What is an LLC? It may seem like an easy question, but the nuances are important. This article explores what makes these legal entities what they are.
What is an LLC?
An LLC is a legal type of business structure that is merely a collection of its owners with limited liability protection. It’s full name is Limited Liability Company.
We created these entities as a hybrid approach between a partnership and a corporation. Unfortunately, partnerships had too much personal liability and corporations had too much rigidity in its rules and taxes.
The legal structure of an LLC is the same as a sole proprietor (for one owner) or partnership (for more than one). Without an agreement otherwise, each member of the company is equal to all others. Fortunately, operating agreements regularly specify ownership percentages or portions.
In North Carolina, by default, each member is also a manager of the company. Therefore, he or she can make decisions for the company as well as bind it to contracts. You can change who management is in your operating agreement. If you specify who is responsible for a particular managerial role, it removes that power from all other members.
A unique aspect of the limited liability company structure is that, in most circumstances, a creditor cannot take the ownership interest from a member for the debt of that member. Instead, a member’s creditor can only take the profits that member was supposed to be paid. This helps prevent creditors from coming in an running the company. In states where that isn’t the default, you can specify this rule in the operating agreement.
Because you’re not dealing with shares of a company, you generally work with percentages. This creates more complicated scenarios if you want to issue more ownership from the company. It is my recommendation to create “units” or fake shares that signify how much of the company each member owns.
Limited liability companies have a different tax treatment than corporations by default. A single member LLC is disregarded for tax purposes just like a sole proprietor. You file these taxes directly on the owner’s 1040. If the LLC has more than one member, the taxes are pass through like a partnership. The company must complete a partnership return and submit a K-1 to each owner.
You can also specify a different tax treatment if you would like. Beyond disregarded and partnership, you can elect corporation or subchapter s corporation tax treatments when beneficial for you.
Common Myths About the LLC
Here are some common myths I’ve encountered regarding LLCs:
- Single member LLCs do not come with liability protection. This is untrue. All LLCs come with liability protection so long as you treat them as separate legal companies.
- LLC stands for Limited Liability Corporation. The “C” stands for “Company” because LLCs are not corporations.
- It is best to form your LLC in Delaware/North Dakota/Nevada/Etc. Mostly untrue. There are a lot of good reasons to form your LLC in Delaware if you’re a company that works United States or Worldwide. However, if you’re a local small business, you want (and need) to form your company in your state. There’s huge added cost and burden in forming in a state that is not your own. And, anytime you are thinking about forming your company in another state for anonymity reasons, it is a good way to risk jail time.
- S Corporation tax treatment is the best. Although a subchapter S tax election could benefit you, it is not always the best choice. You should do that math or seek professional advice before making that election.
In my opinion, LLCs are great. They offer a lot of flexibility and beneficial tax treatment. Especially in smaller business, it is hard to make a critical mistake by choosing LLC as your initial structure. Worst case: you operate for a year and see a slightly worse tax treatment than other choices. At that point, you can change.