What Is a Limited Liability Company (LLC)?

A limited liability company is a pass-through organization

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A limited liability company (LLC) is a legal business entity owned by its members. Many small business owners choose this type of structure because it's simpler to form and operate than a corporation, and offers more protection from liability than a sole proprietorship. This article will explain how an LLC works and the steps involved in creating one. It will also outline the advantages and drawbacks of an LLC compared with other types of business organizations.

What Is a Limited Liability Company?

An LLC is a type of business in which the owners are called members. The business entity is separate from the members so only the entity may be held liable if the company is sued or fails to pay its debts. An LLC contains elements of a sole proprietorship, a partnership, and a corporation.

State laws determine the types of organizations that can create LLCs. Generally, most types of businesses can form an LLC, other than banks and insurance companies. Some states limit the types of services LLCs can offer. California, for example, prohibits LLCs that provide professional services like accounting and law firms, pharmacies, and doctors’ offices. State laws also determine who may be a member of an LLC, and the number of members the entity may have. In most states, members may include individuals, corporations, other LLCs, and foreign entities. Many states permit LLCs that have only one member.

How Does a Limited Liability Company Work?

All LLCs should have an operating agreement, which is essentially the rules and regulations for how the company will work. The agreement should describe who will manage the firm, how membership changes will be handled, and how profits and losses will be distributed. To protect members from liability, the operating agreement should state that the entity is separate from the members.

An LLC may be managed by its members or an outside management company. Many LLCs, however, are managed by their members because they are small businesses with limited resources.

Ownership changes will occur if existing members die or leave the firm or new members are added. The operating agreement should address these potential changes. For instance, it might outline a procedure for valuing and then selling a departing member's share. If the LLC has only one member, the agreement should state how the firm will be dissolved if the owner dies. If membership changes occur at an LLC that has multiple members but no operating agreement, state laws might require the firm to dissolve and re-form.

 Besides management and membership changes, the operating agreement should address profits, losses, and taxes. Most LLCs are pass-through organizations. This means the company's profits and losses are passed through to the members, who report them on their personal tax returns. The Internal Revenue Service (IRS) will normally tax a single-member LLC as a sole proprietorship. If an LLC has two or more members, the IRS will tax it as a partnership. The members of any LLC (including single-member entities) can choose to have their firm taxed as a corporation by filing Form 8832, titled Entity Classification Election, with the IRS.

Even a single-member LLC needs an operating agreement to protect the owner from liability for lawsuits against the business entity.

How to Form a Limited Liability Company

The first step in creating an LLC is to choose a name for your firm that meets your state's requirements. Some states require the words "LLC," "Limited Liability Company," or a variation thereof in the company name. Next, you'll need to select a registered agent who resides in your state. Your registered agent will be responsible for receiving official documents (like lawsuits and subpoenas) on your firm's behalf and forwarding them to your firm's management. The agent may be a member or manager of your LLC or someone outside the firm.

 The next step is to draft your company's operating agreement. You can hire an attorney to write your agreement or draft one yourself using a template you've obtained online. Once your agreement is completed, you can create your articles of organization by filling out a form provided by your state's Office of the Secretary of State. Here are some of the details you'll be asked to provide:

  • Your firm's name and address
  • Your firm's business purpose
  • Your registered agent's name and address
  • Names of the individuals or company that will manage your firm

Once you've completed your articles of organization, you'll need to sign the form, submit it, and pay the required fees.

If you've written your operating agreement yourself, have an attorney review the completed document. This is important even if you've drafted the agreement using a template you've obtained from an online legal company like LegalZoom or UpCounsel.

Pros and Cons of a Limited Liability Company

Pros
  • Flexibility

  • Protection from liability 

  • Pass-through entity

Cons
  • Owners must pay self-employment tax

  • Entity may be subject to other taxes or fees

  • Banking restrictions and fees

Pros of a Limited Liability Company Explained

Flexibility

A key advantage of an LLC is its flexibility. Members can decide how they want the firm to be managed and taxed. 

Protection From Liability 

Except in cases such as fraud, LLC members are generally protected from liability arising from lawsuits against the firm or debts the company assumes. If the LLC is the subject of a third-party suit or a claim for an unpaid debt, the members' assets cannot be used to pay damages or the debt.

Pass-Through Entity

In an LLC, profits and losses are passed through to members, who include them on their personal income taxes. LLC members may be eligible for a 20% pass-through deduction under the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA allows non-corporate taxpayers to deduct up to 20% of their qualified business income (QBI). QBI means income earned from a U.S. trade or business, and excludes capital gains and losses, certain dividends, and interest income. In 2020, the deduction was allowed only for individuals whose income didn't exceed $163,300 for single filers or $326,600 for those who are married and filing jointly.

Cons of a Limited Liability Company Explained

Self-Employment Tax

Members must pay their own self-employment tax (for Social Security and Medicare), which has a rate of 15.3%. Members may deduct half of this amount as a business expense. 

Other Taxes and Fees 

A second disadvantage is that an LLC may be subject to an annual state tax, an annual fee, or both. In New Hampshire, for instance, LLCs are included in the definition of “business organizations” and are therefore subject to the state’s business enterprise tax (BET) and business profits tax (BPT) if gross business receipts exceed $150,000 or the enterprise value tax base was greater than $75,000, respectively. Meanwhile, in California, an LLC must pay $800 to the state whether or not it's conducting any business. If the firm's annual income exceeds $250,000, it must also pay an annual fee that ranges from $900 to $11,790. 

Banking Restrictions and Fees 

When it comes to banking, any check made out to an LLC cannot be cashed, but instead deposited into a separate corporate account. Some banks also have higher fees just for businesses that are incorporated.

Key Takeaways

  • An LLC is a type of business entity that's owned by its members. The entity is separate from the members.
  • An LLC is a pass-through organization, meaning profits, losses, and taxes pass through to the owners.
  • All LLCs should have an operating agreement that explains how the company will be run.