Key Takeaways

  • A limited liability company (LLC) is a legal business structure that blends features of corporations and partnerships.
  • LLCs provide limited personal liability for business debts, meaning members' personal assets are generally protected.
  • They offer flexible tax treatment options, including default pass-through taxation or electing to be taxed as a corporation.
  • LLCs are easier to form and maintain than corporations but still provide more credibility and legal protection than sole proprietorships or partnerships.
  • Despite their benefits, LLCs have some drawbacks, such as self-employment tax obligations and complexities in ownership transfer.

What does an LLC do? Find out whether forming an LLC would be beneficial for your business.

What Is an LLC?

An LLC is a limited liability company in which the owners can't be held personally liable for the company's debts or liabilities. It's a distinct business entity separate from its members.

An LLC gets its own tax identification number and bank account. It carries out its transactions under its own business name.

Owners of an LLC are not liable for any business debts and liabilities, even in extreme circumstances like bankruptcy. If the business funds and assets are insufficient to repay the company's debts or liabilities, the creditors can't hold the owners personally liable for payment. This is one of the major advantages of forming an LLC.

How an LLC Works

A limited liability company (LLC) is more than just a legal classification — it’s a flexible business structure that determines how your company operates, pays taxes, and protects its owners. When you form an LLC, the business becomes a separate legal entity from its owners (called members). This means the company can enter contracts, own property, and be sued independently of its members.

Here’s how an LLC functions in practice:

  • Legal Separation: Because the LLC is legally distinct, members’ personal assets — such as homes, vehicles, or savings — are generally shielded from business debts and lawsuits.
  • Management Flexibility: Members can choose to manage the company themselves (member-managed) or appoint one or more managers (manager-managed). This makes LLCs adaptable for both small family businesses and larger ventures.
  • Ownership Structure: LLCs can have a single owner (single-member LLC) or multiple owners (multi-member LLC), and members can be individuals, corporations, or even other LLCs.
  • Tax Options: By default, profits and losses pass through to members’ personal tax returns, avoiding corporate double taxation. However, LLCs can also elect to be taxed as an S corporation or C corporation if that offers financial advantages.

Because of these features, LLCs are often described as offering the “best of both worlds” — they combine the simplicity and tax flexibility of partnerships with the liability protection of corporations.

LLCs Versus Corporations

  • A corporation is a more formal structure, which is subject to rigid rules and procedures. An LLC, on the other hand, offers a more flexible and lenient setup.
  • An LLC is not taxed as a separate entity; its income or loss goes into the personal tax return of members, unless it chooses to be taxed as a corporation.
  • Unlike in the case of a corporation, an LLC does not have a board of directors. The members either manage the LLC themselves or appoint a manager to oversee its operations.

Many small scale businesses in America opt for LLC due to less complexity, government protection, and ease of formation. Just like a corporation, an LLC can also have any number of employees.

LLCs vs. Other Business Structures

While corporations are the most direct comparison, understanding how LLCs differ from other business entities can help you decide whether this structure is right for your situation:

  • LLC vs. Sole Proprietorship: Sole proprietors and their businesses are legally the same entity, leaving owners fully liable for business debts. LLCs provide a liability shield while preserving simple tax reporting.
  • LLC vs. Partnership: Partnerships offer shared ownership and pass-through taxation but do not automatically provide liability protection. LLCs offer both.
  • LLC vs. Corporation: Corporations offer stronger growth potential through issuing stock and attracting investors, but they require more formalities and often face double taxation. LLCs have fewer compliance requirements and more flexible management but may be less attractive to venture capitalists.

Why Form an LLC?

  • It's fairly simple and straightforward to form with minimal paperwork. The annual filing fee of around $200 is quite affordable, too.
  • The suffix of LLC or limited Liability company changes the perception of the investors, clients, and general public.
  • Personal assets like a home, cars, and bank accounts of members remain safe from business liabilities.
  • You can have significant savings in taxes since the income or loss from the LLC can be clubbed with your personal income.
  • Unlike in the case of corporations, it saves you from double taxation of income.

When an LLC Is the Right Choice

Choosing the right business structure depends on your goals, risk level, and growth plans. An LLC is often ideal if you want:

  • Asset Protection Without Complexity: You want to shield personal assets without the paperwork and formality of a corporation.
  • Flexible Taxation: You want the option to report income on your personal tax return or elect corporate taxation for potential savings.
  • Shared Ownership: You plan to operate with partners or investors while maintaining a simple management structure.
  • Professional Credibility: Adding “LLC” to your business name can boost trust among customers, vendors, and lenders.
  • Scalability: You intend to grow the business while retaining operational flexibility.

