Everything *Most* People Need to Know About Limited Liability Companies (LLCs)
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Author: Ty Leitow
Last Updated: January 4, 2024
What is a Limited Liability Company?
A limited liability company (a “LLC”) is a business structure type that often works well for smaller businesses. LLCs take a key benefit of corporations, limited liability, and combines it with a key benefit of partnerships and sole proprietorships, which is pass through taxation. Each business has a specific structure type, and each type brings its own unique benefits and drawbacks. For example, C corporations have the benefit of easily raising capital, but have the drawback of profits being subject to double taxation. A business’s structure type determines how the company is taxed, and how profits, losses, expenses and liability are attributed to its owners.
Compared to corporations, LLCs generally cost less and are easier to create. Moreover, they provide it’s owners/members limited liability protection, have fewer restrictions on who may be an owner and require fewer corporate formalities. Because of these advantages, LLCs are often the preferred choice for smaller companies. In the US, there’s over 21 million LLCs, compared to roughly 1.7 million C corporations.[1] However, the LLC structure can also work well for large companies. Some of the largest companies in the world are LLCs, including Johnson & Johnson, Exxon Mobil Corp, and Alphabet, the parent company of Google.[2]
LLCs are authorized under state law and there is some variation in the laws between states. Owners of LLCs are generally referred to as “Members”.[3] LLCs may be managed by its members, or by “Managers”, who may or may not also be members. Rules regarding the management of a LLC will vary depending on the state that the LLC is organized in, and the company’s operating agreement.
What are the Benefits of a Limited Liability Company?
Limited Liability. LLCs protect its members from personal liability for the debts and obligations of the business. Generally, the debts and liabilities of a LLC cannot become a personal obligation of any individual member of an LLC. Said differently, as long as basic corporate formalities are practiced, a member cannot be held personally liable for the debts, judgements or obligations of the company. This limited liability is the primary advantage LLCs have over partnerships and sole proprietorships.
Pass-through Taxation. Generally, members of LLCs enjoy the benefit of pass-through taxation, meaning profits and losses may be claimed on the member’s personal tax return. This avoids a key disadvantage of corporations, which is double taxation. Double taxation occurs when profits are taxed once at the corporate level, and then are taxed again when profits are distributed to shareholders as dividends.
For single-member LLCs, the IRS does not consider the LLC to be a separate legal entity from the member for tax purposes. By default, single-member LLCs are taxed like a sole proprietorship, with company profits and losses not being taxed at the company level, but instead are passed through to the single member. The member claims the profits and losses on his/her personal tax return.[4]
For multiple-member LLCs, by default, the IRS treats LLCs like a partnership for tax purposes. Like a single-member LLC, profits and losses are not subject to taxation at the company level, and instead profits and losses pass through to the members who claim a proportionate share of the profits and losses on his/her personal tax return.[5]
LLCs are sometimes referred to as a “disregarded entity” by the IRS for tax purposes.[6] Because LLCs are not subject to corporate income taxes by default, and profits and losses pass through to the member’s individual tax returns, the LLC is considered a “disregarded entity” with regards to taxation.
LLCs also have the option to be taxed as a S corporation or a C corporation by filing IRS Form 2553 or Form 8832, respectively.
Flexible Ownership. Compared to other business structure types, LLCs offer flexibility when it comes to who may be an owner/member. Members may include individuals, partnerships, trusts, corporations or other LLCs. Additionally, generally, there are no restrictions on foreign citizens or foreign entities having a membership interest in a LLC.
Depending on the nature of the business, this ownership flexibility may be a key benefit. For example, S corporations have specific restrictions on who may be an owner and how many shareholders it has.
Flexible Management. LLCs also provide for more flexibility when it comes to managing the business. Members may manage the company, or the members may choose managers to manage the company. Additionally, members or managers may elect and nominate officers (e.g. CEO, CFO, etc.) to manage the company. Corporations on the other hand are required to have its shareholders elect a board of directors, and the board of directors are required to nominate and elect officers to manage the company.
