What is an LLC

If you own a business or are thinking of starting one, choosing the right entity structure for your unique needs is essential. Many business owners prefer the Limited Liability Company (LLC) structure due to its simplicity, flexibility, and the protection it offers to owners.

In this What is an LLC guide, we’ll explore everything you need to know about this structure, from its basic definition and how it works to the steps you’ll need to take in order to set up and maintain one.

How Does an LLC Work

An LLC is a business structure that combines the biggest advantages of forming both a corporation and a sole proprietorship or partnership — making it extremely attractive to small to medium size businesses.

This structure works by providing its owners (often called members or managers) with limited liability protection, which protects their personal assets from being used to settle business lawsuits or debts.

On top of this, LLCs also benefit from pass-through taxation, whereby business income is reported on the members’ personal tax returns, avoiding the double taxation faced by corporations.

In the sections below, we’ve explained how each of these LLC benefits work in greater detail.

Personal Asset Protection

Personal asset protection means that LLC owners are protected from any debts or lawsuits that may be brought against the company. In simple terms, this means that the owners’ assets cannot be pursued by creditors in order to cover any sort of loss faced by the business (e.g., a lawsuit or bankruptcy).

This protection begins when you form an LLC, as you are required to go through the process of separating your personal assets from those of your business. The LLC is then treated as a separate legal entity with its own assets that are separate from the owners’ assets (e.g., cars, homes, and personal bank accounts).

This separation is sometimes known as the corporate veil. Many things go into maintaining the corporate veil, but forming an LLC to separate your business assets from your personal belongings is the best way to start.

Pass-Through Taxation

Pass-through taxation means that LLCs do not need to pay corporate taxes on their income. Instead, the business profits “pass-through” the LLC directly to its members, who then report it on their individual tax returns.

For single-member LLCs, the income tax due is determined by the owner’s entire net income calculated on Schedule C of the owner’s personal Form 1040, according to the Internal Revenue Code. This means that your business’s income will be added to any other personal income (like that of a job) to find the total income for tax purposes.

For multi-member LLCs, each individual member/owner receives Schedule K-1 showing their share of the profit, which is included on the member’s Form 1040. The total income shown on the K-1 is then included on their personal income tax return just like in a single-member LLC.

An LLC can also decide to be taxed as an S corporation or a C corporation, which can change the LLC tax responsibilities of the business entity quite drastically.

Alternatively, you can check out our guides on S corporations and C corporations to find out how each of these business structures works.

Types of LLCs

While all LLCs provide the same major features (personal asset protection and pass-through taxation), some LLCs are designed for more specific needs.

Here are some common terms used to describe different types of LLCs:

• Domestic LLC: A domestic LLC is any business that carries out all business activities in the state in which it was originally formed — this is the most common type of LLC
• Foreign LLC: LLCs that have already been formed in one state will need to register as a Foreign LLC in any other states in which they plan to transact business. For example, a California LLC would need to register a foreign LLC in Texas in order to transact business in this state. If your business is run fully online, it’s considered to be transacting business in your home state
• Professional LLC: This term describes any LLC that caters to licensed professionals, such as doctors, lawyers, accountants, engineers, and architects. To form this type of LLC, you and your members will need to have the required state licenses to demonstrate your credentials. Some states also limit the creation of LLCs for these professions. (e.g., healthcare providers, architects, or accountants in California must opt for another structure like a corporation instead)
• Series LLC: A series LLC (or SLLC) is a unique type of LLC that’s considered to have a “parent” or “master” LLC with separate sub-LLCs beneath it. Each of these sub-LLCs has its liability protection separate from each other and the “parent/master”, meaning they cannot be affected by the liabilities and risks associated with the others. This is generally used in real estate businesses
• L3C: A low-profit LLC (L3C) is a type of business that aims to make a profit while also pursuing charitable or social goals. It combines the financial benefits and tax flexibilities of a traditional for-profit business with the social mission of a nonprofit organization

Find out how to structure your business by learning more about the different types of LLCs that fit your business needs.

Member Managed vs Manager Managed LLC

An LLC’s owners are also referred to as “members” — which can refer to individuals, corporations, or even other LLCs and foreign entities. While an LLC can be formed with just a single member, there is also no limit as to how many can be involved in the company.

However, ownership and management of an LLC are two different things, and when it come to managing an LLC there are two primary structures to be aware of:

• Member-Managed LLC: In a member-managed LLC, all members are actively involved in the day-to-day operations of the business and have an equal say in decision-making (unless otherwise stated in the operating agreement). This structure is straightforward and often preferred by small businesses with a few members who all want to be involved in running the business
• Manager-Managed LLC: In a manager-managed LLC, the members designate one or more managers to handle the daily operations of the business — these can be members, non-members, or a combination of both. The appointed managers then make most of the business decisions and handle operational tasks, while the non-managing members typically take a more passive role

Once you’ve determined which of these management structures best suits your business, you’ll need to specify this decision in the Articles of Organization that you’ll file with your Secretary of State when forming your LLC.

What are the Benefits of an LLC?

The LLC is a preferred business structure among small business owners because it is simple and easy to create and less complicated to manage.

