Everything You Need To Know About LLCs: How They Work, Pros, and Cons

he limited liability company (LLC) is a popular and versatile entity structure for small businesses. But exactly what is an LLC, and how does it work?

An LLC is a legal entity that limits the personal liability of its members, shielding their personal assets from business-related debts and lawsuits. LLCs allow small business owners to reap the advantages of a corporation while still enjoying the simplicity and pass-through taxation benefits of a partnership. 

LLCs provide the benefits of both partnerships and corporations, offering entrepreneurs flexibility, tax advantages, and liability protection.

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How LLCs work

LLCs provide small businesses with a strong foundation for growth and success while minimizing risks associated with entrepreneurship. Understanding how LLCs work will help you determine if it's the right fit for your business and navigate the process of establishing one.

Formation process

You'll form your LLC by submitting the necessary paperwork to the designated state agency. While each state has its specific requirements, the general process is similar. You’ll need to choose a name, make sure that name is available in your state, file the required paperwork, and pay a fee.

Ownership structure

LLCs offer a flexible ownership structure, allowing for single or multiple members, called owners. These members can be individuals, other LLCs, or even corporations. LLC profits are usually distributed according to the size of each member's ownership stake. However, the operating agreement can establish alternative distribution rules.

Management structure

LLCs can be member-managed or manager-managed. In a member-managed LLC, all members are actively involved in the day-to-day operations and decision-making. In contrast, a manager-managed LLC designates one or more managers, who can be members or nonmembers, to oversee the business. You can outline the management structure and decision-making processes for your LLC in the operating agreement.

Taxation

By default, LLCs are considered pass-through entities for tax purposes. This means that profits and losses are passed to the members, who report them on their individual tax returns. This structure helps avoid the double taxation faced by corporations. However, LLCs can also choose to be taxed as C corporations or S corporations if it suits their needs.

Compliance requirements

LLCs are subject to various compliance requirements depending on the regulations in your state. These may include:

• Annual report filing to update information and pay a filing fee
• State taxes and fees, such as registration fees
• Business licenses and permits based on the nature of your business
• Accurate and up-to-date records of your LLC's financial transactions, meeting minutes, and other pertinent documentation

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Pros of LLCs

LLCs offer a range of benefits that make them an attractive option for many small businesses.

• ‍Limited liability protection: One of the primary advantages of an LLC is the limited liability protection it provides to its members. When you’re an LLC member, you aren't personally liable for the business's debts or legal obligations, so your personal assets are protected from potential losses.‍
• Flexible taxation: By default, LLCs use pass-through taxation.  LLC profits and losses are reported on each member's individual tax return, which helps avoid double taxation. However, LLCs can elect to be taxed as C corporations or S corporations based on the business's needs and the preferences of its members.‍
• Flexible management structure: LLCs also offer flexibility in terms of management, as they can be structured as member-managed or manager-managed. You can choose the most suitable management style based on the operational needs and preferences of the members.‍
• Easy formation: The process of setting up an LLC is generally less complex and time-consuming compared to forming a corporation. You can quickly establish your legal structure and begin operations. A detailed look at forming an LLC is outlined later on.‍
• Ability to raise capital: While LLCs may not issue shares like corporations, they can still raise capital through various means, such as attracting new members or obtaining loans.‍
• Perpetual existence: An LLC can have a perpetual existence, meaning it can continue operating indefinitely, even if a member leaves or passes away. That perpetual existence can provide businesses with long-term stability and continuity.

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Cons of LLCs

While LLCs offer numerous advantages, they also come with some potential drawbacks.

