A limited liability company, or LLC, is a hybrid business structure that combines the simplicity, flexibility and tax advantages of a partnership with the liability protection of a corporation.
What is an LLC?
An LLC can have one or many “members,” the official term for its owners. Members can be individuals or other businesses, and there is no limit to the number of members an LLC can have. With an LLC structure, members’ personal assets are protected from the business’s creditors.
LLC was first offered as a business structure option 40 years ago in Wyoming. Today, about 2.4 million U.S. businesses identify as LLCs, and their numbers are growing faster than any other business type, according to the IRS.
LLC: The pros
Choosing to structure your business as an LLC offers a number of advantages:
Members aren’t personally liable for actions of the company. This means that the members’ personal assets — homes, cars, bank accounts, investments — are protected from creditors seeking to collect from the business. This protection remains in place so long as you run your business on the up-and-up and keep business and personal financials separate. (More on this later.)
Pass-Through Federal Taxation on Profits
Unless it opts otherwise, an LLC is a pass-through entity, meaning its profits go directly to its members without being taxed by the government on the company level. Instead, they’re taxed on members’ federal income tax returns. This makes filing taxes easier than if your business were taxed on the corporate level. And if your business loses money, you and other members can shoulder the hit on your returns and lower your tax burdens.
An LLC can opt to be managed by its members, which allows all owners to share in the business’s day-to-day decision-making, or by managers, who can be either members or outsiders. This is helpful if members aren’t experienced in running a business and want to hire people who are. In many states, an LLC is member-managed by default unless explicitly stated otherwise in filings with the secretary of state or the equivalent agency.
Easy Startup and upkeep
Initial paperwork and fees for an LLC are relatively light, though there is wide variation in what states charge in fees and taxes. For example, Arizona’s filing fee for articles of organization is $50, while the fee in Illinois is $500. These variations aside, the process is simple enough for owners to handle without special expertise, though it’s a good idea to consult a lawyer or an accountant for help. Ongoing requirements usually come on an annual basis.
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LLC: The cons
Limited liability has limits
In a court proceeding, a judge can rule that your LLC structure doesn’t protect your personal assets. The action is called “piercing the corporate veil,” and you can be at risk for it if, for example, you don’t clearly separate business transactions from personal, or if you’ve been shown to have run the business fraudulently in ways that resulted in losses for others.
By default, the IRS considers LLCs the same as partnerships for tax purposes, unless members opt to be taxed as a corporation. If your LLC is taxed as a partnership, the government considers members who work for the business to be self-employed. This means those members are personally responsible for paying Social Security and Medicare taxes, which are collectively known as self-employment tax and based on the business’s total net earnings.
On the other hand, if your LLC files forms with the IRS to be taxed as an S corporation, you and other owners who work for the company pay Social Security and Medicare taxes only on actual compensation, not the whole of the company’s pretax profits.
Consequence of member turnover
In many states, if a member leaves the company, goes bankrupt or dies, the LLC must be dissolved and the remaining members are responsible for all remaining legal and financial obligations necessary to terminate the business. These members can still do business, of course; they’ll just have to start a whole new LLC from scratch.
How to start your LLC
- Choose a name: Register a unique name in the state where you plan to do business. To make sure someone else doesn’t have your business name, do a thorough search of online directories, county clerks’ offices and the secretary of state’s website in your state — and any others in which you plan to do business. For a fee, many states let applicants reserve an LLC name for a set period of time before filing articles of organization.
- Choose a registered agent: The registered agent is the person you designate to receive all official correspondence for the LLC. It’s crucial that you nail down who this person will be before filing articles of organization, because states generally require you to list a registered agent’s name and address on the form. Though people within the company are usually allowed to serve in this role, states maintain lists of third-party companies that perform registered-agent services.
- File articles of organization: This is the step that essentially brings your LLC into existence. States request basic pieces of information about your business, which, if you’ve thought through your business plan and structure, should not be hard to provide. You’ll be asked to supply details like name, principal place of business and management type.
- Get an employer identification number: The IRS requires any business that has employees or operates as a corporation or partnership to have an EIN, a nine-digit number assigned to businesses for tax purposes. The rule applies to LLCs because, as creations of state laws, they’re classified for federal tax purposes as either a corporation or a partnership.
- Draw up an operating agreement: Your operating agreement should include specific information about your management structure, including an ownership breakdown, member voting rights, powers and duties of members and managers, and how profits and losses are distributed. Depending on the state, you can have either a written or oral agreement. Many states don’t require one, but they’re a useful thing to have.
- Establish a business checking account: It’s generally good housekeeping to keep business and personal affairs separate. Having a separate checking account draws a bright line between the two. This is critical if you want to mitigate any potential risk to your personal assets if a lawsuit calls into question your business practices.
Learn how to start your business
NerdWallet has rounded up some of our best information on starting a business, including structuring and naming your company, creating a solid plan and much more. We’ll help you do your homework and get started on the right foot.
For more information on how to start a small business, check out our Small Business Guide.
Updated July 28, 2017.