liability company (LLC) owners have the same limited liability protection as if they were corporation shareholders. This means that, except under rare occurrences, an owner can protect his or her personal assets from being used to satisfy business debts.

There is one way in which LLC liability does differ from that of a corporation. A creditor can seek a personal judgment against an LLC member by requesting a charging order. This could result in a claim against the member's economic interest in the business, but that individual's personal assets (house, savings, etc.) remain protected. In a general partnership or sole proprietorship, there is no separation between business and personal assets. Under these structures, a creditor could pursue personal assets to settle a debt.

In the event of a charging order, cash distributions that would normally be paid to the member will be made as payment to the creditor until the debt is satisfied. Even though the creditor is getting the distributions, they will not be entitled to the voting rights or management participation that the member would normally enjoy.

If the LLC has drafted a proper operating agreement, any majority voting issues could have a contingency plan in the event of this occurrence.

Taxation and Financial Flexibility of an LLC

A major advantage of forming an LLC is its flexible tax treatment. By default, a single-member LLC is treated as a disregarded entity and taxed as a sole proprietorship, while a multi-member LLC is treated as a partnership. In both cases, the business itself does not pay federal income tax — instead, profits and losses “pass through” to the owners’ personal tax returns. This structure avoids the double taxation corporations face.

However, LLCs can also elect to be taxed as a C corporation or S corporation by filing IRS Form 8832 or Form 2553. Choosing corporate taxation can sometimes reduce self-employment taxes or make it easier to reinvest profits back into the business.

Other financial considerations include:

  • Pass-Through Deduction: Under the Tax Cuts and Jobs Act, LLC owners may deduct up to 20% of qualified business income through 2025.
  • Profit Distribution Flexibility: LLCs are not required to distribute profits in proportion to ownership percentages. Members can decide how to allocate earnings in the operating agreement.
  • Credibility with Lenders: Forming an LLC can make it easier to open business bank accounts, secure loans, and attract clients or investors.

The Management Structure of LLCs and Operating Agreements

An LLC allows for greater flexibility and more options when creating a management structure. This is particularly advantageous for LLC with multiple members and/or managers. An LLC can be:

  • Member-managed, in which the company is run solely by its members.
  • Managed by member-appointed officers.
  • Manager-managed, in which the members designate managers to run the company's day-to-day operations. This type of structure is most similar to that of a corporation.

An LLC also offers its members the option to draft a customized operating agreement that provides the members with the ability to structure their company how they choose. An operating agreement is similar to a partnership agreement between the managers and members of an LLC. It lays out the rights and responsibilities of all parties. An operating agreement typically includes:

  • The duties and responsibilities of members and management.
  • Each manager and member's rights, powers, permission, and restrictions.
  • How transferring membership interest will occur.
  • How membership interest will be valued.

Along with the above inclusions, a well-drafted operating agreement will also include such member-related issues as:

  • Compensation for management.
  • Expected time commitment from members.
  • The procedures for member removal.
  • The types of issues that require member approval.
  • Voting rights and decisions that require unanimous voting.

If you do choose to create an operating agreement for your LLC, you might want to hire an experienced attorney to make sure it's done properly.

Compliance, Growth, and Legal Considerations

To maintain liability protection and stay in good standing, LLCs must follow certain compliance requirements. These typically include:

  • Annual Reports: Most states require LLCs to file annual or biennial reports, often accompanied by a fee.
  • Franchise Taxes: Some states impose annual taxes on LLCs regardless of income.
  • Separate Finances: It’s critical to keep business and personal finances separate. Commingling funds can lead to “piercing the corporate veil,” exposing owners to personal liability.
  • Operating Agreement Updates: Revisit and update your operating agreement as the business grows or adds members to reflect changes in management or ownership structure.

As your LLC grows, you may also face decisions about adding members, converting to a corporation, or expanding into multiple states. Each of these steps carries legal and tax implications, so consulting with an attorney or tax professional can help you make informed choices. You can connect with an experienced business attorney on UpCounsel if you need legal guidance.

Frequently Asked Questions

  1. How does an LLC work in terms of ownership?
    An LLC can have one or more owners, called members, who hold equity interests. Members can be individuals, corporations, or even other LLCs.
  2. What taxes does an LLC pay?
    By default, LLCs are pass-through entities, but they can elect corporate taxation. Owners report income on their personal returns, and self-employment taxes may apply.
  3. Do I need an operating agreement for my LLC?
    While not always required by law, an operating agreement is highly recommended. It clarifies roles, profit distribution, and dispute resolution.
  4. Can an LLC have employees?
    Yes, LLCs can hire employees. If they do, they must obtain an EIN, comply with payroll tax requirements, and follow labor laws.
  5. What happens if I don’t maintain LLC compliance?
    Failure to file required reports, pay fees, or maintain separate finances can lead to penalties, dissolution, or loss of liability protection.

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