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The letters LLC are everywhere. They have become synonymous with business. We routinely hear very smart people conflate proper LLCs with the general idea of a business entity with limited liability. Today, we will dispel the confusion. This piece will provide insight into what an LLC is and what an LLC is not. We will primarily be discussing what an LLC is in general and why it can be advantageous for your business to form one. Furthermore, we will touch on what it means for an entity to be considered a pass-through entity.
What is an LLC?
The LLC (Limited Liability Company) is a business structure formed by filing Articles of Organization with the state government where it’s based. An LLC resembles a corporation in that anyone who owns even a single share has liability protection for their personal finances and property from LLC activities. However, unlike corporations, LLCs have members instead of owners, and LLCs can often be better understood as partnerships. In addition, since they are similar to partnerships, LLCs have fewer formalities to follow than corporations.
Why are LLCs popular as a business structure?
LLCs are popular because they afford owners maximum creativity and flexibility. Most of this flexibility comes in the form of profit-sharing arrangements. In the case of a traditional corporation, an owner is entitled to the same percentage of profit as their capital contribution. This means that if you own 50% of a corporation’s stock, you are entitled to half the profit. With an LLC, you may have a 1% traditional ownership interest but be entitled to 50% of the profit. This is entirely customizable among you and your co-members. LLCs also are flexible in that they have almost no restrictions on who can become a member. Members can be individuals, partnerships, corporations, trusts, other LLCs, etc.
What is pass-through taxation?
Pass-through taxation refers to the income tax and means that a company does not get its income taxed at the company level, but rather, its owners are taxed directly on their personal income tax returns. These pass-through taxes are reserved for businesses in a pass-through structure, such as partnerships, sole proprietorships, S-corporations, and LLCs, which make pass-through elections. For example, if an LLC only has a single member (called an SMLLC), it can elect to be taxed like an s-corporation, and income will show up on the member’s Schedule C at the end of the year. However, if there are multiple members, the LLC can elect to be taxed as a partnership, giving it pass-through taxation.
What does the process look like for forming an LLC?
The process of forming an LLC is quite similar to that of creating a corporation. Generally, those who seek to form an LLC file articles of organization with a state. These articles have tweaked language, but they are very similar to articles of incorporation for regular corporations. Just like with corporations, LLCs need registered agents. For more on that, click HERE.
LLCs, unlike corporations, must decide whether they are managed by their members or managed by professional managers. Managers vote on critical issues for the LLC, such as making a significant purchase or taking on debt. For most LLCs, it makes sense to be managed by the members (owners). This is a point of considerable flexibility for the LLC because, unlike corporations, it is not required to have directors and officers.
Corporations determine how they will be run by agreeing to bylaws. These are corporate governing documents. The LLC equivalent is the operating agreement. Although usually not required, it is important for LLCs to adopt one so that members, and not the state, determine how the LLC is governed.
What should I know about LLC taxation?
As discussed above, LLCs can elect to be taxed as pass-through entities or taxed like regular corporations. If they are taxed as corporations, the LLC itself pays income tax. If they are taxed as partnerships or s-corporations, tax is only paid by the individual members of the LLC.
Members can decide on each member’s proportionate share of profits and losses. This is generally codified in the LLC operating agreement. This is very important for multi-member LLCs (mmLLCs). At the end of the year, when each member of an mmLLC receives a K-1 (this is the tax form for partnerships received by members of LLCs which elect to be taxed as partnerships), the share of profit or loss may not be the same as ownership interest. Furthermore, members are taxed on a net profit figure after deductible expenses.
When LLCs are taxed as partnerships, they file informational tax returns on Form 1065. These are not tax returns because the LLC is not paying tax.
Is an LLC right for me?
The flexibility of LLCs makes them excellent choices for small businesses and for owning assets like real estate. For example, in real estate, it is common for each property to sit in its own separate LLC to mitigate cross-asset liability. However, a drawback of the LLC is that since it is similar to a partnership, less preferred by venture capital investors than a corporation. Furthermore, it is also harder to pay employees in membership interests in LLCs than to pay them in stock (as with corporations).
If you are forming a new business, it is very likely that an LLC would be a great entity choice. Despite its drawbacks for raising capital, its flexibility makes it an attractive and versatile vehicle that can support your business as it grows.
