Limited Liability Company
A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.
The “owners” of an LLC are referred to as “members.” Depending on the state, the members can consist of a single individual, two or more individuals, and corporations or other LLCs.
LLCs are not taxed as a separate business entity; all profits and losses are “passed through” the business to each member.
Forming an LLC
While each state has slight variations to forming an LLC, they all adhere to some principles:
Choose a Business Name. (1) it must be different from an existing LLC in your state, (2) it must indicate that it’s an LLC and (3) it must not include words restricted by your state. Your business name is registered with your state when you register your business, so you do not have to go through a separate process.
File the Articles of Organization. The “articles of organization” is a simple document that legitimizes your LLC. For most states, you file with the Secretary of State. Other states may require that you file with a different office such as the State Corporation Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations & Commercial Code.
Create an Operating Agreement. An operating agreement is highly recommended for multi-member LLCs because it structures your LLC’s finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, member’s rights and responsibilities and other provisions.
Obtain Licenses and Permits. Once your business is registered, you must obtain business licenses and permits. Use the Licensing & Permits tool to find a listing of federal, state and local permits, licenses and registrations you’ll need to run a business.
Hiring Employees. If you are hiring employees, read more about federal and state regulations for employers.
Announce Your Business. Some states require the extra step of publishing a statement in your local newspaper about your LLC formation.
LLC Taxes
An LLC is not a separate tax entity, so the business itself is not taxed. All federal income taxes are passed on to the LLC’s members and are paid through their personal income tax.
All LLCs must file as a corporation, partnership, or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law.
LLCs that are not automatically classified as a corporation can choose their business entity classification. To elect a classification, an LLC must file Form 8832. This form is also used if an LLC wishes to change its classification status.
You should file the following tax forms depending on your classification:
- Single Member LLC. A single-member LLC files Form 1040 Schedule C like a sole proprietor.
- Partners in an LLC. Partners in an LLC file a Form 1065 partnership tax return like owners in a traditional partnership.
- LLC filing as a Corporation. An LLC designated as a corporation files Form 1120, the corporation income tax return.
Combining the Benefits of an LLC with an S-Corp
There is always the possibility of requesting S-Corp status for your LLC. You’ll have to make a special election with the IRS to have the LLC taxed as an S-Corp using Form 2553. The LLC remains a limited liability company from a legal standpoint, but for tax purposes it can be treated as an S-Corp. Be sure to contact the state’s income tax agency where you plan to file your election form.
Advantages of an LLC
- Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt. Keep in mind that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts, including those of their employees.
- Less Recordkeeping. An LLC’s operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork and there are smaller start-up costs.
- Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity.
Disadvantages of an LLC
- Limited Life. In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.
- Self-Employment Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security.