What Is an LLC and How Does It Work? Everything You Need to Know

Limited liability companies (LLCs) are a popular choice for many business owners in the US. But with various business structures available, how do you know if an LLC is the right fit for you?

For instance, how you set up your business can impact its taxes, creation and operating expenses, and owners' liability.

In this article, we explore LLCs in detail, including their features, advantages, and disadvantages, to help you decide whether this option is suitable for your business.

Interested in learning more about setting up a business? Best Financial offers tools and resources to help you get started.

Short on time? Here are the key takeaways

• LLCs combine the limited liability of a corporation with the tax advantages of a sole proprietorship or partnership, protecting owners' personal assets from business debts and avoiding double taxation.
• LLCs offer flexible management and ownership arrangements and fewer compliance obligations than corporations.
• Establishing and maintaining an LLC can be more costly than other structures; members must pay self-employment taxes, and ownership transfer can be complex.
• You should seek professional legal and financial advice about the best choice for your business before deciding.

What is a limited liability company (LLC)?

An LLC is a business structure that limits its owners' personal liability while offering flexible taxation. In effect, an LLC combines the tax features of a sole proprietorship or partnership with the limited liability of a corporation.

Each state has its own laws for setting up and running an LLC. Generally, an LLC’s owners are called members. LLCs can have just one member (single-member LLCs) or many (multi-member LLCs). Anyone can be a member, including individuals, foreign corporations, and other LLCs—the only exception is that banks and insurance companies can’t be members.

LLCs are a popular choice for US businesses of all sizes. For instance, Google, Pepsi-Cola, and IBM are LLCs. Due to their limited liability, LLCs are also popular with professions like lawyers and accountants, although some states restrict certain professions from forming LLCs. For example, in California, licensed professionals must form a professional corporation instead.

Let’s take a closer look at the main features of an LLC.

Limited liability

LLCs have a separate legal identity from their owners, meaning they can’t be held responsible for the business’s debts and liabilities. This separation protects owners’ personal assets from creditors if the business owes money or files for bankruptcy.

Pass-through taxation

From a tax perspective, LLCs are “pass-through entities” by default. Rather than being subject to federal corporate tax, the LLC’s profits and losses pass to the owners, who declare them on their personal tax returns and pay tax on them at an individual level. This avoids the double taxation that corporations pay. However, LLCs can elect to be taxed at a corporate level instead.

Forming an LLC

The specific steps for forming an LLC vary between states. Check with the relevant formation agency—usually the Secretary of State’s office—in the state where you want to form your LLC.

Here are the steps usually required to set up an LLC:

1. Choose and register a business name. Your business name must be unique, and you usually must register it with the relevant state formation agency. Use the Small Business Administration’s tool to find the appropriate agency in your state. To check if a business name is already in use, start with the US Patents and Trademark Office. State formation agencies also have a search tool on their websites.
2. Choose a registered agent. LLCs must have a registered agent—an individual located in the formation state who can receive legal and tax documents on behalf of the business. Businesses often use a registered agent service provider, such as Northwest Registered Agent or LegalZoom, for example.
3. File articles of organization in the state where you want to form your LLC. Articles of organization set out basic information about the business, including its name, purpose, and details of its owners and registered agent. These forms are available from the formation agency in the state where you’re starting your business. Here is an example from Minnesota. You also need to pay a filing fee. These vary between states and can range from $35 to $500.
4. Apply for a federal employer identification number (EIN). Most businesses require an EIN—a federal tax identification number issued by the Internal Revenue Service. You can apply for an EIN online for free.
5. File a beneficial ownership information (BOI) report. You have 90 days from forming your LLC to notify the federal Financial Crimes Enforcement Network (FinCEN) about the ownership of your business. You can do this online.
6. Create an operating agreement. While not always a legal requirement, most LLCs have an internal operating agreement that sets out how the LLC will work, including decision-making processes, profit-sharing arrangements, and member roles.
7. Obtain any necessary business licenses and open a business bank account. The licenses you require may depend on your industry and the nature of your business. The Small Business Administration is a valuable source of information regarding business licenses. While not legally required, having a separate business bank account is good practice.
8. Check whether your LLC needs to register to do business in other states. Each state has its own criteria, but if you have any operations or sales in another state, you likely need to register with the relevant business formation agency to do business there legally.

Benefits of an LLC

Here are some advantages of forming an LLC.

• Limited liability. An LLC’s limited liability is one of its most attractive features for business owners, especially compared to the unlimited liability of sole traders and partnerships.
• Avoids double taxation. Unlike C corporations, LLCs aren’t taxed at the corporate level. Instead, their members are taxed individually on the business’s profits and losses.
• Flexible ownership and management. There are few restrictions on LLC ownership, and they can have unlimited members. Plus, members can choose to manage an LLC themselves or appoint a management group. This offers more flexibility than corporations.
• Fewer compliance obligations. LLCs aren’t required to hold annual meetings and adopt bylaws like corporations are.
• Flexible profit distribution. Ownership and profit distribution in a corporation are fixed based on a shareholder’s number of shares. In an LLC, members can decide on ownership percentages and profit distribution as they wish.

Drawbacks of an LLC

Here are some disadvantages of forming an LLC.

• Establishment costs. With initial filing and annual fees, LLCs can be more expensive than a sole proprietorship or partnership.
• Self-employment taxes. While LLCs don’t pay federal corporate tax, members must pay self-employment taxes on the profits. This may not be an ideal tax arrangement for some members.
• Ownership transfer is more complex. While ownership is easily transferred in a corporation by transferring shares, LLCs typically need member agreement to add a new member. They must also amend their operating agreement to reflect the change in ownership
• Mandatory dissolution. Several states require LLCs to be dissolved when a member dies or goes bankrupt, meaning the LLC can’t continue beyond its members.

Is an LLC the best choice for your business?

Now that you know what an LLC is and how it works, you can consider whether it's the right structure for your business. Remember, while the limited liability and pass-through taxation features are attractive for many business owners, there are also formation costs involved and potentially complex ownership transfer arrangements.
It’s essential to seek professional legal and financial advice before deciding on the best way to set up your business based on its circumstances and needs.
To learn more about structuring your business, check out our article on the differences between an LLC and an S corp. For further resources on setting up a business, investing, insurance, and more, explore our helpful resources on Best Financial.

FAQs

What is the biggest disadvantage of an LLC?

The most significant disadvantage of an LLC is that it costs more to set up and run than a sole proprietorship or partnership. You must pay filing fees to form your LLC, and many states impose annual fees.

Does an LLC pay less tax?

LLCs may pay less tax than corporations by avoiding double taxation. Corporations pay corporate tax and shareholders are also taxed individually on the profits they receive. In comparison, LLC profits and losses aren’t taxed at a corporate level. Instead, they pass on to the LLC’s members, who are then taxed at an individual level.

Why is an LLC less risky?

An LLC is less risky than a sole trader or partnership because it limits owners’ personal liability for the business’s debts. An LLC is a separate legal entity from its owners. This separation protects owners’ personal assets from creditors if the business owes money or goes bankrupt.

Disclaimer

This article is an informational overview and is not intended as legal or financial advice. Whether an LLC is right for your business can vary based on individual circumstances and the relevant laws, which change regularly. While we aim to provide current and reliable information, we cannot guarantee the completeness or accuracy of this information. We strongly recommend consulting with a qualified attorney or financial advisor to address your specific needs and ensure compliance with all relevant laws.