What You Need to Know about Limited Liability Companies (LLCs)

Smart entrepreneurs know that when they start a business, they should form a business entity to protect their personal assets. The business model, industry, and goals of the founders will play a role in the choice of business entity.

Corporations are a widely used business entity. So much so that the word “corporation” is often used synonymously with business entity. But corporations are just not the right choice for many entrepreneurs. Corporations are expensive to form and maintain, and they are highly regulated.

Fortunately, there is another choice: a Limited Liability Company. LLCs offer greater structural flexibility with the same liability protection as corporations but cost less to maintain. Below, we will concentrate on some fundamental features of LLCs so that you can make a smart and informed decision about whether an LLC is the right choice for your business. You’ll learn the following:

• What an LLC is and who would want one,
• Who can own or run an LLC,
• What forms and filings are needs to create an LLC,
• How LLCs are taxed,
• What the pros and cons are of choosing an LLC.

What Exactly Is a Limited Liability Company?

The most basic answer is that a limited liability company (LLC) is a type of business entity that is a cross between a partnership and a corporation. Like a corporation, an LLC is separate and distinct from its owners. It provides the liability protection of a corporation, but it also allows for a closer business relationship between the founders such as would normally exist in a general partnership.

Members and Managers

The owners of LLCs are known as “members,” and unlike corporate “shareholders” they are allowed to run the company as well. LLC members typically have the right to manage the business of the LLC, receive a share of LLC profits through their capital account, and receive any assets left over after the LLC business has been dissolved.

The members can also opt to have the LLC business managed by “managers” who are elected by the members. The managers manage the day-to-day business of the LLC. Often, managers are given titles that are similar to the officers of a corporation (e.g. President, COO, etc.). But again, this is not mandatory.

LLCs aren’t subject to the restrictions on membership that corporations are. They don’t have to elect a board of directors, hold board meetings, or keep any records of company meetings. For this reason, they require much lower maintenance. 

There is no limit to the number of potential members of an LLC (unless opting for S corporation taxation status, for which see below). It’s even possible to have a single member LLC without the loss of liability protection. For this reason and the tax issues discussed below, most, if not all, sole proprietors should form an LLC for their businesses.

Who Would Want an LLC?

An LLC is often appropriate for closely held businesses or where the entity will hold real estate. An LLC can also be used for subsidiary companies within a larger business for the sake of intellectual property protection or the like.

An LLC is usually not used when there are to be outside investors, key employees are to receive options to buy into the business, or the owners plan to take the company public.

Unlike a corporation, the ownership interests of an LLC are usually not freely transferable. A member may transfer his or her economic interest (e.g. the right to receive profits) at will, but members usually have to get unanimous permission of the other members before a transferee can participate in the management of the LLC business.

And all of the other members have to agree if a member wants to withdraw from the LLC. This often comes as a shock to members who want to “walk away” from a business.

Additionally, in many states, an LLC’s life is limited. If a new owner wants to join, an original owner wants to leave, or even if an original owner dies, the state may require the LLC to be dissolved and reformed with the new members. This can be forestalled with a properly written operating agreement in some cases.

Formation of an LLC

Before you actually file any paperwork, you must choose a name for your LLC. This comes with certain requirements, and it’s best to take the time to consider them up front. All formation paperwork (and future business-related paperwork) must use the precise company name or you might risk losing your asset protection.

For example, here is Florida, the Department of State requires an LLC name to be “distinguishable in the records.” What does that mean? It means that the name of your LLC has to be unique from the name of every other existing business in the Department of State’s database. There are additional state requirements, however, and you should take the time to familiarize yourself with them.

The actual formation of an LLC begins with the filing of Articles of Organization with the secretary of state by an incorporator. You can file these in person, by mail, or online. The Articles of Organization must be signed by a member or the member’s authorized representative. All LLCs must also have a registered agent on file to receive official documents from the state.

