An LLC is an acronym for limited liability company. When you own a business, you get to decide how you will operate, which customers you will target, how you will market yourself, and how you will structure your business, legally and for tax purposes. The last issue is where LLCs come into play.
ABCs of LLCs
In a nutshell, a limited liability company is a business structure somewhere between a sole proprietorship or partnership and a corporation, with characteristics of each. Its taxation is similar to a sole proprietorship or partnership, while it offers legal protections akin to a corporation.
An LLC can be formed and run by a single person or have multiple members.
Let's talk liability
If your business is a sole proprietorship or a partnership, you and any partners (known as "members" in the context of an LLC) bear unlimited liability. If your business is sued, not only might it face a costly judgment against it, but so might you -- and any other members. But by organizing as an LLC, as the "limited liability" name implies, you limit your legal exposure.
The LLC is considered a separate entity and generally only it will be liable for debts or legal judgments. The capital you put into the business will be at risk, but your home and other personal assets won't be. There are exceptions to this blanket coverage if a business owner patently exploits the structure, but it's difficult for plaintiffs and/or creditors to, using the formal legal description, pierce an LLC's veil.
The way that a business is structured dictates its tax treatment. A corporation, for example, is a separate entity for tax purposes, and faces corporate tax rates. A sole proprietorship or partnership, on the other hand, has its owners reporting business income on their personal tax returns and facing ordinary income tax rates. An LLC is considered a "pass-through" entity, with tax liability being passed through the business to the owner(s). As with a sole proprietorship or partnership, the owner(s) will report business income on a separate schedule in their personal income tax return. The LLC structure can be beneficial to many folks tax-wise, because it's simpler and because their personal income tax rate might be lower than the business's corporate rate would be.
The LLC itself doesn't file a tax return of its own. It does , however, file Form 1065 with the IRS, as does a partnership, as well as K-1 forms for its members, reporting the share of income or losses attributable to each member.
Note that some LLCs elect to be taxed as S-Corporations or C-Corporations for additional tax benefits, but that's more complicated and beyond the scope of this article.
How to create an LLC
Forming an LLC isn't hard. You need to register your business as an LLC in your state -- in most states, the Secretary of State's office handles these matters. You generally need to file articles of organization, too, and perhaps also an operating agreement, spelling out how your business is structured and run, and what the duties of its various members are. It's often smart to tap the services of a lawyer for this task, because a sloppily structured document can lead to legal or financial confusion and hassles later, such as if members don't agree on some responsibilities that weren't clearly defined.
As an example, here's an abbreviated summary of how to set up an LLC in Colorado, via the folks at Nolo.com:
- Choose a name, which must include terminology making it clear it's an LLC -- such as "Ltd." or "L.L.C."
- Appoint a registered agent who will receive important tax and legal documents for the company.
- File Articles of Organization with the Secretary of State, including the LLC's name and address, its registered agent, the name and address of the person forming the LLC, and whether it will be run by a manager or members. There's a $50 fee for this, too.
- Prepare an Operating Agreement. This isn't required, but is "highly advisable."
- Comply with any other tax and regulatory requirements, such as obtaining an IRS Employer Identification Number (EIN) if needed and any business license that might be required.
- File annual reports with the Colorado Secretary of State.
Disadvantages of the LLC status
There are some reasons to think twice before forming an LLC. For one thing, it might be harder to raise money as an LLC than as a corporation, as LLCs can't execute initial public offerings (IPOs) and they might be structured in ways that are less standard and less well understood than corporations. Some states tax LLCs, too, such as with a "franchise tax."
You should now have an understanding of what is an LLC, but that's not enough on which to base a very important business decision if you're thinking of forming one. If that's the case, consult with a financial advisor or two, and/or a tax or business attorney.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.