If you’re considering creating a business, a limited liability company (“LLC”) can be a great choice given its “limited liability” (as the name implies) and its flexible tax options. This article will detail some of the basics you need to know about LLCs before you decide whether it’s the best option for your business. We’ll discuss LLCs generally, what and LLC is, how to create an LLC, and how LLCs are managed. In addition, we’ll look at how other business types (i.e., partnerships, and corporations) compare. To conclude, we’ll discuss the advantages and disadvantages in creating and operating an LLC. To begin, let’s discuss the basic concept of an LLC.
What is an LLC?
An LLC is a distinct business entity that uniquely combines the powers held by a partnership and a corporation. One of the ways that an LLC compares to both a partnership and a corporation is how the individuals comprising the LLC are described. Where a partnership has “partners” and a corporation has “shareholders,” an LLC has “members.” Interestingly, however, members are not limited to people. Rather, a member of an LLC can be a partnership, a corporation, or another LLC. A general advantage—and distinct comparison with partnerships—is the LLC’s ability to have only when member, also known as a “single-member LLC” (although sometimes not permitted, depending on your state’s regulations). Luckily, almost any business can qualify as an LLC, however, there is an exception for certain businesses like law firms and doctor’s offices, which are often referred to as “professional partnerships.”
What is Required to Create an LLC?
Unlike a partnership but like a corporation, certain documentation is required to create an LLC. This is known as the “Articles of Organization” (also known as a “Certification of Organization” or a “Certificate of Formation”) The Articles of Organization must be filed with your state—specifically, the Secretary of State—to create a valid LLC. However, before the Articles of Organization can be filed with the Secretary of State, there are some other steps that need to be taken beforehand.
Steps Needed to Create an LLC
To create an LLC, there are some basic prerequisites required, and certain elements that need to be included, in your Articles of Organization. First—although this seems obvious—you need to pick a name for your LLC. The state (and other entities and/or persons) need to be able to identify you. But more importantly, you’ll want to pick a name for your LLC to ensure that that name is not already taken. To ensure the desired name is available, a search can typically be done on your state’s formation website. You’ll also want to pick the state in which you’ll form your LLC. Interestingly, you are permitted to form an LLC in any state, even if you don’t plan on doing business there. While this is an option, it seems logical to create your LLC in the state where you live/and or the state where you plan to conduct the LLC’s business. In addition, you’ll want to apply for a federal tax ID number and understand the annual reporting requirements that the LLC will be subjected to (not discussed in detail here).
The LLC Operating Agreement
Another, more significant step in preparing to form your LLC and filing your Articles of Organization with the state is the creation of an operating agreement. Put simply, an operating agreement sets out the duties and responsibilities of the members and how the LLC will be operated. The operating agreement should explain—in detail—how disputes will be handled amongst members, what will happen if other problems occur (i.e., what will happen if a member dies, what will happen if a member no longer wants to manage the business, etc.), the vote required to approve transactions, the division of ownership, and more.
Articles of Organization Requirements
Once you’ve gotten through the prerequisites to filing your Articles of Incorporation, you’ve gotten through the hard part, as much of what will need to be included in the Articles of Incorporation is information you will now already have. For example, the LLCs name. This is a required element in the Articles of Organization, along with principal location and purpose of the business. In addition, you’ll want to name a “registered agent” in your articles. A registered agent is someone who, amongst other things, can be served with legal documents if the LLC is sued (like a person, an LLC can also be sued). You should also include how the partnership is to be managed (i.e., “member-managed” or “manager-managed,” discussed below). Sometimes, you’ll need to include the names and addresses of the members, depending on your state’s requirements. Lastly, and one of the disadvantages of an LLC (discussed in detail below), is having to pay the fee to file the Articles of Origination. The filing fee ranges from state to state, but generally, you can expect a fee ranging from $100-$800. For a complete list of requirements, you’ll want to speak with the office of the Secretary of State, or an attorney experienced in business formation.
Now that you know how to create an LLC, let’s discuss some more basics you should know about LLCs. Namely, how an LLC is managed. One of the possible advantages of the LLC is flexible management. Unlike general partnerships, where each partner has an equal right to manage the partnership, and a limited partnership, where general partners are required to manage the partnership and the limited partners are prevented from doing so, typically, a choice can be made as to how an LLC will be managed. An LLC can be “member-managed,” where all members share in the management responsibilities of the LLC, or an LLC can be manager-managed—which is exactly as it sounds. A manager (or managers) will manage the LLC, and the remaining members “back” the LLC, meaning their primary responsibility is providing the LLC with capital (the money needed to start and maintain a business).