• ‍Self-employment taxes: In an LLC with pass-through taxation, members are considered self-employed and must pay federal self-employment taxes on their share of the business's profits. These taxes include Social Security and Medicare, which can be a significant expense for members.‍
• Limited life span in certain states: Although many states allow LLCs to have a perpetual existence, some states require an LLC to specify a limited life span. In these cases, the LLC will automatically dissolve after the designated time, which can impact long-term planning and stability.‍
• Potential difficulty in raising capital: While LLCs can raise capital by attracting new members or obtaining loans, they can't issue shares like corporations. Because investors often prefer to buy shares when investing in a business, LLCs can have a harder time raising capital and attracting investors than corporations.‍
• Potential personal liability in certain situations: Although LLCs generally offer limited liability protection, members may still be personally liable in specific scenarios, such as if they guarantee a loan, engage in fraudulent or illegal activities, or breach fiduciary duties owed to the company and the other members.‍
• Complexity in some states: While forming an LLC is typically simpler than setting up a corporation, the process can still be complex in certain states with more stringent requirements or regulations. Additionally, an LLC operating in multiple states may need to register and comply with each state's regulations, increasing administrative complexity and costs.

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LLC vs. other business structures

If you've just begun looking into LLCs, you may wonder: Is an LLC a corporation, proprietorship, partnership, or something else entirely? When you're deciding what type of business entity to form, it's important to understand the differences between LLCs and other common structures, such as sole proprietorships, partnerships, and corporations.

LLC vs. sole proprietorship

A sole proprietorship is the simplest business structure, where a single individual owns and operates the business. Unlike an LLC, there is no legal separation between the owner's personal and business assets, leaving the owner liable for business debts and obligations.

Additionally, LLCs can choose their tax structure, while sole proprietorships are subject to self-employment taxes. However, LLCs require more paperwork and cost more to create and maintain than sole proprietorships.

LLC vs. partnership

A partnership is an unincorporated business owned and operated by two or more individuals. Similar to sole proprietorships, partners in a general partnership are personally liable for the business's debts and obligations, and profits and losses are passed to the partners for tax purposes.  

LLCs offer more flexibility in management structures and the distribution of profits. However, LLCs are generally more expensive to form and maintain than partnerships because general partnerships usually don’t have to file formation documents or annual reports.

LLC vs. corporation:

A corporation is a separate legal entity with shareholders, a board of directors, and officers. Corporations offer limited liability protection, but they are subject to double taxation, where the corporation pays taxes on its profits, and shareholders pay taxes on dividends received.

LLCs have a more flexible management structure compared to corporations, which require a more rigid hierarchy and adherence to corporate formalities.

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How to form an LLC

Forming an LLC involves several key steps, which may vary slightly depending on your state's specific requirements. Here's a general guide for how to set up a company as an LLC.

Choosing a name

Check with your state to determine the specific naming guidelines for LLCs. Typically, the name must include an LLC designator, such as LLC or Limited Liability Company, and avoid restricted words or phrases.

Registering with the state

File the Articles of Organization, sometimes called Certificate of Formation or Certificate of Organization, with the appropriate state agency, usually the secretary of state's office. You'll also have to pay a filing fee, which varies by state.

Drafting an operating agreement

Create an operating agreement outlining your LLC's internal structure, management, and profit distribution. While not always required by law, having a well-drafted operating agreement is crucial for defining the roles and responsibilities of members, documenting ownership stakes, and preventing disputes.

Obtaining necessary licenses and permits

Depending on your business type and location, you may need to obtain various federal, state, or local licenses and permits. These can include general business licenses, professional licenses, sales tax permits, or zoning permits. Research your industry and location to determine which licenses and permits apply to your LLC.

Opening a business bank account

Establish a separate bank account for your LLC to maintain a clear boundary between your personal and business finances. Novo offers a full-featured, free business checking account that makes it easy to manage your LLC's finances to avoid mingling them with your personal finances.

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Final Thoughts

An LLC gives you flexible taxation and management options, making it an ideal solution for entrepreneurs seeking a balance between risk management, simplicity, and growth potential. As you weigh the pros and cons of forming an LLC, consider how this structure aligns with your business objectives and long-term goals.

Consider factors such as liability protection, taxation, management flexibility, capital-raising capabilities, and your state's specific requirements and regulations. Consult legal and financial professionals to ensure an LLC structure fits your business needs. Making an informed decision and diligently following the formation process can lay a strong foundation for your business's future success and growth.

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