Why Form a Limited Company: Everything You Need to Know
Most small businesses form an LLC (Limited liability company) for the benefits of pass-through taxation and to limit the owners' liability.3 min read
Why form a limited company or an LLC for your business? Most small businesses that form an LLC do so for the benefits of pass-through taxation and to limit the owners' liability.
What Is an LLC?
Limited liability companies (LLCs) are gaining rapid popularity among small businesses, mainly due to the simplicity and flexibility they offer compared to traditional corporations. LLCs combine the advantage of pass-through taxation (like a sole ownership or a partnership firm) and limited liability (like a corporation). Thus, when you create an LLC, you give your business a separate legal identity of its own. It gets its own name, debts, and liabilities.
You are not personally liable for repaying your LLC's business debts. The company must repay its debts from its own assets and funds. In the event of its failure to do so, creditors cannot pursue your personal assets and properties. However, you still remain responsible for paying your LLC's taxes.
The owners of an LLC are called its members. An LLC can have one or more members. Members must include the profits and losses of the company in their personal tax returns.
Overall, an LLC is less complex than a corporation.
LLC Business Structure
LLCs have a less formal structure and management than corporations do. In terms of structure, a multi-member LLC is almost like a partnership business and a single-member LLC is like a sole proprietorship, except for the limited liability protection that an LLC offers.
An LLC is typically managed by its members, also called its owners, who look after all of the company's aspects. Unlike in corporations, an LLC does not have separate positions like officers, directors, and shareholders. However, nothing prevents the LLC members from dividing responsibilities among themselves and having titles that they consider appropriate.
An LLC does not issue stock to its members. Instead, its ownership is expressed in terms of percentage holding. For example, A and B each may own 50 percent ownership in XYZ LLC. An LLC can even have another business entity as a member.
Why Form an LLC?
Forming an LLC offers a number of advantages that are not normally available to sole ownership and general partnership businesses.
- Limited liability of owners: LLC owners are not personally liable for debts and liabilities of the company. Creditors cannot pursue the owners' personal assets.
- Pass-through taxation: Unlike typical corporations, an LLC does not have to pay taxes at the company level. The business profits and losses pass through the personal tax returns of owners who pay taxes at the individual level. Thus, no double taxation takes place. The IRS does not classify LLCs as a separate entity for tax purposes. Typically, a single-member LLC is treated like a sole ownership and a multi-member LLC like a partnership business. However, if the members of an LLC desire, they can file the company's tax returns like a corporation.
- Flexibility in profit allocation: LLC members enjoy complete flexibility in allocating business profits and losses among themselves. Members can choose to allocate the profits and losses of the company in different proportions than their ownership percentage.
- Fewer restrictions on ownership: Unlike an S-corporation, which cannot have more than 100 owners, an LLC can have any number of members. Depending on the state of formation, an LLC usually has no or very few restrictions on its ownership structure.
- Flexibility in management: An LLC offers complete freedom to its members in determining the structure of its management.
- Multiple classes of membership: Unlike S-corporations, which can have only one class of ownership, an LLC can have different classes of membership.
- Fewer formalities: Operating an LLC requires fewer compliance and formalities. Unlike in case of corporations, there is no board of directors and no meeting requirements. The number of annual filings is also less.
- Higher credibility: Setting up an LLC increases the credibility of your business in the eyes of your customers and creditors. An LLC is considered more legitimate than sole proprietorship and partnership businesses.
- No insecurity in ownership: In traditional corporations, ownership can be increased simply by buying shares of the company. However, in an LLC, adding new members and increasing the ownership stake requires the written consent of existing members. This removes the insecurity of ownership dilution.
- No restriction on residency: LLC members need not be citizens or permanent residents of the United States.
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