What Is An LLC (Limited Liability Company): Pros and Cons
LLC stands for limited liability and it is a type of business structure allowed by the state statute. In most states, LLC ownership is not restricted and can be single-owned or co-owned by individuals called members, corporations, other LLCs, foreigners, or foreign entities. However, some entities like banks and insurance companies cannot own an LLC.
Limited liability companies were introduced to make a partnership or sole proprietorship arrangements more formal, make business formation simple, provide more tax flexibility and liability protection. As such, it is a hybrid structure combining the characteristics of a corporation with that of a sole proprietorship and partnership.
This article will walk you through everything you may want to learn about limited liability companies including:
- LLC meaning
- The benefits
- How it compares to other business structures
- Types of LLCs
- Who should form an LLC
- How to start an LLC
- Disadvantages of LLCs
- Frequently asked questions about LLCs
What Is an LLC?
In simple terms, a limited liability company (LLC) is a type of business structure that can be formed to own and operate a business as a separate entity from the company owners. For that reason, an LLC can own assets and bank accounts; can sign loans and other contracts, and be sued in a court of law such that in the event of the company debts or other liabilities the company stands for itself.
With that said, your personal assets such as bank accounts and car or home cannot be used as collateral to cover company debts and other liabilities. However, there are several other benefits besides personal asset protection that limited liability companies come with. Let’s jump right in.
What Are the Benefits of an LLC?
LLCs are popular among new businesses or small business owners due to the following reasons:
Personal Liability protection
A limited liability company is a separate legal structure that can own assets, bank accounts, sign contracts, and can sign a lawsuit or be sued. That means that it is liable for its own debts and other liabilities. The company owner’s personal assets cannot be used to cover business debts, lawsuits, or claims.
An LLC also offers personal liability protection from wrongdoings committed by co-owners during the course of the business. Your personal assets cannot be touched to compensate for your partner’s wrongdoings.
Tax Advantages of LLCs
LLCs don’t have their own federal tax classification but can adopt the tax status of corporations, sole proprietorships, and partnerships.
Normally, the IRS classifies single-member LLCs as sole proprietorships and multi-member LLCs as partnerships for tax purposes. This means that LLCs are subject to pass-through taxation where the LLC profits and losses are passed through to every member. The company owners then pay taxes on their personal tax returns.
However, the company owners may choose to be taxed as a corporation in order to avoid self-employment taxation.
Flexible Income Distribution
Unlike corporations where shareholders’ incomes and shares are proportionally related, LLCs require that the members get to decide how to split up income. That is to say, it is not a must that the profits have to be distributed equally or according to ownership percentage. However, you must still follow the Internal Revenue Service (IRS) partnership income distribution rules .
You don’t have to create a board of directors during LLC formation and there is no extensive record-keeping once it is formed. Besides, there are no annual members meetings and in most states, you don’t have to create annual reports. For that reason, LLC is always the best option for new business owners who want to form a business without a lot of formalities.
The members can decide to have voting rights equal to their own interest or can choose to have equal rights without regard to the percentage of the LLC they own.
Besides, LLC doesn’t limit the number of people required to own the company. It can be owned by one or more members. Besides, anyone, including foreigners, and other business entities can own an LLC.
Limited liability company owners are at liberty to decide how they want their company to be run. The company can be managed in one of the following ways: manager-managed or member-managed. Member-managed LLC is where each member participates in the day-to-day running of the LLC, usually referred to as “managing members”. Manager-managed on the other hand is where the company designates a manager or managers who may or may not be members of the company, to run the business.
How Does an LLC Compare to other Business Structures?
LLC is owned by members who have an equity interest in the assets of the business. On the other hand, corporate owners, referred to as shareholders have shares of stocks in the business.
Besides, LLCs don’t have ownership restrictions like S-corporation. The company can be owned by anyone including, foreigners, and other business entities, and doesn’t limit the number of members required. Other entities such as S-corps limit their ownership to not more than 100 US residents only.
LLCs create an LLC operating agreement to help in the day-to-day running of the business. The LLC operating agreement set forth the details about the business including the initial contribution of each member, the percentage and profit to be distributed to each member, and the voting rights of each member.
Business entities like corporations will require that you create a board of directors to oversee the day-to-day running of the business. The board of directors is required to hold annual meetings to discuss the company matters and therefore involve a lot of record-keeping. LLC operating agreement doesn’t require annuals meetings like a corporation and this makes LLCs easy to operate.
A sole proprietor is the boss of his company. A general partnership is managed by partners who assume the responsibility of the company. Corporations are managed by a board of directors who approve major business decisions.
However, limited liability company owners are at liberty to choose how the company is managed. Members can choose to have it member-managed where management is delegated to members or a group of members to serve as “managing members”. Alternatively, they can have a third-party non-member or a member to manage the business.