However, alongside this key attribute there are a number of other important advantages associated with this business structure:

• Liability Liability Protection: Since members aren’t held responsible for any debts or liability associated with the business, an LLC allows its members to invest without risk of personal losses beyond their investments
• Pass-Through Taxation: Since LLCs are not taxed as a business entity, they can avoid paying corporation tax on profits and losses as they are “passed through” to the personal income tax returns of its members. In this way, LLCs are not exposed to the double taxation of corporations
• Tax Flexibility: An LLC can also elect to be taxed as a C Corporation or an S Corporation for federal tax purposes, partnership, or sole proprietorship, depending on what is most beneficial to the business and its owners’ needs
• Flexibility in Ownership: LLC owners members don’t need to be US citizens or permanent residents of a specific state and can be individuals, corporations, and even other LLCs or foreign entities

What are the Disadvantages of an LLC?

While there are many benefits to forming an LLC, there are also a few disadvantages:

• Cost: Compared to a sole proprietorship, LLCs typically cost much more to form and maintain. In order to organize your business as an LLC, you’ll be required to pay your state’s initial formation fee as well as any ongoing fees (e.g., for annual reports or franchise tax)
• Self-Employment Taxes: If taxed as a disregarded entity (i.e., the default tax status for LLCs), each member will be required to pay self-employment taxes as well as personal income tax on their portion of the business’s profits that they receive. However, this can be avoided by electing to form your LLC as an S Corporation or C Corporation for tax purposes
• Limited Investor Appeal: It’s much harder to attract investment for an LLC through equity financing because this business structure lacks the ability to issue stock options and other equity incentives. The opposite is true for corporations, which can raise capital through the sale of shares

How to Form an LLC

While the exact process can vary slightly depending on your state, you’ll typically be required to complete six general steps in order to get an LLC up and running, including:

1. Choose your state: Generally, it is best to form an LLC in your “home state” — which is the state in which you currently live and want to work from. If you are planning to conduct business in another state (besides your home state), note that you’ll need to register it as a “Foreign LLC” in the state you are transacting business in
2. Name your business: Find and decide on a unique business name and ensure that it complies with all of the LLC regulations of your state. Among other requirements, this will require your name to include a designator that indicates it’s an LLC (e.g., “Limited Liability Company,” “LLC” or “L.L.C.”)
3. Nominate a registered agent: When forming an LLC, you are required to appoint a registered agent in order to accept tax and legal papers on your LLC’s behalf. Your registered agent must be a resident of the state your business will be based in — you can act as your own agent, hire a professional registered agent service, or appoint any other individual that meets your state’s criteria
4. File Articles of Organization: Articles of Organization (also called the Certificate of Formation or Certificate of Organization in some states) is the document you must file with your state in order to officially form your LLC. This typically involves navigating your Secretary of State’s website paying the relevant filing fee, though it can also often be filed by mail or delivered in-person if you prefer
5. Create an LLC operating agreement: An LLC operating agreement outlines the ownership structure, member roles, operating procedures, and other general information that will be in the LLC members’ agreement. While only mandatory in a handful of states, it’s still highly recommended that you create and keep this document in your own records
6. Get an EIN (Employer Identification Number): An EIN, or Employer Identification Number, is used by the US Internal Revenue Service (IRS) for federal income tax purposes. While not a legally mandated step to form a business, obtaining an EIN from the IRS website is essential to be able to perform certain business functions, such as hire employees or open a business bank account

Note: To find your state’s specific LLC formation steps, check out our guide on How to Start an LLC.

Alternatively, If you would like a professional to take care of this task for you, check out our review of the Best LLC Services.

After Forming Your LLC

Once you’ve completed the formation process, you’ll typically be required to wait for your Secretary of State to process your LLC’s Articles of Organization. The processing time of your LLC’s formation varies greatly by state, with the average being somewhere in the one to three-week range.

Once your LLC has been accepted by the state, you’ll need to obtain any licenses, permits, or certifications required to legally operate your business.

How Much Does It Cost to Form an LLC?

LLC formation costs will depend on the state where you choose to register your business — with everything from filing your Articles of Organization to reserving a name for your LLC varying in price. With that said, you can expect it to generally cost between $50 and $500 to form an LLC in most areas.

Alongside general formation costs, there are also three states (Arizona, Nebraska, and New York) in which you’ll need to publicize the formation of your LLC in local newspapers — which will increase the overall cost of your LLC formation by anywhere from $50 to $1,200 depending on your location.

Finally, if you choose to have an LLC formation service file your LLC for you, this will increase your overall total by between $29 and $249. However, most people choose to use these services instead of forming on their own due to the low cost and the peace of mind that it will be done right the first time with little to no headache.

Differences Between LLCs and Other Types of Businesses

To give you a better understanding of LLCs, we’ve compared its features to those of other common business entities in the sections below.

LLC vs Corporation

A corporation (also referred to as a C Corporation) is a state-incorporated business structure that also provides personal liability protection for owners, like LLCs.

However, since corporations do not benefit from the pass-through taxation treatment of LLCs, they are subject to double taxation. This means that the corporation income is taxed once at an entity level and again when the shareholders also pay tax on the dividends from those profits.

LLC vs Sole Proprietorship

A sole proprietorship is similar to a single-member LLC, where it only consists of one person managing the business. Like LLCs, sole proprietorships are pass-through taxation entities as the owners only file personal income tax and do not pay a corporate tax on their business.

However, the main difference between these two structures lies in the fact that LLCs that provide personal asset protection while sole proprietorships do not. This means that the owner of a sole proprietorship would be held financially responsible for all of the company’s debts and liabilities.

LLC vs Partnership

In a partnership, the business is managed and controlled by two or more owners, with all profits flowing directly through the business to each one.

Just like a sole proprietorship, partnerships do not offer liability protection, so partners can be held personally responsible to settle any debts or liabilities that result from the business operations.