Limited liability company: definition of the legal structure
Would you like to start a company? Theoretically, there are many legal forms to choose from. Liability, the required start-up capital, and formal aspects, are important criteria that you should take into account when deciding on a specific legal form. LLCs are one of the most important business types in America today and you don’t even need to be an American citizen to start one! But what exactly is an LLC and what are the advantages and disadvantages?
- What is an LLC?
- How much is the capital contribution?
- Who is liable for the company and its members?
- The hierarchy of a limited liability company
- Taxing a limited liability company
- Advantages and disadvantages of an LLC
What is an LLC?
An LLC is the least complex business structure and unlike an S corporation or a C corporation, its structure is also really flexible. The members cannot be held personally reliable for any debts or liabilities the company might incur, which means that owners are protected from lawsuits and bankruptcy. If the company goes bankrupt, the members don’t have to sell any of their possessions to cover the settlement.
A limited liability company is a popular business structure that provides the benefits of both a partnership and a corporation. An LLC provides its owners with corporate-like protection against personal liability.
LLCs are a kind of hybrid company, since they combine characteristics of a corporation and a partnership or sole proprietorship. The fact that it is limited liability makes it similar to a corporation, but the flow-through taxation to the members makes it similar to a partnership. The LLC itself doesn’t pay income tax. Instead, the owners report any profits and losses on their personal tax returns.
How much is the capital contribution?
All members of an LLC put money into the business to get it off the ground. This amount is known as a capital contribution or a contribution to the ownership. By giving this capital contribution, it means you now have a share in the LLC, which in turns gives you the right to a percentage of the profits that the company makes, but also to any losses it might incur. If you are the only person running the company then you have 100% of the ownership, but if there are several owners, the amount of shares each person has is usually determined by a formal operating agreement. You can read more about this in our article titled “Creating an LLC”. The contributions don’t necessarily have to be money, they could also be property, for example. The members must agree on how much the non-cash item is worth.
The initial capital contributions can be any amount, but generally, they are enough to cover startup expenses and assets. If you aren’t able to make a contribution, this could land you in hot water regarding legality and taxes, since you don’t have a personal risk in starting your business.
Making the contribution in the first place is very easy: you simply have to write a check and deposit it in your new business account. Depending on what your business is, a few hundred dollars might be sufficient to get it up and running.
Who is liable for the company and its members?
It’s very important to follow the rules concerning LLCs, otherwise you could find yourself in legal trouble if the limited liability of the company is compromised. When everything goes to plan, members are shielded from the company’s debts and most lawsuits. The only exception is that LLC members could be liable for any employee claims that occur, such as work accidents.
If an LLC has to close, members will only be liable for the amount of money they invested. If an LLC goes bankrupt, members won’t have to fear losing any personal items.
Member will lose their limited liability if they commit fraud using the company, or mix this business with their own business. They also lose this liability if they try to sabotage the company in any way.
The hierarchy of a limited liability company
Similar to corporations, LLCs also have certain titles when the business is more than a single member limited liability company (SMLLC). As with the running of the LLC, these titles and roles are also relatively informal. There are two main titles for an LLC: members and managers.
The members are the “owners” (similar to how a corporation has shareholders). The members are expected to choose the manager and there isn’t a limit to how many there can be: most states even allow single-member LLCs. How much involvement each member has depends on what was agreed upon in the Articles of Organization.
The managers are elected by the LLC’s members. The manager is the person who runs the business and acts as the contact person for the public. They have the authority to make day-to-day decisions to keep the business running smoothly. The number of managers depends on the number of members and the size of the company. Having managers isn’t compulsory though: the members may decide to manage the company equally.
Taxing a limited liability company
An LLC is not a taxing entity and isn’t recognized by the Internal Revenue Service for tax purposes. It can be taxed as a partnership or a corporation (for several members), or as an entity separate from its owner (for a single-member LLC).
Taxing for single-member LLCs
LLCs with a sole member are taxed as sole proprietorships. Schedule C needs to be filled out, which includes the LLC’s income, expenses, and net income. The net income entered in Schedule C needs to be entered in line 12 of the owner’s personal tax form (usually Form 1040). Despite this, the owner and the LLC still remain separate entities when it comes to taxes.
Taxing for multiple-member LLC
If an LLC has more than one member, then it’s normal for it to be taxed as a partnership. Taxes aren’t paid directly to the IRS; the individual partners actually pay tax depending on the size of their share in the LLC. The partnership needs to fill out Form 1065, then a Schedule K-1 is prepared for each of the partners, which contains the company’s profits and losses. The K-1 is be filed with the partner’s own tax return, and the gain/loss is shown on Form 1040.
State income tax
All businesses pay federal income taxes, and most states pay state income tax depending on whether the particular state imposes it or not. Your state’s department of revenue can reveal how you can expect your business to be taxed. There are two factors:
- What is the tax based on? The majority of states use the federal income tax liability as the basis, but some states choose to alter the basis for the tax that they impose.
- How does the LLC’s tax classification affect the state income tax? The classification refers to whether your company is sole proprietor, partnership, corporation, etc.)
Advantages and disadvantages of an LLC
A limited liability company might be the least complex business structure, but it doesn’t come without its drawbacks. We’ve compiled a list of the pros and cons of LLCs so you can decide whether this business structure is for you.
Advantages of an LLC
- Easier taxes: You don’t need to file a corporate tax return, since LLC owners report profit and loss on their personal tax returns. This also means that double taxation can be avoided.
- Less paperwork: LLC are less stringent meaning there is less paperwork to fill out. The company will be governed by the default rules in your state.
- Legal stability: The “limited liability” in the name means that you aren’t personally responsible for any debts the company might incur.
- Increased credibility: Partners and suppliers may favor your business over others since more commitment is shown.
- Flexible management structure: The owners can decide to implement any organizational structure.
Disadvantages of an LLC
- Limited potential for growth: Owners aren’t allowed to distribute shares to attract investors.
- Lack of uniformity: Different states treat LLCs differently. It may be confusing to abide by all the rules if you operate across multiple states.
- Role confusion: LLCs don’t have specific roles within the companies, so it can be difficult to know who is responsible for what. An LLC Operating Agreement can clarify the roles.
- Difficult to transfer ownership: All current owners must approve any new owners and any alterations made to the owner shares.