The cost to file the Articles of Organization (including an identification of the registered agent) ranges from $50–$500 depending on the state. In Florida, the LLC filing fee for the Articles of Organization and statement identifying the registered agent is $125.00.

Once the articles are filed, the LLC is formed. But you aren’t done. You still need to go through a few more steps to make sure that your business entity is solidly founded and can protect yourself and your business interests.

You’ll need to apply for a Federal Tax ID Number (EIN) with the IRS, obtain any and all business licenses or permits required to operate in the state and county, open a business bank account, and—most importantly—draft a comprehensive operating agreement.

Key LLC Formation Documents

The Articles of Organization are a standard document with basic information on the company. They are a necessity to form an LLC, and they are the same for everyone.

However, each business relationship is unique, and the LLC members will need to determine among themselves their relationships to the company and to each other. For this there is no such thing as a standard document.

The members of an LLC should enter into a comprehensive and professionally drafted operating agreement. As the bylaws do for a corporation, the operating agreement should address key elements of the management and operation of an LLC such as allocation of profits, transfers of membership interests, and dispute resolution. A properly written and implemented operating agreement is a means to address membership disputes, avoid business disruptions, and maintain the profitability of the business.

Other documents should be written at this time as well to address the various other contractual relationships your business will be involved in during the normal course of business. Consult with your business attorney to decide whether your LLC will need such agreements. Examples of some common agreements are employment agreements, independent contractor agreements, license agreements, and terms of services.

How Are LLC’s Taxed?

With the drafting of the operating agreement, the founding members must also consider the tax status they will elect for the LLC. Depending on the number of members, an LLC can opt to be taxed as one of four types of businesses:

• Sole Proprietorship (i.e. disregarded tax entity),
• Partnership,
• S corporation,
• C corporation.

This flexible tax structure is one of the most appealing aspects of the LLC as it allows owners to optimize their business entity to suit their particular needs and circumstances.

Disregarded Tax Entity

A single-member LLC will by default be taxed as a sole proprietorship. You don’t need to file anything with the IRS, but to be taxed as a disregarded tax entity (i.e. sole proprietorship), it must be a single-member LLC.

For the IRS’ purposes, a sole proprietorship is a disregarded tax entity. This means that no distinction is made between the tax status of the business entity and the owner. The income and expenses of the LLC pass through to the tax return of the owner. Hence, such structures are often called “pass through” entities.

Partnership

Multi-member LLCs (i.e. with more than one member) are taxed as a partnership by default. Owners would report personal income on Schedule C of Form 1040, but the LLC would also file a Form 1065 with the IRS and issue K-1 statements to all LLC members. Again, this would be know as a pass through entity.

S Corporation

The previous sections covered the default tax schedules for single- and multi-member LLCs. However, LLC members can elect for corporate taxation as well, either as a C corporation or an S corporation. To be taxed as an S corporation, an LLC must file Form 2553 with the IRS. S corporations are still pass through entities, however, and aren’t subject to double taxation like C corporations.

By electing S corporation tax status, LLC owners may be able to avoid other taxes that a Sole Proprietor must pay, such as self-employment taxes (i.e. Social Security and Medicare). For 2018, the self-employment tax rate was 15.3% (up to $128,400 net income), meaning that the owner of a single-member LLC with $100,000 in net income would have paid $15,300 in self-employment taxes for the year.

By opting for S corporation status, the owner becomes an employee of the LLC and has to take a reasonable salary. The salary is still subject to the 15.3% tax, but the remaining profits are not. Taking a $60,000 salary means the owner would pay $9,180 in self-employment taxes, but he would save $6,120 overall.

The tax savings can quickly be offset by the increased costs to the owner in payroll and accounting fees, additional bookkeeping costs, or filings for corporate and payroll tax returns. You should weigh the costs and benefits against one another. But, in short, the higher your net income, the likelier that S corporation tax status will benefit you. However, you must consult with your accountant to decide whether S corporation tax status would suit your business needs.