Ease of Creating. LLCs, compared to other business structure types, are easier to create. Generally, there are only three steps to create an LLC: (1) draft and file the articles of organization with the state, (2) determine a registered agent, and (3) draft and adopt an operating agreement. Additionally, the costs and fees to make the required filings are generally lower when compared to corporations.
Because LLCs are authorized by state statutes, specific steps may vary from state to state. A more detailed outline of how to create a LLC will be discussed below.
Credibility. For smaller businesses and entrepreneurs, creating a LLC lends more creditability to the business when compared to a sole proprietorship. A business that is incorporated, whether as a LLC or some other business structure, is often viewed by customers and vendors as being more legitimate and trustworthy.
Reduced Corporate Formalities. Both S and C Corporations are required to hold shareholder meetings, board meetings, and retain detailed minutes and voting records. Collectively, these activities are referred to as “corporate formalities”. Subject to applicable state laws, LLCs generally have fewer corporate formality requirements, often only being required to have an annual member meeting.
What are the Drawbacks of a Limited Liability Company?
Self-Employment Taxes. Self-employment taxes refers to amounts owed for Social Security and Medicare by individuals who earn money from self-employment. Generally, when you’re employed by a company, it’s the company’s responsibility to make certain withholdings, designated on a paystub as FICA and MEDFICA. Currently, these withholdings consist of 12.4% for Social Security and 2.9% for Medicare. When you’re a W2 employee, the employee is responsible for half, and the company pays the other half (7.65% each, 15.3% total).
Generally, self-employed individuals who earn more than $400 during the year, such as members of an LLC who work for the LLC, are required to pay on a quarterly basis the Self-Employment Tax of 15.3%. In 2023, the first $160,200 of earnings are subject to the Self-Employment Tax. For 2024, that amount increases to $168,600. Amounts earned above the threshold are not subject to the Social Security portion of the Self-Employment Tax, but the Medicare tax still applies. Additionally, if your earnings exceed $200,000 (single filer) or $250,000 (married filing jointly), you’re required to pay an additional 0.9% Medicare tax.[7]
The self-employment tax is a drawback for anyone who works for themselves.
Ownership Transfer Restrictions. Compared to corporations, transferring ownership interest in a LLC is often more difficult. Generally, ownership in a corporation is achieved by the purchase of shares of stock, and those shares can be freely transferred and sold by the shareholder at the shareholder’s discretion.
With LLCs, unless agreed to otherwise by the other members, all members must approve any transfer of membership interest. Additionally, generally, all members must also approve the addition of new members and any transaction that would alter the ownership percentage of existing members.
How do you Start a Limited Liability Company?
Speak to a Professional, Maybe. Generally, I always recommend that anyone looking to start a business, whether it’s a LLC or some other business structure, to speak to a lawyer, accountant or other business professional who has applicable experience. However, for single-member LLCs or other smaller business ventures, an individual may be able to create an LLC by themselves using online resources.[8]
Choose a State to Organize In. All 50 states authorize the creation of LLCs, and generally speaking, you can choose to organize your LLC in any state you desire. Most LLC owners choose the state that they plan to operate in, but you don’t have to. For example, the State of Delaware has some business-friendly tax laws, fee structures, and courts. As a result, over 60% of all Fortune 500 companies are incorporated in Delaware, even though few actually do business in Delaware.[9]
Choose a Legal Name for Your Company. Choosing a name for a company can be fun, or daunting, depending on the type of person you are. Company names may simply be a family name (e.g. John Smith, LLC), something descriptive (e.g. The Weather Channel), or unique (e.g. Apple, Starbucks). Once you’ve decided on a company name, you’ll want to check two things: (1) if it’s available in the state you plan to organize in and not previously registered by someone else, and (2) the name won’t be confused with another business.
Business name availability generally depends on the state you organize in, and most secretary of state websites provide a business name lookup tool (as an example, this is a link to Michigan’s business entity search website). These tools allow you to search databases to see whether a business name is available.
