What Is a Limited Liability Company (LLC) and What Should You Know Before Forming One?
6 min. Read
Last Updated: 07/25/2023
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If you pay attention to business names, it won't take long to spot one that has the acronym "LLC" attached to it. A limited liability company is one of a number of ways an employer can structure their business.
Choosing to make your business an LLC will have implications on your tax obligations and can protect your personal assets from the debts and liabilities associated with your business. Structuring your business as an LLC comes with pros and cons. Here's some information that might be helpful to consider while you try to determine if establishing your business as an LLC is right for you.
What Is an LLC?
An LLC stands for a limited liability company, but what does it mean to be an LLC? The answer varies depending on your business and the way you set up your LLC. There are several main types of business structures such as sole proprietorship, partnership, and corporation. Corporations have a further level of distinction as an S-Corp or C-Corp. Each of these structures offers an array of benefits and disadvantages. LLC is simply another way you can structure your business.
Compared to other business structures, an LLC can offer owners flexibility and options. For starters, a limited liability company has a mixture of many of the same characteristics of a sole proprietorship and a corporation. Specifically, it combines a corporation's limited liability feature — reducing the risk of an owner being held personally responsible for a company's debts and financial responsibilities — with the flow-through taxation that is used with a sole proprietorship. An LLC can also be recognized as a partnership if there is more than one owner.
Types of LLCs
As mentioned earlier, among the various types of legal structures for a small business, an LLC structure can provide flexibility for the owners along with options. There are two main types of LLCs depending on the number of owners. Keep in mind that with an LLC, employer(s) or owner(s) are called members. These two main types of LLCs are:
- Single member: This is an LLC with only one owner.
- Multi-member: This is an LLC with more than one owner.
For federal income tax purposes, the IRS treats an LLC as either a corporation, partnership, or flow-through entity based on the elections made by the LLC and the number of its members. The IRS classifies an LLC with more than one owner as a partnership by default.
How Does an LLC Work?
Like a corporation, an LLC is its own legal entity. By keeping the business separated from the owner, financial and legal transactions such as loans, payments, credit cards, and bank accounts are held by the business.
When it comes to federal taxes, however, an LLC is not taxed separately unless its member(s) elected to be taxed as a corporation when it was established. Like a sole proprietorship, a single member of an LLC pays their personal income tax rate for earned income.
Pros and Cons of LLCs
From sole proprietorships to international corporations, every business structure comes with its own set of distinct benefits and disadvantages. And while an LLC offers a hybrid approach, there are variations in how to handle setting up your LLC. With so many choices, how do you decide if an LLC is right for you? Let's take a closer look at the pros and cons of an LLC.
Benefits of an LLC
- Limited liability: One of the more attractive advantages of an LLC is that the financial liability of the member(s) is limited to their investment. With a few exceptions, members are not personally responsible for the debts and liabilities of the business. In the event a business is sued or files for bankruptcy, the member(s)' personal assets are protected and cannot be used to fulfill the business's financial obligations.
- An unlimited number of owners: LLCs are not restricted in terms of who can be a member or the number of members allowed. In addition to individuals, members can be other types of business entities.
- Pass-through taxation: If an LLC is set up as a sole proprietorship or partnership, it eliminates double taxation. The federal tax rate "passes through" to the individual members who pay based on their individual income level.
- State and Local Taxation: Some states allow pass-through entities to be taxed at the entity level, which would be deductible for Federal tax purposes. This could help members receive a tax benefit for state taxes that would have otherwise been limited by Federal deductibility limitations on their personal returns.
Potential Disadvantages of an LLC
- Requires meticulous recordkeeping: Because an LLC is a separate business entity from the owner (or member), careful attention must be paid to keep personal and business funds separate and well-documented. Additionally, you should keep these documents organized for easier retrieval should the need arise, such as for a tax audit.
- Self-employment tax: Because an LLC is a pass-through entity, profits made by the member may be subjected to self-employment tax. The member will have to carefully track earned income to pay appropriate tax liabilities when due. Note that LLC’s that are treated as S Corporations can partially mitigate the self-employment tax obligation.
- Annual renewal fees: Unlike a sole proprietorship or partnership, you must pay annual fees to keep the LLC in good standing. Fees will vary according to each state and can range from as little as $10 (Colorado) to $500 (Massachusetts).
6 Things To Know Before Starting an LLC
While an LLC can be an attractive option for many small and mid-sized businesses and you may have a better idea of what is an LLC, it's important to do your research before opening one. Because it's your business, addressing the following items thoughtfully and methodically will ensure a successful and smooth start to your LLC business entity. Here are some things to consider before forming an LLC:
1. Choose a Distinguishable Name
You may have your idea of the perfect name for your business already picked out, but you must make sure that it's distinguishable from any other in the state in which you're registering your LLC. Additionally, the name cannot use any restricted or prohibited words, or imply a connection to a government organization. When registering your business name, take care to be accurate with your spelling to avoid headaches and hassles down the road to change it. Depending on your state, you can reserve a name for a certain amount of time for a small fee while you go through the steps of establishing your LLC.
2. Mitigate Risk With Business Insurance
It's true that an LLC helps to protect members from a business entity's financial liabilities, but what about the business itself? Property damage, theft, data breaches, and potential lawsuits can go a long way in damaging a small business's financials and ability to keep the doors open. Business insurance is one way to mitigate risk.
It's worth noting that if you have employees, you may be mandated to carry certain types of business insurance, such as worker's compensation. And if you're looking to attract investors, insurance can make you look much safer and demonstrate the soundness of your enterprise.
