Updated on 11.02.15

What Is a Limited Liability Company, or LLC?

forming an llc

When my husband and I created our first WordPress blog, we did it as a hobby. But once we started earning a real income from our website, we began to think of it as a profitable business endeavor. As such, we realized we needed to begin treating it that way — and not just in our own minds, but in a professional and legal sense as well.

With that in mind, we decided to open our first limited liability company, also known as an LLC.

What Is an LLC?

A limited liability company is a business entity that offers certain legal protections and rights to its owners. An LLC is neither a true corporation or a sole proprietorship/partnership. Actually, LLCs combine some of the best aspects of both.

Like other corporate entities, the owners’ personal liability is limited — meaning an LLC provides a layer of protection over the members’ personal assets. In theory, this means only the assets of the company could be exposed to a lawsuit if one were to arise — not your personal savings or possessions.

Meanwhile, LLCs are not very restrictive, easy to form, and provide pass-through taxation benefits to their members. Since the government views the company and the owner as one taxable entity with this business setup, members are also allowed to pass LLC profits through their personal income taxes. In this sense, creating an LLC offers the perfect trifecta of advantages — ease and simplicity, legal protection, and potential tax savings — all in one fell swoop.

Unlike most business entities, laws regarding LLC structure and formation rest entirely with the states. This means that, while forming an LLC is relatively easy, 50 different sets of laws govern them in the U.S. That doesn’t necessarily make the process of starting an LLC more complicated, but it does mean you have to pay attention to your local laws and regulations above all else.

Why Should I Form an LLC?

There are many reasons why you might choose an LLC for business purposes. Here are some of the most important:

Limited Liability

By forming an LLC for your business, you can effectively protect your personal assets and keep them separate. That way, if your business is sued, the plantiffs are not able to go after your personal funds or possessions.

Of course, it works the other way around as well. If somebody is injured at your house, they can’t turn around and sue your LLC — unless, of course, the LLC owns your home.

Pass-Through Taxation

One of the biggest benefits that comes with forming an LLC instead of a corporation is that the profits from the business are only taxed once. Those profits can be “passed through” to members’ personal income taxes, saving huge amounts on taxes over time.

Ease of Formation

Rules and regulations governing LLCs are far less restrictive than those governing corporations. In general, LLCs are not held to the same standards when it comes to record keeping, nor are they restricted in size — although it is advised that an LLC operate as a corporation, regardless of its tax classification. LLCs are also permitted to own sole businesses, own stock in corporations, or own other LLCs.

Save Money on Self-Employment Taxes

Operating as a limited liability corporation can also save you from paying more in self-employment taxes than you need to, which we’ll explain in detail below.

LLCs and Taxes: How Do They Work?

Because limited liability companies are governed by the states, the IRS does not recognize an LLC as a taxable entity. Therefore, LLCs must elect how they wish to be taxed.

By default, single-member LLCs are considered disregarded entities while LLCs with more than one member are considered partnerships. If an LLC chooses to be taxed as either a partnership or disregarded entity, the members will owe 100% of the self-employment taxes on all profits.

However, LLCs may elect to be taxed as either an S-Corporation or a C-Corporation. In this instance, members must pay themselves a “reasonable” wage, on which the payroll taxes are paid by the LLC. The other profits may be retained or distributed to the members without them having to pay self-employment taxes on all profits made by the company.

In order to elect S-Corp status, an LLC can choose to file IRS Form 2553. In this case, the members will still enjoy all of the major benefits of an LLC (limited liability, ease of formation, and pass-through taxation), but the LLC will now be considered a taxable entity, potentially reducing the amount of self-employment tax owed on the company’s profits.

How Various Business Entities Work

Confused yet? The following chart compares several business setups in terms of owner recognition, flexibility, and tax liability:

 LLCSole Proprietorship or ParternshipS-Corp.C-Corp.
Owners are called...MembersOwner(s)ShareholdersShareholders
Limits liability?YesNoYesYes
Double taxation?NoNoNoYes
FlexibilityFlexible requirements for record keeping, management, and meetingsMost flexibilityMore restrictive record-keeping, management, and meeting requirementsMore restrictive record-keeping, management, and meeting requirements
Number of owners or shareholdersUnlimitedUnlimited1-100Unlimited
Can be owned by another business?YesN/ANo Yes
Can deduct business losses on personal taxes?YesYesYesNo

Who Should Form an LLC?

