Limited Liability Companies: What Startups Need to Know

A limited liability company is a hybrid legal structure that provides limited liability features of a corporation and tax efficiencies and operational flexibility of a partnership.

The "owners" of an LLC are referred to as "members." Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns via K-1’s, just like partnership owners. Below we discuss the steps in forming a LLC, LLC taxes, and the advantages and disadvantages of a LLC.

Forming a LLC

While each state has slight variations to forming a LLC, they all adhere to some general principles:

1. Choose a Business Name. In choosing a business or company name: (1) it must be different from an existing LLC in your state, (2) it must indicate that the business is a LLC (such as "LLC" or Limited Company") and (3) it must not include words restricted by your state (such as "bank" and "insurance"). Your business name is automatically registered with your state when you register your business, so you do not have to go through a separate process.

2. File the Articles of Organization. The "articles of organization" is a document that legitimizes your LLC and includes information like your business name, address, and the names of its members. For most states, you file the articles of organization with the Secretary of State and pay a filing fee.

3. Draft an Operating Agreement.  An operating agreement is highly recommended because it is often required to open a bank account. Also, for multi-member LLCs, an operating agreement structures your LLC's finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, member's rights and responsibilities and other provisions.  Additionally, the operating agreement often includes key buy-sell provisions that allow the members to understand what will happen to their ownership, if anything, upon their death, disability or desire to sell their interests.

4. Obtain Licenses and Permits. Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality.

LLC Taxes

The IRS does not view a LLC as a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC's members and are paid through their personal income tax.

Because the IRS does not recognize a LLC as a business entity for taxation purposes, all LLCs must file taxes as a corporation, partnership, or sole proprietorship tax return.  

A LLC Member should file the following tax forms depending on your classification:

    Single Member LLC. A single-member LLC files Form 1040 Schedule C like a sole proprietor.

    Partners in an LLC. Partners in an LLC file a Form 1065 partnership tax return like owners in a traditional partnership.

    LLC filing as a Corporation. A LLC designated as a corporation files Form 1120, the corporation income tax return. A LLC may elect to be taxed as a C-Corporation or S-Corporation.

Combining the Benefits of an LLC with an S-Corp

LLC Members may elect to tax the company as a S-Corporation. Typically members make this election when the company pays payroll taxes.  To make this election, the Member must file IRS Form 2553 prior to the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.

The LLC remains a limited liability company from a legal standpoint, but for tax purposes it can be treated as a S-Corporation.

Advantages and Disadvantages of LLC

Advantages of LLC

Limited Liability

Members are protected from personal liability for business decisions or actions of the LLC. If the LLC incurs debt or is sued, members' personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Limited liability means "limited" liability, members are not necessarily shielded from wrongful acts, including those of their employees.

Less Recordkeeping

A LLC's operational ease is one of its greatest advantages. Compared to a corporation, LLCs have less startup paperwork and generally less costs.

Sharing of Profits

LLCs have few restrictions on profit sharing and members may distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity. Consequently, the members decide who has earned what percentage of the profits or losses.

Disadvantages of LLC

Limited Life

In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.

Self Employment Taxes

Members of a LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.