LLCs: What They Are And How They Work

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Starting a company is a daunting task. But for many business owners, setting up a business as a limited liability corporation, or LLC, is a no-brainer thanks to the benefits — especially the fact that it reduces the legal liability of its members.

“Generally, most people can benefit from forming an LLC,” says Carl Breedlove, a leading Block Advisors small-business expert from The Tax Institute at H&R Block.

But, as with most business decisions, he recommends carefully considering the pros and cons before deciding whether this type of business structure makes sense for you.

Pros and cons of an LLC

While there are several benefits of forming an LLC, there are some potential downsides, too.

Pros

• Liability protection: The biggest benefit that LLCs offer is liability protection, Breedlove says. LLCs can protect members by separating business and personal assets. Thus, members’ personal assets cannot be seized by creditors or due to lawsuits. “If you’re just operating as a freelancer or sole proprietor, you really don’t have any liability protection,” Breedlove says. “Any debts the business has, any lawsuits, anything like that is on you personally as well…the business is considered a piece of you.”
• Tax flexibility: Once you form an LLC, you can choose to not be taxed as a sole proprietorship if that’s not the most beneficial classification for your business, Breedlove says. LLCs can also avoid double taxation. That’s unlike C corporations, which are often taxed at the corporate and shareholder levels.
• Management flexibility: LLCs tend to be subject to fewer regulations than corporations, allowing for greater flexibility in their management structure.
• Easy to start: LLCs require less paperwork and fewer fees to start than setting up a corporation. However, paperwork and fees vary by state. (Running your business as a sole proprietorship generally requires no paperwork or fees, but you also don’t get that liability protection.)
• Offers room for growth: Expanding your business can be easier as an LLC than as a sole proprietor, Breedlove says. As an LLC, there are different ways to have others buy into your business. Plus, that LLC at the end of your business name lends credibility, which can be attractive to investors, he adds.

Cons

• Cost and filing requirements: You have to pay to set up the business, and most states have an annual filing requirement that includes a fee, Breedlove says.
• Liability protection isn’t foolproof: While LLCs can protect the personal assets of their members, that protection isn’t always guaranteed. For example, sometimes LLC owners don’t clearly separate their business and personal finances. Members also might not be protected in cases of fraud. “It’s not absolutely bulletproof,” Breedlove says of liability protection.
• Not as resilient as corporations: In some states, an LLC might be dissolved if a member leaves the company or dies. In this case, any remaining members must form a new LLC. Corporations can continue even if someone leaves the company or dies.
• Tax disadvantages: LLCs have tax advantages, but they also have potential disadvantages for taxes. For example, if the LLC is taxed as a sole proprietorship or partnership, members must pay Social Security and Medicare taxes (also known as payroll or FICA taxes) on the business’s net earnings . As the business grows, the LLC could face a large quarterly tax bill.

Limited Liability Company explained

A limited liability company (LLC) is a business entity formed in the U.S. LLCs can be organized in many ways, such as a single-member LLC, a multi-membership LLC, or a member-managed LLC. Members can include individuals, corporations or even other LLCs.

LLCs are organized at the state level, so laws around LLCs may vary. People often form LLCs in their primary state of residence, though you might be able to form an LLC in another state. Forming an LLC in another state can have certain advantages in some cases, such as favorable tax treatment compared to one’s home state.

Typically, forming an LLC requires certain documentation, such as articles of organization. Other documents, such as an operating agreement, are also usually required.

What is the purpose of an LLC?

People tend to form LLCs at least partly for the protection they provide. When someone is a member of an LLC, their assets are kept separate from the business’s assets. Thus, the LLC can prevent the members’ assets from being seized by creditors. The same is true in the event of a lawsuit.

LLCs also have tax advantages; avoiding double taxation is their main benefit, compared with setting up a corporation. Income for C corporations is taxed both at the corporate level and on shareholders’ tax returns. However, LLCs are not required to pay federal taxes directly. Instead, profits and losses are reported only on the tax returns of an LLC’s members.

The various benefits of the LLC have made them one of the most widely used business entities in the U.S. They are even useful when they have a single member due to the separation of business and personal assets. Thus, entrepreneurs and self-employed individuals often decide to form an LLC.

LLCs vs. corporations

There are many differences between LLCs and corporations. As mentioned earlier, one of the key differences between LLCs and corporations is how they are taxed. LLCs often avoid double taxation, while corporations may have to pay taxes twice.

LLCs may also be subject to fewer regulations than corporations, allowing for increased flexibility. For instance, LLC members have greater freedom in determining how the company should be governed as long as it complies with state law.

Incorporating a business also requires a different set of documentation than organizing an LLC. Corporations primarily have articles of incorporation instead of articles of organization. A corporation is said to be owned by shareholders if it is publicly traded. On the other hand, an LLC is owned by a member or LLC interest.

Bottom line

Limited liability companies, or LLCs, are business entities formed in the United States. LLCs have several advantages. One of their main benefits is the separation of business and personal assets, a feature that a sole proprietorship doesn’t offer. Their other important benefit is the possibility of avoiding the double taxation that corporations face.

LLCs are also relatively cheap and easy to organize; a single person might often create an LLC for their business. That said, there are usually annual fee and paperwork requirements.

However, the protection LLCs provide and the ease of organizing one has made them one of the most widely used business structures in the U.S.