A limited liability company (LLC) is a hybrid legal structure providing the limited liability features of a corporation with the tax efficiencies and operational flexibility of a partnership. The “owners” of an LLC are called “members.” Depending on the state, the members can be a single individual (one owner), two or more individuals, corporations or other LLCs. Unlike shareholders in a corporation, LLCs are not taxed as separate business entities, rather all profits and losses are “passed through” the business to each member of the LLC. The LLC members then must report the profits/losses on their personal federal tax returns in the same manner owners of a partnership would do.
Forming an LLC
Each state has slight variations as to how to form an LLC; however, they all follow the same basic principles:
- Choose a Business Name. You must follow three rules when naming your LLC: (1) it must different from an existing LLC in your state; (2) it must indicate that it’s an LLC (for example “LLC” or “Limited Company”); and (3) it must not include words restricted by your state (for example, “bank” and “insurance”). Your business name is automatically registered with your state when you register your LLC so there’s not a separate registration process.
- File the Articles of Organization. The “articles of organization” is a basic document that legitimizes your LLC and includes information such as your business name, address and the names of its members. In most states, you file the Articles with the Secretary of State. Some states require you file with a different office, such as the State Corporation of Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations and Commercial Code. There may also be an associated filing fee.
- Create an Operating Agreement. Most states don’t require an operating agreement; however, having an operating agreement is highly recommended for multi-member LLCs because it structures the LLC’s finances and organization, and provides rules and regulations for optimal operation. The Operating Agreement typically includes percentage of interests, allocation of profits and losses, members’ rights and responsibilities, and other provisions.
- Obtain Licenses and Permits. Once your business is registered, you must obtain the required business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool [1] on the Small Business Administration website to find a listing of federal, state and local permits, licenses and registrations required for your business.
- Announcing Your Business. Some states, such as Arizona and New York, require the extra step of publishing a notice in your local newspaper about your LLC. Check with your state’s business filing office for requirements.
LLC Taxes
According to the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Rather, all federal income taxes are passed on the LLC’s members and are thus paid through their personal income tax. While the federal government doesn’t tax income on an LLC, some states do. Check with your state’s income tax agency.
Since the federal government doesn’t recognize an LLC as a business entity for tax purposes, all LLCs must file a corporation, partnership or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law. Visit IRS.gov for guidelines on how to classify your LLC.
An LLC that is not automatically classified as a corporation can choose their business classification. To choose a classification, an LLC must file Form 8832. This form is also used if an LLC wants to change its classification status. Read more about filing as a corporation or partnership and filing as a single member LLC at IRS.gov.
Depending on your LLC’s classification, you should file the following tax forms:
- Single Member LLC: Form 1040 Schedule C like a sole proprietor.
- Partners in an LLC: Form 1065 partnership tax return like owners in a traditional partnership.
- Filing as a Corporation: Form 1120, the corporation income tax return.
Combining the Benefits of an LLC with an S-Corp
You can always request S-Corp status for your LLC. You’ll have to make a special election with the IRS to have your LLC taxed as an S-Corp using Form 2553. You must file prior to the first two months and 15 days of the beginning of the tax year in which the election is to take effect. An attorney can advise you on the advantages and disadvantages of changing to an S-Corp status.
The LLC would remain a limited liability company legally, but for tax purposes it would be treated as an S-Corp. Contact your state’s income tax agency about the tax requirements and if they recognize elections of other entities such as the S-Corp.
Advantages of a Sole Proprietorship
- Limited liability: Members of an LLC are protected from personal liability for business decisions or actions of the LLC. If the LLC incurs debt or is sued, the members’ personal assets are usually exempt. Remember that limited liability means “limited” liability in that members are not necessarily protected from wrongful acts, including those of their employees.
- Less recordkeeping: The operational ease of an LLC is one of its biggest advantages. There is less registration paperwork and smaller start-up costs compared to an S-Corporation.
- Sharing of profits: Members distribute the profits as they see fit so there are fewer restrictions on profit sharing.
It’s up to the members to decide who has earned what percentage of the profits or losses.
Disadvantages of a Proprietorship
- 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 in order to close business. However, you can include provisions in your operating agreement to prolong the life of your LLC should a member choose to leave the business.
- Self-employment taxes: Members of an LLC are considered to be 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.