3. Understand Your Tax Options
Taxes are a reality of doing business and failure to fulfill your tax requirements in a timely way can lead to hefty fines. Understanding your tax options with an LLC is critical to making a decision that saves you time, hassle, and money over the life of your business.
Typically, a single-member LLC is treated like a sole proprietorship and a multi-member as a partnership. Both of these enjoy pass-through taxation. The individual owner or members are taxed based on their personal income. LLCs also provide an option of being taxed as a corporation, either an S-Corp or a C-Corp. There are many differences between these two; depending on your business type and aspirations, one may be better than the other.
4. Know Your Registration Obligations
You must pay annual fees to keep your LLC in good standing with the state. Filing fees to start your LLC will vary from state to state, as do annual filing fees. Also, depending on your state, your LLC may need a registered agent. This is an individual or business entity that is your official point of contact for your business in that state.
5. You May Need an EIN for Your LLC
An Employer Identification Number or EIN, per the IRS, is also known as a Federal Tax Identification Number and is used to identify a business entity. An EIN is free to obtain. Many banks require an EIN to open a business account. So even though a single-member LLC without employees may not be required to have an EIN, it could still be a good idea for your LLC to obtain one. You will need a business bank account to begin building your LLC's credit history. A business bank account is also an excellent tool that helps keep your personal and business financials separated and organized.
6. You Will Need To Prepare Articles of Organization
Articles of organization are a collection of legal documents that are filed with the state to establish your LLC. These documents cover the fundamentals of your LLC such as the name and address of the registered agent, the name and address of the company, the purpose of your business, and the type of business structure. If there is more than one member, you should consider creating an operating agreement that describes each member's rights, liabilities, responsibilities, and any other obligations.
How To Start an LLC
It's easy to start an LLC, but that doesn't mean you should rush into it without doing your due diligence. Carefully review the following steps and make sure you have everything in order before beginning the process.
Determine the state that you'll use to register your LLC. This answer is easy if you're a single owner who does business in one state. If your business operates in multiple states, you'll have to choose. After you've identified the state, you can select a distinguishable and compliant name for your LLC. At this point, you should also have a written business plan. It's not a requirement, but it's a smart move when starting a business.
Once you have your state, name, and business plan, you're ready to choose your registered agent and prepare the final documentation. Some states may require an operating agreement, a document outlining the LLC's rules over financial and functional decisions that is signed by the members of the LLC. Finally, file your articles of organization and pay your registration fee.
How Much Does It Cost To Start an LLC?
The cost to establish an LLC will vary from state to state. Fees can range from as little as $1 (Colorado) to $500 (Massachusetts). Annual renewal costs to keep your LLC in good standing will also vary according to your state. Check with your state to confirm the most updated fees.
Is an LLC Incorporated?
No. An LLC is formed, and only an S-Corp and C-Corp are incorporated. Members of an LLC can choose to be taxed as an S-Corp or a C-Corp, but this is not the same as an incorporated designation.
What Is the Purpose of Having an LLC?
Most business owners want an LLC for the protection of their personal assets. The LLC is its own business entity, and the owner(s) or members are typically not personally responsible for any financial liabilities the business may face such as debts, bankruptcy, or lawsuits.
Does an LLC Need an EIN?
Yes, an LLC needs an EIN from the IRS for tax purposes. Many banks also require an EIN to open a business account. There is one exception. According to the IRS, a single-member LLC that is a disregarded entity that does not have employees and does not have an excise tax liability does not need an EIN.
How Are LLCs Taxed?
By default, single-member LLCs and multi-member LLCs, or partnerships, have pass-through taxation. The federal tax rate "passes through" to the individual member who pays based on their individual income level. Multi-members of an LLC also pay taxes based on their share of income earned through the business. There may be additional state and local taxes. LLC members are also on the hook for paying self-employment taxes.
If your LLC has an S-Corp designation for tax purposes, you will avoid self-employment tax and only pay taxes based on the salary you make from your business.
If your LLC has an C-Corp designation for tax purposes, your business will also have to pay taxes in addition to paying taxes on your salary. This is known as double taxation.
Does an LLC Need Insurance?
While not mandated, the cost of LLC insurance is worth it. Business insurance for an LLC can help mitigate risks such as property damage, theft, cyber-attacks, and potential lawsuits. Depending on the number of your employees and your state's regulations, you may also be mandated to carry certain types of insurance such as worker's compensation and health insurance.
Even without a mandate, it's a good idea to carry business insurance. Doing so makes your business more attractive to potential candidates and can help retain workers. In the event of an accident or death at work, insurance can also protect your business and your employees' livelihood.
What Is an Example of an LLC?
An LLC can range from a single-member entrepreneur to a globally recognized international company. Freelance writers, electricians, painters, consultants, and other contract workers will often create an LLC for their business. On the other end of the spectrum, IBM Credit, a subsidiary of IBM, is an LLC. Blockbuster LLC, though arguably past its prime, is another well-known brand.
Do I Need a Business License if I Have an LLC?
Some states require a business license in addition to your LLC registration. Check with your state requirements, as it can be different depending on your state and type of business.
Start Your Business on the Right Foot
Setting up an LLC is relatively easy and can be an excellent structure for many types of businesses. Partnering with reputable financial advisors can give you valuable tools and easy-to-understand insights on exactly what is an LLC — the different types of LLCs, state requirements, and the pros and cons of an LLC for your business. Doing so can help you feel confident that you're making the best decision.
Moving forward with your business also means looking ahead and staying organized with payroll, recordkeeping, compliance, and other HR duties. Paychex can help free up your time and resources so you can focus on what counts: developing and growing your business.