What Is an LLC?

An LLC, or Limited Liability Company, is a type of business structure that can combine the perks of a corporation with the flexibility of a sole proprietorship. 

If you have been searching for more information about what an LLC is, you have likely seen this already on a number of websites.

But what does that mean?

To back things up a bit, when starting a business you really have four choices of business entities to choose from. A business entity is a fancy way of describing how a business is organized. 

The four choices include:

Sole proprietorship: The easiest of the entities to start and run. This is a business that is owned by one individual. 

Partnership: Similar to a sole proprietorship, except it is owned by two or more people. 

Corporation: A business entity that is separate from its owner(s). A corporation can be owned by one or more individuals and protects the owner(s) personal assets from many lawsuits and debts. Forming a corporation is the most complicated entity to form. 

Limited Liability Company: Let’s go back to the earlier definition of “a type of business structure that can combine the perks of a corporation with the flexibility of a sole proprietorship.”

Like the corporation, the LLC is a separate legal entity and provides its owner’s liability protection. Unlike the corporation, the LLC doesn’t require annual board meetings, shareholder meetings, recording minutes, issuing shares, etc. 

There are actually several more benefits of an LLC, so let’s dive into these some more!

8 Benefits of an LLC

1. Personal Liability Protection

This benefit was mentioned earlier but is worth repeating. Liability protection is the biggest reason people choose to form an LLC. As we stated before, an LLC is a legal entity that is separate from the LLC owner (referred to as a member). This means that in most cases, the owner’s personal assets are protected in the event that the LLC is sued or the business fails and can’t pay back certain debts. 

This liability protection also protects members if an employee does something that causes legal action against the LLC.

While not having to pay back debts sounds really good in theory, it’s important to know that there are limitations. If a business purchases inventory, raw materials, etc. from suppliers or creditors that allow the business to pay back over time (referred to as accounts receivable) and the business closes, the supplier has very little recourse to recover that debt from a corporation or LLC.  A sole proprietorship or partnership, however, would still be on the hook to repay that debt. 

Business debts that require a personal guarantee are a different story. If the business needs to get a bank loan, the bank in almost every case is going to require a personal guarantee from the owners. This means that regardless of the business entity, if the company closes, the bank will first go after the assets of the business and any remaining debt will be paid by the owners. 

Related: How does an LLC protect you?

2. Inexpensive to Form

The cost to form an LLC varies in every state. The state filing fee ranges from $40 to $500.

Considering only the value of the liability protection for a small business, the cost of an LLC is reasonable. 

Related: How much does it cost to form an LLC?

3. Easy to Form

While slightly more complex to form than a sole proprietorship or partnership, the Limited Liability Company is much easier to form than a corporation.

We have guides for forming an LLC in every state below:

4. Tax Flexibility 

LLCs offer the greatest flexibility of the four types of business entities when it comes to taxes. 

The LLC itself doesn’t have a tax structure. As a result, the Internal Revenue Service (IRS) allows an LLC to choose to be taxed as a sole proprietorship, partnership, C-corporation, or S-corporation.

This is a bit confusing. You aren’t changing the type of business entity, simply electing how the IRS treats the taxation of the business. 

As you might guess, there are some pros and cons to each type of taxation.

Sole Proprietorship – An LLC owned by one person is referred to as a single-member LLC. An entity taxed as a sole proprietorship is called a “disregarded entity” or “pass-through entity” for income tax purposes. A disregarded entity means that the entity is not separate from its owner for tax purposes, but is still separate for liability purposes.

Like a sole proprietorship, an LLC taxed as a sole proprietorship will pay taxes on the profits of the business and self-employment taxes as well. Self-employment taxes are a combination of Social Security and Medicare taxes totaling 15.3%. Often an LLC taxed as a sole proprietorship is better for businesses with profits under $75,000.

The default tax status for an LLC with one owner is a sole proprietorship. 

Partnership – An LLC with two or more members can be taxed as a partnership. This type of taxation is similar to how the Sole Proprietorship is taxed. 

By default, multi-member LLCs are taxed as a partnership. 

C-corporation – A Limited Liability Company can elect to be taxed like a C-corporation.  In this scenario, the profits of the business are at corporate tax rates. Then any distributions, called dividends for a corporation, are taxed at the shareholder level. Also, if a shareholder also works for the company, their salary is also taxed.

The C-corporation tax election is the most complex and is subject to double taxation. When an LLC elects to be taxed like a C-corporation, the LLC pays taxes on gross income and then distributes the share of the profits to the owner(s) as a distribution. The owner then pays income tax on the distributions which is where the term double taxation comes from. 

S-corporation –  For taxation purposes, taxation as an S-corporation is similar to a sole proprietorship in that the business profits “pass through” to the owners and are taxed on their personal tax returns. This avoids the double taxation issue with the C-corporation. 

What makes the corporation election (both the s-corp and c-corp) the most interesting is that members working in the LLC must receive a “reasonable salary” as deemed by the Internal Revenue Service. Salaries will need to have payroll taxes taken out, which is a combination of Social Security and Medicare for 15.3%. After their “reasonable salary” members can receive a distribution, which isn’t subject to payroll taxes (income taxes still apply).

The choice of tax election is confusing and we recommend talking with a CPA regarding what is best for your business. That said, you aren’t locked into your first choice. One of the great benefits of the LLC is the tax flexibility as you are able to change the election over time as the business grows and the owner’s financial situation changes. 

Related: How is an LLC taxed?

5. Fewer Formalities and Paperwork 

For many businesses, the liability protection of the corporation and LLC is essential. LLCs have fewer formalities and less paperwork than corporations. 

For example, corporations are required to hold annual shareholder meetings and keep detailed minutes of the meeting. They also must elect a board of directors and officers. LLCs are not required to do any of these things.

6. Credibility  

The importance of this benefit will be more for some businesses than others, but every state requires a unique business name and have the words “Limited Liability Company”, LLC, etc. at the end of the business name. 

For many customers, the LLC identifier is more professional and credible than a sole proprietorship or partnership.  

7. Flexible Management Structure 

An LLC can be managed in one of two ways: member-managed or manager-managed. 

In a member-managed LLC, all the members (owners) are actively involved in running the business. This is a very common choice and is similar to how a sole proprietorship or partnership would be run. 

A manager-managed LLC is when the members appoint one or more managers to run the LLC. The managers can be members or non-members of the LLC. This is similar to how a corporation would be run with a board of directors overseeing the management team. 

8. Transferability

LLCs (and corporations) offer the ability to easily transfer ownership in the company. This is a big advantage if you ever want to sell your business or give ownership to someone else. With a sole proprietorship or partnership, those entities would have to be closed and a new one started in its place. This could lead to more taxes on the sale of the business, along with issues continuing contracts or relationships with vendors.