What Are Limited Liability Companies?
UPDATED: June 19, 2018
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A limited liability company (LLC) is a business entity created by state statute. There are no limits on the number of members that can join a limited liability company and there are no limits on the types of members that can join. This means that it's possible to form an LLC with just a single member. The members can consist of both individuals and/or business entities.
An LLC is a business entity that combines aspects of a corporation with a partnership or sole proprietorship. It is like a corporation in that it provides its owners (also called members) with limited liability, as a corporation does for its shareholders. This means that by law, the owners of the LLC are usually not personally liable for any debts of the business, aside from the value of their investment in the business.
Why Form an LLC?
Ultimately, choosing an LLC as your business entity will give you the flexibility offered by the management and tax structure of a sole proprietorship or partnership, while also providing you with the limited liability of a corporation. This means that you are only liable up to the amount of your investment in the limited liability company, and your business debts stay within the business. Limited liability prevents creditors from being able to reach personal assets such as homes or family cars. However, it is important to note that limited liability protection is not absolute. Some creditors will ask you to sign away your limited liability protection when you apply for a loan. If you refuse, this could cost you the loan.
In most states, the default taxation method of an LLC is like that of a sole proprietor or partnership. This method of taxation is called pass-through taxation. This means that the business income “passes through” the entity itself and is taxed directly as the owner’s income. While the owners of the LLC will have to file a tax form 1065 for the limited liability company, this form is only for informational purposes and can be used as a check by the IRS on the owner’s claimed income that year.
Some business owners may choose to have the LLC taxed as a corporation. This is done by filing a form 8832 with the IRS, which elects corporate status for taxation purposes. This method of taxation is often called double taxation, as both the business entity as well as the owners’ income is taxed. This method of taxation is useful for owners that want to keep the profits within the business to build capital. This means that any portion of the profits kept within the business are not received as dividends, and the owners are not personally taxed for these earnings. Because the entity is taxed at a lower rate than the owners are, this method of taxation is beneficial to the business in this case.
In a partnership, usually each individual is personally responsible for all the debts of the entity. In most jurisdictions, an LLC is treated like a partnership in that pass-through income taxation is available to the business. Pass-through income taxation means the income of the entity is treated as the income of the individuals that own the entity. This means that the entity can be treated like a non-entity for taxation purposes.
There is also far less administrative work involved in an LLC than in a corporation, and in some states, an LLC can be formed with just one person.
Assets are easier to remove in an LLC than in a corporation and in a majority of states there is no requirement that the shareholders have an annual meeting. There is also no requirement that there is a board of directors, but there is the option of setting up an operating agreement to centralize the management.
Because many investors feel more comfortable with investing in a corporation, which has a better-understood internal structure than the flexible LLC, owners of the LLC may find it more difficult to raise financial capital than they would in a corporation. For example, an LLC is not required to have a strict management structure, like the board of directors that is required in a corporation.
In some states, LLC have to pay a franchise tax and renewal fees may be higher for an LLC than for a corporation. In addition, if 35% or more of the LLCs losses can be attributed to individuals who are non-managers, the LLC may lose the ability to do its accounting through a cash method.
While there may be benefits to pass-through income taxation, the downside is that the earnings of the LLC are subject to self-employment taxation. Further, many foreign jurisdictions treat LLCs as if they were corporations for tax purposes.
But keep in mind that LLC laws differ among the states, which means that LLCs can be treated differently depending on the location.