However, if you plan to seek venture capital, issue public shares, or eventually become a large enterprise, a corporation may be more appropriate.

Things to Consider Before You Set Up an LLC

  • While the existence of a corporation is not affected by entry and exit of shareholders, an LLC can be very susceptible to such developments. Even if a single member leaves the LLC, it can terminate its existence.
  • Forming an LLC in your home state (where you wish to conduct the business) may cost you less since you'll not have to pay franchise taxes. It will also save you from the burden of filing annual reports in several states.
  • Forming a single-member LLC may not be of much benefit unless your business involves a significant amount of risk.

The Advantages of an LLC

  • Protection of personal assets: Unlike in the cases of sole proprietorships and partnership firms, the personal assets of LLC owners are not vulnerable to business debts.
  • Flexibility in tax filing: By default, a single-member LLC is taxed like a sole proprietorship business, while a multi-member LLC is taxed like a general partnership. However, an LLC can elect to file its tax returns as a corporation.
  • Credibility and perception: Forming an LLC builds your credibility since it shows that the owners are committed to the business.
  • Minimal formalities: Legal documentation required in forming an LLC is less than that in the case of a corporation. The organizational structure is simpler since it does not have a board of directors.

Additional Benefits of Forming an LLC

Beyond the commonly cited benefits like liability protection and tax flexibility, LLCs offer several other strategic advantages:

  • Pass-Through Deductions: Under the IRS’s Qualified Business Income (QBI) deduction, many LLC owners can deduct up to 20% of their business income on their personal tax returns.
  • Fewer Formal Requirements: LLCs typically don’t need annual shareholder meetings, complex recordkeeping, or detailed bylaws.
  • Customizable Operating Agreements: Members can define voting rights, profit distributions, and succession plans to fit their business’s needs.
  • Ability to Attract Investors: While not as straightforward as corporations, LLCs can still bring in new members or convert into a corporation later if growth demands it.

The Disadvantages of LLC

  • Formation expenses: Formation expenses of LLCs are usually higher than in the case of sole proprietorships and general partnerships.
  • Transfer of ownership: Unlike corporations where you can easily transfer your ownership by selling your shares, it's difficult to transfer your ownership in an LLC.
  • Less evolved structure: Since an LLC is a relatively new form of business, the laws governing it are not very evolved. This may sometimes lead to confusion in interpretation and application of legal provisions.
  • Self-employment taxes: Owners of an LLC are subject to self-employment taxes. Sometimes, the amount of these taxes may be higher than the income tax savings you make.
  • Lacks clarity in roles: Without specific roles of members, it often becomes difficult for creditors and investors to know the person authorized to sign a contract or document. However, such confusion can be avoided through an operating agreement.

Common Misconceptions About LLCs

Despite their popularity, several misconceptions about LLCs can mislead business owners:

  • “I Don’t Need an Operating Agreement.” While not always required by law, having a written operating agreement can prevent disputes and clarify roles.
  • “I’m Fully Protected From Lawsuits.” Limited liability doesn’t shield you from personal wrongdoing, fraud, or personally guaranteed debts.
  • “LLCs Are Always Cheaper.” In some states, ongoing fees, annual reports, and self-employment taxes can make LLCs more expensive than other structures.

Being aware of these nuances helps you make informed decisions and avoid costly legal or financial surprises.

Frequently Asked Questions

  1. What is an LLC and how does it differ from a corporation?
    An LLC is a legal business structure that provides liability protection and tax flexibility while requiring fewer formalities than a corporation.
  2. Do LLC owners pay corporate taxes?
    By default, LLCs are pass-through entities, meaning profits are taxed on the owners’ personal tax returns. However, they can elect to be taxed as corporations.
  3. Can a single person start an LLC?
    Yes. A single-member LLC is owned and managed by one individual and offers the same liability protection as multi-member LLCs.
  4. Does forming an LLC protect personal assets?
    Generally, yes. Members’ personal assets are shielded from business debts and lawsuits, provided they maintain proper business formalities.
  5. Can an LLC convert into a corporation later?
    Yes. Many businesses start as LLCs for flexibility and later convert into corporations as they grow or seek outside investment.

If you need help with the question what is an llc, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.