What Is an LLC?
An LLC is a business structure similar to a sole proprietorship or a general partnership. According to the IRS:
It is designed to provide the limited liability features of a corporation and the tax efficiency and operational flexibility of a partnership.
As a pass-through entity, all profits and losses pass through the business to the LLC owners (also known as members).
The members themselves report the profits or losses on their federal tax returns — not the LLC itself. Some states, however, do charge the LLC an income tax.
What differentiates the LLC is the limit of the liability for which a member is responsible. Typically, the member’s investment in the company is that limit.
Pros and Cons of the LLC
Advantages
- Operational Ease:
One of the features that distinguishes the LLC from an S-Corp is its operational simplicity. There are far fewer forms required for registering and there are fewer start-up costs. - Simplified Tax Filing:
Filing taxes is a once-a-year affair on April 15:- A single-member LLC files a 1040 and Schedule C like a sole proprietor.
- Partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership.
- Flexible Profit Sharing:
There are also fewer restrictions on profit-sharing within an LLC as members distribute profits as they see fit. Members might contribute different proportions of capital. Consequently, it’s up to them to decide who has earned what percentage of the profits or losses. - No Formalities Required:
LLCs are not required to have formal meetings and keep minutes.
Disadvantages
LLCs are not the perfect entity for all businesses:
- Limited Life:
An LLC has a limited life. When a member dies or undergoes bankruptcy, the LLC is dissolved. Typically, you determine in advance the length of the LLC’s duration when you file it with your state.
If your future plans include taking your company public or issuing shares to your employees (essentially prolonging its life), then you would need to convert to a corporate business structure. - Self-Employment Tax:
The owner of an LLC is considered to be self-employed and must pay the 15.3% self-employment tax contributions towards Medicare and Social Security. As such, the entire net income of the LLC is subject to this tax. - IRS Restrictions on Corporate Characteristics:
The IRS limits the ‘characteristics’ of your company. An LLC may only have two of the four characteristics that define corporations:
- Limited liability to the extent of assets
- Continuity of life
- Centralization of management
- Free transferability of ownership interests
If you wish to have more than two of these characteristics, you’ll need to convert to a corporate business structure.
Frequently Asked Questions
What is the main benefit of forming an LLC?
The main benefit of forming an LLC is limited liability protection. This means members are generally not personally responsible for business debts or legal liabilities—only their investment in the company is at risk.
How is an LLC taxed?
An LLC is taxed as a pass-through entity. This means profits and losses are reported on the individual tax returns of the members. The LLC itself typically does not pay federal income taxes, although some states may levy separate taxes on the LLC.
Can an LLC have just one owner?
Yes, an LLC can have a single owner. This is known as a single-member LLC, and it is treated like a sole proprietorship for tax purposes, filing a 1040 and Schedule C.
What are the startup requirements for an LLC?
Forming an LLC usually requires fewer formalities than a corporation. Most states require filing Articles of Organization, paying a registration fee, and sometimes designating a registered agent.
When should I consider forming a corporation instead of an LLC?
You might consider a corporation if you plan to go public, issue stock options to employees, or need unlimited continuity regardless of ownership changes. Corporations also offer advantages if you want more centralized management or different ownership structures.