What is a Limited Liability Company (LLC)

A limited liability company, or LLC, is a flexible business entity that provides many of the advantages of being a traditional corporation, including limited liability, while retaining many of the characertistics of unincorporated business entities, such as sole proprietorships  and partnerships.

An LLC allows its owners to avoid some of the more significant formalities and burdens imposed on traditional corporations, such as the need to appoint directors and to hold annual meetings.

While the owners of a corporation are referenced as shareholders or stockholders, the owners of a limited liability company are called "members". An LLC that is formed by a single individual is commonly described as a single-member LLC.

What Businesses Qualify to Become LLCs

Most businesses will qualify to form as LLCs, although the law does exclude certain categories of business. For example, banks and insurance companies may not be formed as LLCs.

The LLC can be attractive to businesses that might otherwise form as S Corporations, but would either have too many shareholders to qualify, or want to include owners who are not citizens or residents of the United States. Similarly, investment ventures that might previously have been formed as limited partnerships may find that the LLC provides a more suitable vehicle for managing assets while preserving protections against liability for passive investors.

Some states restrict professionals such as lawyers, accountants and doctors from forming as LLCs, or have a similar corporate form, the Professional Limited Liability Company (PLLC), for professional practices.

Limited Liability

Members of a limited liability company enjoy protection from individual liability similar to that afforded to corporate shareholders. That is to say, if a business is sued or is unable to pay its debts, the creditors can ordinarily only reach the LLC's assets and cannot reach the assets of the members beyond the value of their ownership interest in the LLC.

As with a corporation, a creditor may attempt to pierce the corporate veil of an LLC in an effort to reach the personal assets of an LLC member, based upon such factors as the allegedly wrongful conduct of its members, commingling of personal and business finances, or failure to observe required formalities.

The LLC does not protect a member from liability for the member's own wrongful acts, and members of an LLC should anticipate that if they use the LLC to advance their personal purposes or to perpetrate fraud, courts will hold them personally liable for the LLC's associated liabilities.

Members of an LLC can also potentially be held responsible for their own negligence and misconduct as well as for the actions of employees under their direct supervision, for actions intended to damage or defraud the LLC, and for debts of the LLC that they have personally guaranteed.

Articles of Organization

When starting an LLC, you must prepare Articles of Organization, to be filed with the state's corporations division along with a filing fee. Most states offer standard forms that may be used to prepare and submit articles of organization.

Typical Articles of Organization include:

  • The name and address of the LLC's principal office,
  • The names and addresses of the initial members (owners), and
  • The name and address of the LLC's registered agent, the person or company designated by the LLC to receive legal documents and notices.

Upon forming a LLC or converting an existing business into a LLC, before you may file your Articles of Organization with the state, some states require that you publish an announcement in a newspaper qualified to publish legal notices. The state's corporations division may maintain a list of newspapers qualified to publish legal notices, or you can inquire with your local paper and ask if it qualifies.

The Operating Agreement

When you starting an LLC, although generally not required by law, the members should create and approve an operating agreement for the LLC.

  • The operating agreement governs the operation and management systems for the LLC, and may direct the manner in which profits are to be divided.
  • The operating agreement may also include procedures for the departure or addition of LLC members, and the valuation of the LLC for purposes of buy-in or buy-out.
  • An operating agreement should describe the ownership interest of the members, their associated voting rights, and how profits are to be distributed among the owners.

Without an operating agreement the basic operation of the LLC will be governed by state law, and a state's default rules may not be advantageous to the LLC or the business it conducts. Under typical state law, if a member of an LLC quits, the LLC ceases to exist. Many LLCs would prefer that their operations continue even if a member departs, and thus provide for that contingency in their operating agreements such that the LLC continues to operate with its remaining members.

Unlike corporations, LLCs are not required to hold annual meetings or prepare annual reports. An LLC may nonetheless find it beneficial to voluntarily hold regular meetings, or to provide in its operating agreement that meetings be held before certain actions deemed important by the LLC's members.

There are many companies that offer standard LLC operating agreements that can be modified to suit the needs of the LLC and its members. It is helpful to have an attorney review the proposed final version of an LLC's operating agreement prior to its formal adoption, in order to ensure that it is complete, that its provisions are consistent with state law, and to ensure that its terms will benefit the business and its members.

Annual Fees and Taxes

It is important to investigate the fees and taxes that will be imposed by the state in which the LLC is formed, and any other state where it will conduct business, prior to forming as a LLC. Some states require that LLCs pay an annual franchise tax or registration fee.

For purposes of income taxation, the income of a limited liability company passes through to its members, who report the income on their personal tax returns. Thus, a single member LLC is treated as a sole proprietorship for purposes of income tax and, by default, a multiple member LLC is treated as a partnership.

The income members earn remains subject to income and self employment tax (Medicare and Social Security contributions), and members are responsible to pay those taxes.

  • In most cases, members will be required to make quarterly payments of their estimated tax liability, to both the state and to the federal government.
  • Members who do not play a management role in the LLC, but who instead simply receive a share of the profits by virtue of their ownership interest, may be exempt from paying self-employment taxes on those profits.

The LLC itself does not ordinarily pay taxes on its own behalf as a separate entity. An LLC will ordinarily be required to file an annual informational tax return with the IRS.

It is possible for an LLC to elect with the IRS to be taxed in the same manner as a C Corporation, in which case the LLC pays taxes on its retained profits at the corporate tax rate. As this election will last for a minimum of five years, and as there may be tax consequences for switching back to pass-through taxation, careful consideration must be taken before exercising this option, including the possibility that the business would be better served by forming as a corporation.

You should discuss the manner in which your LLC will be taxed with a qualified financial professional.

Securities Law

Most LLCs have few members, with the members being active participants in the operation and management of the LLC, such that securities laws don't come into play. However, if an LLC intends to have owners who are not actively involved in the business, or sell ownership interests in order to raise capital, it may be required to follow certain procedures and registration requirements set forth in state and federal securities laws.

Before engaging in activities that may implicate securities laws, it will benefit an LLC to obtain legal advice and to try to qualify for any applicable exemptions to the securities laws.

Know Your Local Law

Before you opt to become an LLC, make sure you have a full understanding of the state laws that will govern your operations, including any limits on the duration of your LLC, and the amount of any filing fees or annual fees associated with starting and maintaining an LLC.

Copyright © 2004 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on May 8, 2018.