Taxation and Fees
LLCs have a flexible tax election  that you will not find in any other business entity. Normally, the IRS subjects an LLC to pass-through taxation unless it fills form 8832 and elects to be taxed as a corporation. As a pass-through entity, profits and losses are passed through to each member who then reports to their personal tax return. That means the company owners will pay tax once as opposed to C-Corporation which is subjected to double taxation.
However, LLC owners can elect to be taxed as a corporation to avoid self-employment taxation of an LLC. Even better, they can elect to be taxed as an S-Corporation to avoid both self-employment taxation of LLCs and double taxation of C-Corporations at the same time.
Types of LLCs
You can come up with several types of LLCs depending on what your classification is based on. However, the main types of LLCs include:
A domestic LLC is a type of limited liability company that operates in the state where it was created. In other words, if you register an LLC in a state and this is the state where you are doing business, you are registering a domestic LLC.
If your initially registered LLC is transacting business in another state, you will have to register it in each state where it transacts business. That way, you are registering a foreign LLC. For instance, if your business that was initially registered in Texas with a Texas address wants to do business in Nevada, you must register it as a foreign business (LLC) in Nevada.
A professional LLC is a type of business entity designed for licensed professionals such as architects, engineers, lawyers, accountants, chiropractors, etc. In most states, licensed professionals who want to form an LLC will have to form a PLLC instead. Some states require that at least a member be a licensed professional, others may require at least 50% of members while some may want every member to be a licensed professional.
A series LLC is a type of LLC that is set up to hold up several interests under one LLC. In simple terms, a series LLC consists of a “parent” LLC with one or more series that are established under the “parent”. Each series has unique characteristics from the “parent” itself and any other series. Each series can have its own assets, managers, purposes, members, and investment objectives.
A restricted LLC is designed with an aim of transferring assets within the family and it is not created for doing business. However, it cannot make any distribution for 10 years after its formation.
A single-member LLC is owned by one person who has full control over the company. The company owner can decide to manage the LLC or have it manager-managed by a third party.
Multi-Member LLC is owned by two or more business owners that share the control of the company. Just like single-member LLC, it can have the company members-managed or third party manager-managed.
Who Should Form an LLC?
A person starting a business or a business owner currently operating as a sole proprietor and is concerned with asset protection as much as possible. Business owners who want an LLC to protect themselves from the liability of co-workers should also form an LLC.
Disadvantages of an LLC
Self Employment Tax
IRS considers limited liability company members self-employed unless they choose to be taxed as a corporation. This means that the members are subject to social security and medicare taxes, collectively known as self-employment tax. This may make LLC owners pay more taxes than corporations.
Fewer Fringe Benefits
The company members who receive fringe benefits such as medical insurance, medical reimbursement plans, group insurance, and parking must treat them as taxable income.
How To Start An LLC?
Starting an LLC may differ depending on the state of formation. But in general, these are the most common steps in most states:
- Choose your LLC name based on your state of formation requirements.
- Choose a registered agent
- Create an operating agreement
- File the LLC with the secretary of state office
- Obtain an EIN from IRS
However, depending on the type of business, it may take some additional steps like obtaining a permit or a license.
A limited liability company is a hybrid structure that combines the characteristics of the corporation with those of sole proprietorships and partnerships. For that reason, it comes with a long list of benefits, with the most common one being personal asset protection.
Apart from protecting your personal assets, LLC is the most flexible type of business entity in terms of management structure, distribution of profits/losses, dealing with new and departing workers, and tax election. For a new business or small business owner planning to form a business, an LLC is very straightforward to operate.
Frequently Asked Questions
An LLC member is the owner of the limited liability company holding a membership interest in the company. An LLC member does not own LLC property and may not manage the business and its affairs.
If you are on a tight budget that you can’t afford a formation service, you can form an LLC by yourself. This may leave you with only state filing fees to worry about as opposed to hiring an attorney or online legal service that will charge you service fees.
One owner LLC pays himself by making an owner’s draw. you simply transfer the money from your LLC account to your personal bank account or write yourself a check. Multiple members LLC pay themselves by taking a distribution of the profits.
Some states have unique LLC laws. Even the common laws regarding liability, privacy, and taxes vary from state to state. However, there are standard rules that apply to all states.
It is advisable to form an LLC in the state where you are located, or where your business will have a physical presence. Though some states may offer cheaper filing fees and friendly taxation, you may register as a foreign LLC in those states.
An LLC is not a separate tax entity like a corporation. The LLC income is distributed among the LLC owners as personal income. Each member then reports to their individual income tax return.
Both an LLC and a corporation offer personal asset protection. LLCs are favored by owner-managed or small businesses that want flexibility without a lot of formalities. For business owners who are seeking outside investment, a corporation is the right choice.
LLCs are rapidly becoming preferred for investing in and holding real estate courtesy of their personal liability protection and their favorable tax treatment.