Starting a business is half the battle won, but choosing the right structure is just as important. One popular choice for entrepreneurs and small-business owners is the Limited Liability Company (LLC). An LLC blends flexibility with legal protection, making it a practical choice for various business types.
At Remitly, we understand that managing business and finances can feel like a complex battlefield, especially when dealing with international transactions. Just as we strive to simplify sending money across borders, this guide will help demystify LLCs. We’ll explore what an LLC is, its benefits and drawbacks, and how to determine if it’s the right choice for your business.
What is an LLC, and what are its benefits for entrepreneurs?
Let’s start by defining what an LLC is and looking at the main benefits for entrepreneurs.
Definition of Limited Liability Company
A Limited Liability Company (LLC) is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability protection of a corporation. This means that the business owners, also known as “members,” are generally not personally liable for the company’s debts and obligations.
Key features of an LLC
- Limited liability: As mentioned, this is a primary benefit. LLC members’ personal assets are protected from business debts and lawsuits
- Pass-through taxation: The business itself doesn’t pay federal income tax. Profits and losses are “passed through” to the LLC members’ personal income tax returns.
- Flexible management structure: LLCs can be managed by the members themselves (member-managed) or by appointed managers (manager-managed)
- Relatively easy to set up and maintain: Compared to corporations, LLCs generally have fewer administrative requirements, although they do vary by state
- Credibility: An LLC structure can validate a business’s credibility with customers, vendors, and lenders
Benefits: liability protection and flexible taxation
The two main benefits of an LLC are liability protection and flexible taxation.
Liability protection is handy for safeguarding personal assets, as long as the LLC is properly operated. If the business incurs debts or faces a lawsuit, the members’ personal assets, such as their homes and savings, are generally protected. Nevertheless, the liability protection is not absolute. LLC members can still be held liable for their own negligence or wrongdoing.
LLCs provide flexibility in how they are taxed. By default, they are taxed as pass-through entities, but they can also elect to be taxed as an S corporation or a C corporation, depending on eligibility and what’s most advantageous for the business.
Understanding the tax advantages of an LLC
One of the biggest advantages of an LLC is its tax flexibility. Let’s explain the tax implications in more detail.
Overview of pass-through taxation
Pass-through taxation is the standard tax treatment for LLCs. This means that the business itself doesn’t pay income tax. Instead, the profits and losses of the LLC are “passed through” to the LLC members’ personal income tax returns. Members then pay income tax on their share of the profits at their individual income tax rates.
Differences between an S corporation and a C corporation for LLCs
While pass-through taxation is the default, LLCs can choose to be taxed as either an S corporation or a C corporation:
S Corporation (S Corp): An LLC can elect to be taxed as an S Corp to potentially reduce self-employment taxes. While members still pay income tax on their share of the profits, they can also be considered employees and receive a salary. Only the salary is subject to self-employment taxes, but the remaining profits may be taxed at a lower rate. However, S Corp status comes with stricter requirements. For example, members must be US residents or citizens, and a maximum of 100 shareholders is permitted.
C Corporation (C Corp): An LLC can also elect to be taxed as a C Corp. C Corps are subject to double taxation, meaning the business pays corporate income tax on its profits, and then members pay personal income tax on any dividends they receive. This structure is generally less advantageous for small businesses but may be suitable for businesses seeking significant outside investment.
How LLCs affect personal tax returns
The tax treatment of a limited liability company (LLC) directly influences how owners report business income on their personal returns. LLCs provide flexibility in tax classification, with three primary options affecting individual filings:
- Pass-through taxation: By default, single-member LLCs treated as disregarded entities report profits and losses on Schedule C attached to Form 1040. Multi-member LLCs file Form 1065, with income flowing through to individual K-1 forms. Each member then uses Schedule E on their Form 1040 to report income shown on their K-1.
- S corporation election: Owners drawing a reasonable salary receive W-2 wages, while remaining profits are distributed via K-1 forms, which are taxed as ordinary income but are not subject to self-employment taxes.
- C corporation classification: This structure is less common for small businesses, and requires owners to report dividends on Schedule B. If applicable, capital gains/losses from selling ownership interests are reported on Form 8949.
Determining if an LLC is the right business structure for you
Let’s consider how to determine if an LLC is the best fit for your business.
Evaluating your business needs
To determine if an LLC is right for you, consider the following questions:
- Liability protection: How important is it to protect your personal assets from business debts and lawsuits?
- Tax flexibility: Do you want flexibility in how your business is taxed?
- Administrative complexity: How much time and effort are you willing to devote to compliance and paperwork?
- Future plans: Do you plan to seek outside investment or grow your business significantly?
Comparing LLC and other entity types
Sole proprietorship
With a sole proprietorship, there’s no legal separation between the owner and the business. All income flows to Schedule C, with unlimited personal liability for debts.
General partnership
A general partnership means partners share profits/losses through Schedule K-1 and Schedule E of their personal tax returns. Each partner has joint liability for business obligations.
Corporation
A corporation is a more complex structure that is legally separate from its owners. There are two main types:
- C corps: Subject to corporate income tax plus shareholder-level taxes on dividends (double taxation)
- S corps: Avoid double taxation, but impose strict ownership rules and salary requirements
Consideration factors: liability, management, costs
Three vital factors guide entity selection:
1. Liability exposure
- LLCs and corporations create legal separation between business and personal assets
- Sole proprietorships/partnerships leave owners fully liable for business debts
2. Management requirements
- LLC operating agreements allow customized management structures
- Corporations mandate boards of directors and shareholder meetings
3. Formation/maintenance costs
- LLCs often have lower startup costs than corporations
- Corporations incur higher annual compliance fees and administrative burdens
Who benefits most from having an LLC?
