The “owners” of an LLC are referred to as “members.” Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations, other LLCs, and even other entities.
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, just like the owners of a partnership would.
Forming an LLC
While each state has slight variations to forming an LLC, they all adhere to some general principles:
- Choose a Business Name. There are 3 rules that your LLC name needs to follow: (1) it must be different from an existing LLC in your state, (2) it must indicate that it’s an 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.
- File the Articles of Organization. The “articles of organization” is a simple document that legitimizes your LLC and includes information like your business name, address, and the names of its members. The form is provided by and filed with your state’s LLC office. For most states, you file with the Secretary of State.
- Create an Operating Agreement. Operating agreements are not required by most states and are not filed at your state office. However, an operating agreement is highly recommended for multi-member LLCs because it structures your LLC’s finances and organization, and provides rules and regulations for smooth operation. Percentage of interests, allocation of profits and losses, member’s rights and responsibilities, and other provisions are usually included here.
In the eyes of the federal government, an LLC is not a separate tax entity, and therefore the business itself is not taxed. Instead, all federal income taxes are passed on to the members of the LLC and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states do, so check with your state’s income tax agency.
Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole proprietorship. Certain LLCs are automatically classified and taxed as a corporation by federal tax law.
Advantages of an LLC
- Limited Liability. Members are protected from personally liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members are not required to satisfy the claims with their personal assets. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means “limited” liability – members are not necessarily shielded from their or their employees’ tort actions, such as accidents.
- Less Recordkeeping. An LLC’s operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork and there are smaller start-up costs.
- Sharing of Profits. There are also fewer restrictions on profit-sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat-equity. Consequently, it’s up to the members themselves to decide who has earned what percentage of the profits or losses.
Disadvantages of an 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 out. 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, should a member decide to leave the business.
- Self-Employment Taxes. Members of an 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.
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