However, all members, whether they are a member of a member-managed or manager-managed LLC, “own” the LLC. In fact, ownership is a prerequisite to being a member in an LLC. To be an owner, and accordingly, a member of an LLC, a capital contribution is required. The contribution can be money, services, and/or property, and is made in exchange for an ownership interest in the LLC (which should be detailed in the operating agreement).
LLCs v. Partnerships
Remember, at the beginning of the article, we discussed that an LLC, while it is its own unique business entity, essentially encompasses the best of both partnerships and corporations. While this article has discussed how an LLC can be compared with a partnership throughout, here are some highlights as to what you should remember when trying to determine whether a partnership or an LLC will be the best business type for you.
“Less Accountability Means More Liability”
A good rule to remember is, the less regulation involved and the more “hassle” it is to maintain the business, the more risk to the people (or entities) that make up the business. Look at a general partnership, for example. There are no documents required to create a partnership; there are no filing costs, partnerships aren’t required to file annual reports with the Secretary of State, etc., and the partners ultimately bear the consequences—they don’t have the option to limit their liability. If the partnership (or a partner) “goes down,” the other partners are going down, too. This makes sense: more accountability equals less risk. In this way, an LLC more closely favors a corporation rather than a partnership.
While the additional reporting requirements and regulations can be a drag, it also can make your business seem more credible. Knowing that your business is subject to reporting requirements and regulations will give those people and/or entities that you provide services to peace of mind knowing that you’ll be “playing by the book.” While additional reporting requirements and regulations can be seen as trouble, ultimately, it can serve as an advantage if you’re willing to compromise on the additional time and effort it could take.
As discussed above, an LLC can very much favor a partnership. Of course, the main difference between an LLC and a partnership boils down to limited liability. Where general partners are responsible for all partnership debt (and can be held personally liable), LLC members do not take on the debt of the LLC or its members. But how can a real distinction be made between the two, when really, the only variation between an LLC and partnership comes down to limited liability? This is where an operating agreement comes in handy. Ultimately, the operating agreement (although optional), can be your only safeguard against losing limited liability. Outlining the rules on how the internal affairs of the LLC will be conducted—including the duties of the members and what members are responsible for—will not only provide a single point of authority on all matters concerning the LLC, but it will also provide the protection that partnerships inherently lack. Unfortunately, the fact that you went through the formation process to create an LLC, which is not required of a partnership, is likely not enough to keep you from losing limited liability.
The other similarities between LLC and partnerships are the tax advantages that come along with both. Both LLCs and partnerships have the option of “pass-through” taxation, meaning that the LLC’s members can report the LLCs income in their personal tax returns rather than reporting it separately. We will discuss this more below, along with the other tax options an LLC has, but for now, keep in mind that LLCs enjoy the same tax advantages that partnerships do.
LLCs v. Corporations
Now that we’ve compared LLCs and partnerships, let’s highlight how LLCs compare with corporations. An LLC is like a corporation in so far as the regulations and reporting requirements they are subjected to, and the more “formal” process required to create an LLC (directly contrasted with a partnership, discussed above). While it is not discussed in detail here, you should note that corporations come in two forms: the “S-Corporation,” and the “C-Corporation.” How an LLC compares with a corporation will vary based on what type of corporation you are considering.
Membership Interest v. Stock
While an LLC’s members are said to have an “ownership” or “membership” interest in an LLC, and shareholders are said to have “stock” in a corporation, an ownership interest and stock are essentially the same. A member of an LLC will make a capital contribution that will directly correlate to their ownership interest (example: if your capital contribution is $10,000 and the total capital contribution from all members equals $100,000, you’d have a 10% interest). A shareholder of a corporation’s stock represents their fractional ownership—entitling the shareholder to a portion of the corporations’ profits and/or assets equal to how much stock they own. As you can see, although LLCs and corporations utilize different terms to define ownership—and shareholders make a purchase where members a contribution—the concept of “ownership” is ostensibly the same.
As discussed above, an LLC is either managed by its members (member-managed) or managed by members who are designated as “managers” (manager-managed). Unlike an LLC, a corporation has a clear power structure that devises the management authority to “directors” and “officers” who are elected through shareholders. While shareholders own the stock (and subsequently each own fractions of the business), they have no real say in the day-to-day management. Instead, the shareholders elect board members and officers to manage the corporation.
One of the more significant advantages that both LLCs and corporations have is limited liability. To be discussed in more detail below, all members of an LLC enjoy limited liability, meaning that they aren’t personally liable on the LLCs debts (with exceptions, also discussed below). Both the owners and managers maintain limited liability. As discussed above, the distinction between “owners” and “managers” is associated with whether the LLC is member-managed or manager-managed. However, don’t let this confuse you. Remember, everyone that is a member is an owner, as ownership is a prerequisite to membership. Accordingly, all members (“owners”) have limited liability. A corporation’s directors, officers, and shareholders (whether an S-Corp or a C-Corp, all maintain limited liability at every level. In this way, LLCs bear a strong resemblance to corporations and simultaneously differ from partnerships.
