A limited liability company (LLC) is a form of business that protects a business owner’s personal assets from legal claims against the business. Unlike with limited partnerships, protection extends to all members of the LLC, including those with managerial authority.
If the election to tax the LLC as an S corporation (S-corp) is made, then the profit paid to the owner beyond their salary is not subject to self-employment tax. This may result in thousands in savings. LLCs have the distinct advantage of combining partnership flexibility with the limited liability protection of S-corps.
Key Takeaways:
- LLCs may have a single member or unlimited members.
- LLCs are considered the most flexible ownership structure of US business entity types.
- LLC members must pay a 15.3% self-employment tax on entity earnings—unless the LLC elects to be taxed as an S-corp.
- LLC benefits include limited personal liability, pass-through taxation, limited annual paperwork, and flexible ownership requirements.
How LLC Taxation Works
Single-member LLCs
A single-member LLC is a disregarded entity for income taxes. This means that its taxable income is reported directly on the owner’s individual tax return. Farming activity is reported on Schedule F, rental activity is reported on Schedule E, and other trade or business income is reported on Schedule C.
Multi-member LLCs
Multi-member LLCs are taxed as partnerships and not taxed at the entity level. This means that federal income tax is not due with the filing of Form 1065 Form 1065 is the IRS tax form used to report the income and expenses of partnerships and LLCs with more than one member. . Instead, self-employment tax and federal and state income tax are assessed at the personal level for each member.
Electing Alternative Tax Treatment
Single-member and multi-member LLCs have the option to be treated as either C corporations (C-corps) or S-corps.
- C-corps pay a low 21% income tax rate on all earnings but are faced with double taxation when dividends are paid.
- S-corps are taxed similarly to partnerships, but earnings beyond a member’s salary are not subject to self-employment tax.
LLCs file Form 8832 to be treated as C-corps and file Form 2553 to be treated as S-corps.
Best Candidates for LLC Structure
An LLC can be comprised of a single member or multiple owners and is a great option for those needing flexibility in their business ownership structure. You don’t have to be a US citizen to create or be a member of an LLC.
The following entities may benefit from LLC structure:
- Individually-owned business: You can set up an LLC even if the only member is the owner. As mentioned earlier, single-member LLCs are generally disregarded by the IRS.
- Multi-owner business: If you are organizing a business with other owners, an LLC offers the most flexible option for partner type and quantity while providing limited liability protection.
- Foreign national business owner: When compared to other entity types, an LLC is generally the best business structure for non-US citizens.
- Business with passive owners: Businesses may have owners who want to invest financially without being a part of the day-to-day operations. This structure can be accommodated through a Manager-Managed LLC.
- Anonymously owned business: With anonymously owned businesses, ownership details are not made public. Delaware, New Mexico, and Wyoming allow for anonymous LLCs, but a registered agent is still required.
- Real estate endeavors: In most cases, real estate should not be put in C-corps due to double taxation on appreciated assets. This factor makes real estate companies good candidates for LLCs.
When an LLC May Not Be Right
- Businesses with multi-state operations: While many existing LLCs operate across state lines, the legal protection of LLC structure has not been extensively tested outside of the state of formation. Inquiries on the scope of the LLC protection should be directed to your attorney.
- Businesses with tax-exempt investors: Tax-exempt entities are generally not subject to income tax. However, they may be subject to tax if they have investments that generate unrelated business income tax. This kind of tax may be generated from LLC operations.
Legal Considerations for LLCs
There are important factors that should be assessed to protect the longevity of the organization. The following legal considerations should be evaluated when setting up an LLC:
- Operating agreement: It’s best for your operating agreement to be drafted under the guidance of an attorney; however, it is legal for you to prepare your own. The document should include the structure of operations, profit and ownership allocation, the process for transferring ownership or dissolving the entity, and basic identifying information—such as the business name, EIN, and entity purpose.
- Business insurance: While an LLC can help shield your personal assets, your business assets still need to be protected. LLC insurance helps protect against the loss of physical assets and one’s own wrongful acts, which is not covered under LLC liability protection.
- Multi-state operations: While an LLC may be organized in one state, operations in other states can subject the LLC to the laws of multiple states. This may create an administrative burden on the LLC or inhibit operations altogether.
- State vs federal law: For IRS purposes, LLCs are generally subject to the same treatment as partnerships. Many states follow the federal LLC treatment for tax purposes but are not required to. In addition, federal partnership treatment does not apply for purposes of determining the legal rights and responsibilities of members. Those elements are determined by the state of LLC formation.
How to Start an LLC
To start an LLC, you’ll need to perform the following:
- Confirm the availability of the name. Generally, no more than one entity can be registered to a single name. Name availability can generally be confirmed on each state’s website. LLC applications using a pre-registered name will be rejected.
- Identify a registered agent. A registered agent is a person or business who receives official communication on behalf of the LLC and is generally required by the state as part of the formation process. External registered agents generally require a fee for their services, but in many cases, you are allowed to perform the role yourself.
- Create an operating agreement. This is a legally binding contract outlining the roles and responsibilities of all relevant parties. Additional components should include the business purpose, income allocation percentages, voting rights, and processes for terminating and acquiring interest in the company. While it is legal to create your own LLC operating agreement, note that this document is legally binding and should be created under the guidance of an attorney.
- File Articles of Organization. This required document is filed with the state and includes basic details about your business. A registration fee is generally required for this filing, and state fees and requirements may vary.
Most jurisdictions minimally require the following items to be included at a minimum:
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- business name
- registered agent
- address of main business location
- contact information
- purpose of the company
Most state websites contain systematic instructions for LLC setup. Failure to follow state guidelines for registration may result in the state denying liability protection for the LLC.
Additionally, some states require that an LLC with professional ownership register as a Professional Limited Liability Company (PLLC). Examples of professionals who may be required to register as a PLLC include lawyers, doctors, accountants, and engineers. Also, certain types of businesses may be barred from being LLCs, like banking and insurance companies.
Frequently Asked Questions (FAQs)
An LLC is a legal entity that protects an owner’s personal assets from legal claims. It provides the tax advantages of a partnership with the legal protection of a corporation.
LLC benefits include limited personal liability, pass-through taxation, limited annual paperwork, minimal ownership restrictions, and flexible taxation options (such as being taxed as an S- or C-corp).
Disadvantages include the 15.3% self-employment tax and the possibility of default termination that could result from state law.
The main purpose of an LLC is to prevent legal claims from affecting the assets of the owners.
LLC owners are paid through cash transfers from the business account to their personal bank accounts. However, owners are taxed on their allocation of the LLC’s net income, irrespective of how much cash is withdrawn. If the LLC is taxed as an S-corp, the LLC owner is paid a reasonable salary, which may be supplemented by cash withdrawals.
Bottom Line
An LLC protects the owner’s assets from legal claims. They are considered to be the most flexible ownership structure of US business entity types and allow for an unlimited number of members. Electing to be taxed as an S-corp can save a business owner thousands of dollars in taxes. LLCs can be set up directly on the respective state website or established through an online legal service.
