A limited liability company (LLC) is a business structure that offers its owners protection of their personal assets. The owners’ private wealth (like their homes, cars, and investment accounts) won’t be at risk if the company goes bankrupt or is sued.
It’s helpful to think about limited liability companies as having qualities of both corporations and partnerships. LLCs are a great option for small businesses that want to safeguard personal assets by forming a legal entity, but don’t want to pay corporate taxes. LLCs also have minimal requirements as to how they’re governed and maintained.
An LLC is owned by members and is formed by filing articles of organization with the state. Articles of organization are a fairly straightforward document that assigns the members, physical location, and registered agent of an LLC.
A Professional Limited Liability Company (PLLC) is a type of LLC that is available to licensed professionals providing a service in the same state.
LLCs are often confused with Limited Liability Partnerships (LLPs), a type of partnership, and Professional Limited Liability Companies (PLLCs). These alternative business structures are popular among licensed professionals like lawyers and architects who can’t form LLCs in certain states, but want to limit their personal liability.
The structure of an LLC is very flexible — it’s up to the members to decide how voting, ownership, management (LLC member vs manager-managed) and meetings will function, and to describe these terms in an LLC operating agreement. Though not required by most states, an operating agreement is an important measure in ensuring the success of an LLC.
Let’s take a closer look at how LLCs differ from corporate and partnership business structures.
LLC vs Corporation
Unlike an LLC, a corporation is owned by shareholders instead of members, and has more obligations, such as holding annual shareholder meetings and maintaining detailed financial records.
Corporations and LLCs both offer limited liability, but the main distinction is that corporations are considered a separate entity by the IRS. The taxation process for LLCs is simpler and benefits smaller businesses, because LLC members report business activity on their personal taxes, and can deduct operational costs and losses. The corporate structure is usually better suited to businesses with higher incomes.
LLC vs Partnership
A partnership is formed when two or more individuals decide to conduct business without establishing a legal entity. The major disadvantage of a partnership is that, unlike under an LLC, personal assets are not protected by this business structure, and may be used to settle company debts in cases of bankruptcy or legal disputes.
While there is less paperwork involved in establishing a partnership, you should weigh the personal risk before deciding to operate without a separate legal entity.
In contrast to a partnership, one individual operating a business is considered a sole proprietorship. Solo entrepreneurs often have to make the call between a single-member LLC or sole proprietorship.
LLC Advantages and Disadvantages
Creating an LLC is a great option for many business owners, but there’s no one-size-fits-all in the business world. Here are a few pros and cons of LLCs to consider:
- Limited Liability — This is the defining advantage of an LLC, because the business is legally separate from its members. This means members don’t have to worry about their personal assets being at risk when it comes to business debts or lawsuits.
- LLC Tax Advantages — LLCs are suitable for many types of businesses because of the flexible tax structure. By default, LLCs are taxed the same way as a partnership or a sole proprietorship: as a pass-through entity (if a multi-member LLC) or disregarded entity (if a single-member LLC). LLCs may also choose the corporate tax designation. Understanding the ways LLCs are taxed will help you make the most advantageous decision for your business.
- Minimal Obligations — LLC members are not required to have a board of directors, hold annual meetings, or conduct extensive record keeping like corporations. In many states, LLCs also don’t have to file annual reports.
- Self-Employment Taxes — Members of LLCs that are viewed as a pass-through entity or disregarded entity in the eyes of the IRS may be liable for self-employment tax. The corporate tax structure may be suitable for a higher-income LLC, but generally, smaller businesses can still profit more from avoiding corporate taxation despite self-employment tax liability.
- State-by-State Requirements — Because LLCs are organized at the state level, it requires a fair amount of research to make sure you understand the specific filing fees, requirements, and limitations of your state (and in some cases, your city or county). For example, in California, attorneys, accountants, and veterinarians are among the professions that cannot form an LLC.
How to Start an LLC
If you’re ready to create an LLC, there are a few steps to consider, but rest assured that the process involves minimal bureaucracy in comparison to other business entities.
- Know your state-specific, as well as county- or city-level requirements (only applicable to certain localities).
- Apply for an employer identification number (EIN) and relevant business licenses.
- Select a registered agent to receive official mail on behalf of your business.
- Set up an LLC bank account to ensure a clear distinction between company and personal funds.
- Submit your articles of organization to the Secretary of State’s office, and pay a filing fee.
- Create an LLC operating agreement to designate how your LLC will function.
Now that you understand what LLC means, the benefits of limited liability, and how LLCs work, take the next step to forming your own LLC by drafting an LLC operating agreement.