Advantages of an LLC
An LLC is an attractive business option due to the wide realm of advantages an LLC has when it comes to taxation and limited liability. LLCs are notorious for their favorable tax options. As discussed above, an LLC retains the ability to avoid paying taxes directly. Rather, each member can report the LLC’s income and losses on their personal tax return. This is known as “pass-through taxation.” In this way, an LLC is like a partnership (and other types of partnerships, such as limited partnerships (“LPs”)). However attractive pass-through taxation may be, an LLC is not bound to this taxation type. A significant advantage of the LLC is its members’ ability to choose how to be taxed. For example, an LLC might strategically choose to be taxed as a corporation.
“Limited Liability” as an Advantage
The primary advantage to an LLC is that all members have “limited liability,” meaning that members are not personally liable on the LLCs business debts. This means if the LLC is sold or becomes bankrupt, a creditor is prohibited from pursuing the members’ personal assets. However, limited liability is not absolute, and there are well-founded exceptions to limited liability. For example, a member that intentionally harms someone (maybe a client of the LLC, someone whom the LLC does business with, etc.) will not have limited liability. This exception also applies to a member that gives a personal guarantee on a bank loan or business loan, with the LLC subsequently default on the said loan. Of course, fraudulent, or illegal activity will also cause a member to lose limited liability—and this makes good sense. Limited liability should not be extended to members who intentionally (or even mistakenly) engage in fraudulent activity and take advantage of a business ultimately created to protect its members.
While the exceptions to limited liability may appear daunting, commonsense steps can be taken to avoid personal liability. For instance, it is always recommended to keep your personal assets separate from the LLC’s assets (co-mingling your assets with the LLCs assets will never end well). Another tip to avoid losing limited liability is providing adequate funding for the LLC. Ultimately, if the LLC has adequate funding, there won’t be much need to co-mingle your assets with those of the LLC. The biggest tool to assist members in avoiding losing their limited liability is the operating agreement, discussed more above.
Disadvantages of an LLC
Surprisingly, the disadvantages associated with an LLC are minimal—truly making it one of the best business types available (depending on the needs of your business). Certainly, it can be agreed that, under almost all circumstances, the advantages outweigh the disadvantages. Most of the disadvantages are associated with the exceptions to limited liability (discussed above). However, there are some more nuanced disadvantages that you might want to consider.
Dissolution of an LLC as a Disadvantage
Although some states permit single-member LLCs, other states prohibit them. Like a partnership in states that don’t recognize single-member LLCs, the death of an LLC member can result in the LLCs dissolution. However, also like in partnerships, buy-sell agreements can be utilized through the LLCs operating agreement, and can permit remaining members to purchase the deceased member’s interest, preventing dissolution. So, while this could be seen as a disadvantage, depending on your state’s regulations, it’s a preventable disadvantage.
The Cost of an LLC as a Disadvantage
One of the more basic disadvantages of an LLC is that it will cost more to create and manage and LLC than it would a sole proprietorship or a partnership, for example. Not only is an initial filing fee required, but states often impose other ongoing fees, such as those associated with required annual reports. To understand the total costs associated with an LLC (in your state), call the Secretary of State, who can provide you with specifics on the fees your state will require.
Transfer of Ownership as a Disadvantage
One disadvantage that an LLC has over a corporation is the ability to transfer “ownership” of the LLC. In this way, an LLC is much like a partnership in that you can’t be forced to be a partnership with someone you don’t want to be partner with. The same applies here in a sense. In an LLC, each member must agree to the addition of a new member and agree to any alternation as to ownership percentages. This is contrasted with a corporation, where the corporation can sell stock to increase the corporation’s ownership. Typically, unless a corporation utilizes a “shareholder agreement,” a shareholder is free to sell their stock.
Is the LLC the right business type for me?
Ultimately, the LLC is an advantageous business structure with little disadvantage involved. Since LLCs can be used for almost any business, whether the LLC is right for your business will largely be dependent on the goals of your business and personal preference. If you’re willing to endure the additional reporting requirements in exchange for limited liability and the tax advantages that come with an LLC, then an LLC could be a viable option. Please note that this article is not meant to be a complete guide on LLCs, and you should consider, among other things, doing some of your own research, consulting an attorney experienced in business formation, and your Secretary of State, to develop a complete understanding of LLCs and to determine whether an LLC will be right for your business.