After you’ve confirmed that your chosen name is available, you’ll also want to do some research to make sure your business name won’t be confused with another company with a similar name. This is not a legal requirement, but generally speaking, you don’t want your business to be confused with another company, especially if you plan to operate in a similar market, similar geographic area, or sell similar products and/or services.
File the Articles of Organization and Select a Registered Agent. After you’ve determined your business name, you’ll need to draft and file your Articles of Organization.[10] Drafting the articles of organization is relatively simple, but it’s advisable to seek professional assistance prior to filing. The articles of organization require certain information, such as the company’s name, the purpose of the company, duration of the company, and the registered agent. Here’s an example form from the State of Michigan.
Having a registered agent for your LLC is a legal requirement, and the name and address of your registered agent will need to be included in the articles of organization. Registered agents are where legal notices and service of process are delivered. For single-member LLCs, your business address or even your home address may be listed. However, a more standard practice is to utilize a third-party to be your registered agent. There are several companies that specialize in providing registered agent services.[11] Law firms are also commonly used as registered agents.
Draft and Adopt an Operating Agreement. Next, you’ll want to draft and adopt an operating agreement. Operating agreements function like the by-laws for corporations, and describe how the LLC is managed. Operating agreements include what powers, rights and responsibilities the members have, if there are managers and what their powers, rights and responsibilities are, and when and how meetings will take place, among other things. Because of the complexity and importance of the operating agreement, I always recommend that it be drafted by a knowledgeable attorney.
Issue Membership Certificates, Determine Tax Status, Obtain a Tax EIN, and Open a Bank Account. The activities in this step are not necessarily legal requirements, but are important things to consider. Depending on the state and operating agreement, the LLC may be required to issue membership certificates, which formally designates the ownership interest of each member. With regards to tax status, the IRS has a default treatment for LLCs (e.g. sole proprietorship for single-member LLCs, partnerships for multi-member LLCs), but members may elect to be treated as a S corporation or C corporation for tax purposes.
Additionally, many new LLCs will need to obtain a Tax Employer Identification Number (generally referred to as a “Tax EIN”). Tax EINs are required for any LLC that has employees or will be required to file certain excise tax forms.
Finally, to help ensure the members maintain personal limited liability protection, the LLC should open a business bank account. Keeping business funds separate from personal funds is an important step in ensuring members are personally protected from being found liable for the business’s debts and liabilities.
Each State is Different. As a final note, I’d like to reiterate that each state is different. This article covers the basics, and from state to state, the above process will be mostly accurate. However, because of the variances between states, you should speak to a lawyer or accountant before beginning the LLC creation process.
[1] https://www.rocketlawyer.com/business-and-contracts/starting-a-business/form-an-llc/legal-guide/why-start-an-llc-advantages-and-disadvantages
[2] https://www.investopedia.com/terms/l/llc.asp
[3] The term Members will be used in this article to refer to the owner(s) of a LLC.
[4] For single-member LLCs, the member would file profits and losses on a Schedule C
[5] For multi-member LLCs, members would file profits and losses on From 1065. Each member would claim a percentage of profits and losses equal to their respective ownership percentage of the company. The LLC is required to issue each member a Schedule K-1, which outlines the profits and losses, as well as the amount of tax each member is responsible to pay.
[6] https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
[7] https://www.nerdwallet.com/article/taxes/self-employment-tax
[8] Not a paid affiliate.
[9] https://www.cnbc.com/2023/03/13/why-more-than-60percent-of-fortune-500-companies-incorporated-in-delaware.html#:~:text=Delaware%20has%20cultivated%20a%20reputation,Delaware%20their%20legal%20home%2C%20though.
[10] This document’s name may differ depending on the state, and you may also see it be referred to as a certificate of formation or certificate of organization; regardless of the name, it serves the same purpose across all states.
[11] Not a paid affiliate.