Small-business owners concerned about personal liability: The best reason to start an LLC is to protect your personal assets from business liabilities. With the ease and low cost of formation, there are very few (if any) reasons to operate legally as a sole proprietorship or partnership without the liability protection of an LLC.

Business owners seeking flexibility: If you’re looking for a flexible business entity, look no further than an LLC. Limited liability companies are extremely flexible. They can be owned by one or more members, own real estate, and choose their preferred accounting method. In most cases, they are not held to the stricter standards of record keeping, annual meetings, and management required of corporations — although it is always good practice to stick to those standards.

Business owners who want to avoid double taxation: An LLC is a great way to protect your personal assets while still avoiding the double taxation experienced by C-Corps. LLCs allow their members to pass the company’s profits (or business losses) through to their personal taxes. This can have a significant impact on the amount of taxes paid by the owners of an LLC.

Who Shouldn’t Form an LLC?

Certain types of businesses: Not all types of businesses are eligible to operate as an LLC. Typically, businesses such as banks, insurance companies, and trusts are not allowed to become LLCs. Furthermore, some states restrict certain professions from operating as LLCs. Be sure to know your state’s requirements prior to forming your LLC.

Business owners seeking a more formal distinction: Because corporations tend to have more formal requirements, it may be easier to distinguish between a business structured as a corporation and an individual. In this way, your liability protection may be stronger than it is with an LLC. If you choose to form an LLC, be sure there is a clear distinction between your personal assets and your business assets.

Businesses that wish to offer publicly traded shares: Although LLCs may be traded publicly on rare occasion, businesses wishing to offer publicly traded shares should avoid forming as an LLC. Because LLCs are governed by each state, trading LLCs publicly is extremely difficult. Entities governed under federal law, like C-Corps, are much easier to take public.

Basic Steps to Forming an LLC

Since LLCs are governed by state laws, forming an LLC is different in each state. However, the basic process is typically the same, and you may not even need a lawyer to do it. Here are some of the basic steps to forming your own LLC:

  1. Choose the name of your business: Before forming your LLC, you must first choose the legal name of your business. This can be anything you like, typically followed by the letters “LLC.” Of course, you need to make sure nobody else is using your business name first. You should run a simple trademark search through the U.S. Patent and Trademark Office as well as a business name search through your state’s Secretary of State’s office prior to formalizing your business name.
  2. File the ‘Articles of Organization’: Next, you need to file the Articles of Organization with your state. This is the document that will make your LLC official. Although they sound like they’d be pretty cumbersome, most of the time they are super-easy. Usually, all you’ll need to file is your legal business name, the address of the business, and the contact information for a representative of the business. Many states allow you to do this online. Of course, you’ll also have to pay any applicable fees. These vary by state, but they typically run anywhere from $75 to $250.
  3. Create an Operating Agreement: This document outlines what your business does, its corporate structure, and rules of operation. Essentially, it is a contract among the members that delineates responsibilities, how ownership percentage is determined, and the process for cashing out or liquidating the business. While most states don’t require this document, you should always keep your Operating Agreement updated and on file.
  4. File any DBAs with local governments: If you’re doing business under any other names, you must file those with your local and/or state governments. For example, if the legal name of your business is Red Flowers LLC, but you also do business as Pete’s Florist, you need to let your state — and possibly your county or city — know.
  5. Get an Employer Identification Number: Now that you have an official LLC, you need to let the IRS know about it. An Employer Identification Number (EIN) is like a Social Security number for your business. Even if you’re running a single-member LLC, it’s good practice to apply for a separate EIN. Again, this provides a clear distinction between the owner and the business itself, which helps establish the corporate veil of limited liability. As we stated before, the default tax classification for an LLC is either a disregarded entity or partnership, depending upon the number of members. You can elect to be taxed as a corporation if you think it will benefit you. Once you have your EIN, you can use it to open a bank account or business credit card for your business.

Wrapping It All Up

Forming an LLC is a great way to protect your personal assets from your business liabilities without having to pay any more taxes than absolutely necessary. Setting one up is easy and relatively inexpensive, and can help you limit liability when it comes to potential problems or lawsuits that could affect your business enterprise.

Since our LLC provides us with legal protections and helps us create a barrier between our personal and business lives, the move was a no-brainer. If you find yourself in a similar situation with a side hustle or small-business endeavor, you may also want to look into creating an LLC to protect your family.

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