A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.
The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Forming an LLC
While each state has slight variations to forming an LLC, they all adhere to some general principles:
Choose a Business Name. There are 3 rules that your LLC name needs to follow: (1) it must be different from an existing LLC in your state, (2) it must indicate that it's an LLC (such as "LLC" or Limited Company") and (3) it must not include words restricted by your state (such as "bank" and "insurance"). Your business name is automatically registered with your state when you register your business, so you do not have to go through a separate process.
Create an Operating Agreement. Most states do not require operating agreements. However, an operating agreement is highly recommended for multi-member LLCs because it structures your LLC's finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, member's rights and responsibilities and other provisions.
Obtain Licenses and Permits. Once your business is registered, you must obtain business licenses, permits and registrations.
Announce Your Business. Some states, including Arizona and New York, require the extra step of publishing a statement in your local newspaper about your LLC formation.
In the eyes of the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC's members and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states do, so check to see what applies to your state.
Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law.
LLCs that are not automatically classified as a corporation can choose their business entity classification. To elect a classification, an LLC must file Form 8832. This form is also used if an LLC wishes to change its classification status.
You should file the following tax forms depending on your classification:
- Single Member LLC. A single-member LLC files Form 1040 Schedule C like a sole proprietor.
- Partners in an LLC. Partners in an LLC file a Form 1065 partnership tax return like owners in a traditional partnership.
- LLC filing as a Corporation. An LLC designated as a corporation files Form 1120, the corporation income tax return.
The IRS guide to Limited Liability Companies provides all relevant tax forms and additional information regarding their purpose and use.
Combining the Benefits of an LLC with an S-Corp
There is always the possibility of requesting S-Corp status for your LLC. An attorney can advise you on the pros and cons. You'll have to make a special election with the IRS to have the LLC taxed as an S-Corp. You must file prior to the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. For more information about S-Corp status, visit IRS.gov.
The LLC remains a limited liability company from a legal standpoint, but for tax purposes it can be treated as an S-Corp. Be sure to contact the state's income tax agency where you plan to file your election form. Ask about the tax requirements and if they recognize elections of other entities (such as the S-Corp).
Advantages of an LLC
- Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members' personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means "limited" liability - members are not necessarily shielded from wrongful acts, including those of their employees.
- Less Recordkeeping. An LLC's operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork and there are smaller start-up costs.
- Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity. Consequently, it's up to the members themselves to decide who has earned what percentage of the profits or losses.
Disadvantages of an LLC
- Limited Life. In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.
- Self-Employment Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.