Finance glossary

What is an LLC?

Bristol James
5 Min

A limited liability company (LLC) is a type of business structure in the United States that combines aspects of corporations, partnerships and sole proprietorships.

LLCs protect the assets of the owners from lawsuits and creditors, with this limited liability referred to as the “corporate veil.” The LLC structure also affords owners the tax efficiencies and operational flexibility of a partnership.

Understanding LLCs

Limited liability companies are hybrid entities that create a legal separation between the business and its owner(s).

The owners – or members – are not personally liable for the business’s debts or financial losses. This means that in the event of legal action or if the business were to fail, liability is assumed by the company rather than those who founded it.

While LLCs protect members from having to sell their assets to pay business debts, it is important to note the use of the word “limited.”

Limited liability companies do not absolve members of liability in every scenario. For example, an individual may be pursued by creditors in court for acts of negligence.

Key characteristics of an LLC

In addition to limited liability, what are the other key characteristics of LLCs that make them popular?

Pass-through taxation

Pass-through taxation means LLCs do not file corporate taxes with the Internal Revenue Service (IRS).

Once the company has paid its expenses and debts, the members of a limited liability company pay tax on profit.

LLCs are separate legal entities but they are not separate entities for tax purposes. Instead, owners can adopt whatever tax structure they like based on the various types listed in the next section.

Members may elect to be taxed as a corporation, but those who opt to be taxed as a partnership save money because they avoid double taxation at both the personal and corporate levels.

Flexible management structure.

LLCs also offer a flexible management structure, with no need to appoint executives or a board of directors.

There are two options here:

  1. Member-managed LLCs – where each member of the company contributes to its management, and
  2. Manager-managed LLCs – where one or more members are elected to manage the business (or parts thereof)

LLCs are also governed by an operating agreement that can be adjusted as the business evolves. These documents also clarify:

  • The ownership structure of the business.
  • Any decisions that require a member vote.
  • How profits and losses will be distributed.
  • How members can leave the LLC, and
  • Who has invested capital and in what amount.

Minimal compliance requirements

Limited liability companies are not required to meet many of the onerous requirements that are applicable to corporations.

LLCs do not need to hold periodic board or shareholder meetings, which reduces administrative paperwork and increases efficiencies.

Reporting is also less demanding, and while compliance requirements vary by state, most LLCs must only report basic information on either an annual or biannual basis.

Flexibility of ownership

LLCs can be owned by almost any entity – whether that be individuals, corporations, general partnerships, trusts, non-profits, foreign entities and even other LLCs. There is also no limit on the number of members an LLC may have.

Some entities are prohibited from owning a limited liability company, however. These include governments, some non-citizen residents and foreign entities from specific countries.

Different types of LLC classification

LLCs come in various types, with each suited to particular business needs, purposes and objectives.

Single-member LLCs

Single-member (sole proprietor) LLCs are comprised of one person (the owner) who reports profit and loss on their personal tax return.

Multi-member LLCs

Multi-member LLCs, as the name suggests, are comprised of two or more members.

Multi-member LLCs tend to be treated as partnerships for tax purposes. Profit and loss are passed to individual members in proportion to each member’s share of ownership in the company.

In 2023, partnership LLCs accounted for 71.7% of all tax returns in the United States. Limited liability companies also accounted for 25.5% of all partnership profits in the same year.

Domestic and foreign LLCs

Domestic LLCs operate primarily in the state in which they were formed, while foreign LLCs operate in multiple states.

In the case of the latter, members are subject to the specific laws and regulations in each state they conduct business.

Professional LLCs (PLLCs)

Professional LLCs are formed for the express purpose of providing any professional service that requires a state license.

Typically, PLLCs are suited to doctors, lawyers, accountants, architects, chiropractors and real estate agents, among others.

Low-profit LLCs

Low-profit limited liability companies (L3Cs) tend to be businesses that want to further a charitable or social cause and generate profit at the same time.

L3Cs are a relatively new LLC type that is similar in purpose to B Corporations.

Drawbacks of LLCs

LLCs come with many benefits and they are popular for a reason. However, there are some drawbacks to the structure.

Cost

Depending on the state, a one-time filing fee of $40-$500 applies to found a limited liability company. Other upfront costs include agent fees, publication fees and business name reservation fees.

Once the company is operational, an annual fee is also charged to maintain registration and verify that the business is still active. The annual fee in California, for example, is $820.

Some states will also collect franchise fees – even if the business in question does not operate as such – and there are also professional legal fees to consider in certain contexts.

Limited liability

Earlier, we touched on the fact that limited liability did not mean zero liability.

If an LLC is not properly maintained, creditors may be able to pierce the corporate veil and hold members liable.

This may occur when:

  • Personal and business assets are commingled.
  • The LLC’s capitalization is small in relation to its business activities or risk level (inadequate capitalization), or
  • Members fail to adhere to formalities and procedures.

Complicated transfer of ownership

Transfer of ownership of an LLC can be complicated if there is more than one member.

Each member must approve to transfer, and if the LLC does not have an operating agreement in place that stipulates how the business may be sold, the whole process can become complex and cumbersome.

Summary:

  • A limited liability company (LLC) is a versatile and flexible business structure that combines aspects of corporations, partnerships and sole proprietorships.
  • The defining characteristic of an LLC is that it offers limited liability to its owners. Owners are not personally liable for the company’s debts and other liabilities, which means their assets are protected. In some circumstances, however, liability may be pursued in the courts.
  • While LLCs constitute separate legal entities, they are not considered by the IRS to be separate entities for tax purposes. LLC owners are free to follow whatever tax structure they desire, which is often dictated by the type of LLC they register.
  • Some of the potential drawbacks of LLCs include upfront and ongoing costs, limited (but not zero) liability and complicated transfer of ownership if terms have not been stipulated in an operating agreement.

References

 

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