While LLCs can be suitable for many businesses, some benefit more than others.
Entrepreneurs and small-business owners
LLCs work well for:
- Freelancers and gig workers (e.g., graphic designers, Uber drivers)
- Retailers and food businesses with physical inventory
- Immigrants building side hustles while employed elsewhere
- Independent contractors
Ideal scenarios and business types for LLCs
Here are some ideal scenarios and business types for LLCs:
- Businesses with moderate risk: If your business has a moderate risk of lawsuits or debt, an LLC can provide valuable protection
- Businesses with multiple owners: LLCs are a good choice for businesses with several owners, as they offer flexibility in profit sharing and management
- Real estate investors: LLCs are commonly used by real estate investors to protect their personal assets from liabilities associated with their properties
- Consultants and service providers: Professionals like consultants, designers, and web developers often choose LLCs
Drawbacks of forming an LLC
While an LLC offers many benefits, you need to understand the potential downsides before deciding if it’s the right structure for your business.
Potential disadvantages to consider
- Costs: Starting and maintaining an LLC usually costs more than a sole proprietorship due to filing fees and ongoing state requirements
- Limited investment opportunities: Some investors prefer the stock structure of corporations, which can make fundraising harder for LLCs
- Self-employment taxes: By default, LLC owners pay self-employment taxes on all profits. You can elect corporate taxation to potentially reduce this, but that adds complexity.
- Limited lifespan: In certain states, an LLC may dissolve if a member leaves or passes away—unless your operating agreement states otherwise
Self-employment taxes and their implications
LLC owners usually pay self-employment tax on their share of the business’s profits. This covers Social Security and Medicare contributions. Although this is similar to what sole proprietors pay, it can be a drawback compared to corporate structures, where only salaries (not profits) are taxed this way. Choosing to be taxed as an S corp may reduce this burden, but it comes with stricter rules and reporting requirements.
Missteps to avoid when operating an LLC
To keep your LLC in good standing and protect your liability shield, watch out for these common mistakes:
Mixing personal and business finances
Use a separate bank account for your business. Blurring the lines can weaken your liability protection.
Not having an operating agreement
This document outlines member roles, responsibilities, and procedures. It helps prevent internal disputes and strengthens your legal footing.
Failing to comply with state regulations
Missing deadlines for filings or fees can result in penalties or even dissolution. Stay organized and on schedule.
Not maintaining accurate records
Keep clean, detailed records of all financial transactions and decisions. It’s paramount for taxes, legal protection, and business growth.
Step-by-step guide to establishing an LLC
If you decide that an LLC is the right business structure for you, here’s a general step-by-step guide to establishing one.
Naming your business and filing requirements
- Choose a business name: Select a name that complies with your state’s naming requirements and is available. You’ll normally need to check name availability with your state’s Secretary of State or similar agency.
- Appoint a registered agent: A registered agent is a person or entity designated to receive legal and official documents on behalf of the LLC
- File articles of organization: This is the primary document that formally creates the LLC with the state. It includes information about the LLC’s name, address, and registered agent
- Pay filing fees: Most states in the US require a fee to file the Articles of Organization
Creating an LLC operating agreement
An operating agreement is an internal document that outlines how your LLC will be run. While not always required by law, it’s highly recommended, even for single-member LLCs. Having an operating agreement helps prevent misunderstandings and proves your LLC is a legitimate, well-organized business. It also strengthens your liability protection by showing you’re treating your business as a separate legal entity.
This agreement covers key details like:
- Ownership structure: Who owns what percentage of the business
- Management roles: Who will manage the LLC, and how decisions will be made
- Profit distribution: How profits and losses will be shared
- Procedures: What happens if a member leaves or the business closes
Managing and maintaining compliance with state laws
Once your LLC is established, you’ll need to manage it and maintain compliance with state laws, which may include:
- Filing annual reports: Most states require LLCs to file annual reports and pay a fee
- Maintaining a registered agent: Ensure your registered agent remains active and can be contacted
- Keeping accurate records: Maintain detailed financial and operational records
- Complying with tax requirements: File federal and state tax returns as required
FAQs
What is the primary benefit of forming an LLC?
The primary benefit of forming an LLC is the limited liability protection it offers to its members. This means that their personal assets are generally protected from the business’s debts and lawsuits, as long as the LLC is properly operated.
How is an LLC taxed by default?
An LLC is not taxed as a separate legal entity. Instead, by default, it is considered a pass-through entity, meaning that the profits and losses are reported on the members’ personal income tax returns.
What is an operating agreement, and why is it important for an LLC?
An operating agreement is a legal document that outlines the ownership structure, management responsibilities, profit and loss allocation, and other key aspects of an LLC. It’s important because it helps to avoid misunderstandings among members and provides a framework for how the LLC will operate.
Can an LLC choose to be taxed as a corporation?
Yes, an LLC can elect to be taxed as either an S corporation or a C corporation by filing the appropriate forms with the Internal Revenue Service (IRS). This election can be made for various tax planning reasons.
What are some of the ongoing requirements for maintaining an LLC?
Ongoing requirements for maintaining an LLC include filing annual reports with the state, paying annual fees, maintaining a registered agent, and complying with state and federal tax laws. Specific requirements vary by state.
Who is best suited to form an LLC?
LLCs are often a good choice for entrepreneurs, small-business owners, businesses with multiple owners, real estate investors, and consultants who want liability protection and tax flexibility without the complexities of a corporation.