What's an LLC?
Curious about LLCs? Here’s a guide that explains what this structure is, how you can form one and what the benefits and disadvantages are.
A limited liability company (LLC) is a hybrid 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 (one owner), or two or more individuals, corporations or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership.
Forming an LLC
While each state has slight variations in its requirements for forming an LLC, they all adhere to the same general principles:
Choose a Business Name. There are three general rules for your LLC’s name: 1. It must be different from an existing LLC in your state, 2. It must indicate that it is an LLC (such as LLC or Limited Liability Company), and 3. It must not include words restricted by your state (such as bank or insurance).
File Articles of Organization. This is a simple document that includes information such as your business name, address, registered agent and sometimes the names of the members. In Ohio you file with the Secretary of State, though in other states it may be the State Corporation Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations & Commercial Code. There is typically a filing fee that must accompany the articles of organization.
Create an Operating Agreement. Most states do not require operating agreements. However, 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, members’ rights and responsibilities, buy-out provisions and covers other important items.
Obtain Licenses and Permits. Once your business is registered, you must obtain other necessary business licenses and permits. Regulations vary by industry, state and locality.
In the eyes of the federal government, an LLC is not a separate tax entity so the business itself is not taxed. Instead, all federal income taxes are passed through to the LLC’s members and are paid as part of their personal income tax. Note that though the federal government does not tax income on an LLC, some states do.
LLCs must file a corporation, partnership or sole proprietorship tax return. Talk with your accounting professional to determine whether your LLC is automatically classified and taxed as a corporation by federal tax law, or which tax classification to choose that best meets your needs, as well as which tax forms to file. For additional guidance visit IRS.gov.
There is an additional option 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, and must file prior to the first two months and 15 days of the beginning of the tax year in which the election is to take effect. 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 to determine how it handles an S-Corp election as well. Your accountant can best guide you in making these decisions and filing the proper paperwork.
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. This is similar to the liability protections afforded to shareholders of a corporation. 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 lower 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 also contribute different proportions of capital and sweat equity. Consequently, it’s up to the members themselves to decide who has earned what percentage of the profits or losses.
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 toward Medicare and Social Security. The entire net income of the LLC is subject to this tax.
New Tax Considerations
Effective January 1, 2018, the tax audit rules affecting LLCs have changed. If you have an existing LLC, it is important to update your operating agreement to accommodate these critical changes.
Stacy is a founding member of BauerGriffith, a business law firm providing high quality legal and business counsel to a wide array of clients, with an emphasis on non-profit organizations, small business and individual planning clients. She serves as outsourced corporate counsel for diverse clients, partnering with executive management to design, plan and implement stated and defined business objectives within legal parameters.