What is an LLC?
An LLC, or limited liability company, is a business entity where the members (the owners of the LLC) enjoy limited liability for the debts and obligations of the business, while still being able to participate in the management of the business (at least to the extent allowed in the company’s operating agreement). The members are often individuals, but they can also be other business entities.
The LLC, as a separate legal entity, should have its own business bank account and tax ID number entirely separate from the entrepreneur’s personal bank accounts. Contracts and leases should be executed in the name of the LLC instead of an individual member.
How is an LLC Formed?
Unlike defaulting to a sole proprietorship or general partnership, forming an LLC requires filing Articles of Organization with the Secretary of State and paying a filing fee. But this is a small price to pay for limiting your personal liability. The LLC should also have an operating agreement in place—a legal agreement between the owners of the business and the business itself—that governs how the business is to be run and everyone’s rights and obligations.
When should you form your LLC?
As soon as possible!
How is an LLC Taxed?
By default, LLCs are taxed as pass through entities, meaning that each member of the LLC pays income tax on their share of the profits earned by the LLC (or deducts as a loss their share of the losses). If your business is a single-member LLC, then you may notice the IRS referring to the business as a “disregarded entity” or even as a “sole proprietorship.” And if your LLC has multiple members, then the IRS refers to it as a “partnership.” This can be confusing because attorneys and accountants are using the same words but discussing very different concepts! When the IRS refers to a business as a disregarded entity or partnership for tax purposes, they are not talking about whether a business entity has been formed with the Secretary of State or whether that business enjoys limited liability protection. The IRS is simply referring to the fact that the LLC, regardless of how many members it has, doesn’t pay taxes itself.
The biggest downside to pass through taxation is that the members of the LLC must pay taxes on their share of the business’s profits regardless of whether the business actually distributes those profits to the members. Your LLC might decide to retain some of the profits to reinvest in the business. Contrary to popular belief, an LLC is not required to distribute profits to its members until the business is dissolved and wound up. Whether profits are distributed and when and in what proportions is determined by the operating agreement or default rules in the state’s Limited Liability Company Act.
Instead of pass-through taxation, an LLC can also elect to be taxed as a corporation. It’s not unusual for a profitable LLC, whose members work in the business to elect to be taxed as an S Corp. This allows the members to put themselves on payroll like any other employee and potentially save on self-employment taxes. In this scenario, the business is both an LLC (for legal purposes) and an S Corp (for tax purposes). (An LLC can also elect to be taxed as a regular corporation, but this is rare because of the double taxation problem that corporations face.) Anytime you start planning tax strategies, you should plan to sit down with both your accountant and your business attorney.
What is an operating agreement?
An operating agreement is the formal governing document for an LLC. The operating agreement tells us who owns the LLC, what their percentage of ownership is, what they are required to contribute to the business, how management decisions are made, what happens if a member wants to leave the business, and even what should happen if there is a dispute between the members.
Why does my single-member LLC need an operating agreement?
Even if you are the sole owner of your LLC, you still need an operating agreement.