A Limited Liability Company, also known as an LLC, is a type of business structure that combines traits of both a sole-proprietorship and a corporation. An LLC is eligible for the pass-through taxation feature of a partnership or sole proprietorship, while at the same time limiting the liability of the owners, similar to a corporation.
As the LLC is not considered a separate entity, the company does not pay taxes or take on losses. Instead, this is done by the owners as they have to report the business profits, or losses, on their personal income tax returns. However, just like corporations, members of an LLC are protected from personal liabilities, thus the name Limited Liability.
Limited Liability Companies are recognized in all 50 states and the District of Columbia. In most states any type of business can form an LLC, though some state laws may require at least two members in order to form one.
Advantages of an LLC
- The members of an LLC have protection against liability. They cannot be held liable for company losses, or debts and business credit, and their personal assets (such as a house or car) cannot be recovered by the debtors.
- LLCs have the freedom of selecting any form of profit distribution, which does not have to be in the ratio of the ownership between different members.
- LLCs do not have a legal requirement to conduct formal meetings, maintain minutes of the meeting, or record resolutions.
- Benefits similar to a corporation are available without going through any incorporation formalities.
- Pass-through taxation principles apply and the company itself is not taxed unless it opts for being treated as a regular corporation. All business profits, losses, and expenses are accounted for by its individual members. Members have to show the earnings in their individual tax returns and accordingly pay taxes. This allows the avoidance of double taxation by way of corporate tax payment along with the individual income tax.
Disadvantages of an LLC
While the advantages largely benefit most small businesses, certain aspects of an LLC can prove to be disadvantageous. This is especially true for larger organizations. Some of the disadvantages of an LLC are:
- LLCs have a limited life and are usually dissolved when a member dies, or if the company faces bankruptcy.
- LLCs cannot go public, as there are no shares or shareholdings. For the same reason, issuing shares to employees through stock options is not possible.
- Even though the paperwork and the complexities associated with LLCs are significantly less than those required for forming a corporation, its formation is still substantially more complex than a partnership or sole-proprietorship.
In most states, an LLC can be created simply by filing the “articles of organization” and paying the required filing fee. This document is also known as a “certificate of organization” or a “certificate of formation”. Some states have an additional requirement of publishing an intention to create an LLC in a local newspaper. Another part of forming an LLC is the operating agreement, which is not compulsory in most states, but is highly recommended. This document explicitly states the rights and responsibilities of the LLC owners.