Limited Liability Company (LLC)
- How It's Taxed
- An LLC combines the advantages of a corporation’s limited liability protection with a partnership’s pass-through taxation.
- An LLC may be managed solely by the owners, called members, or the members may appoint one or more managers to run the business on a daily basis. An LLC is therefore characterized as member-managed or manager-managed.
- An LLC is formed by filing Articles of Organization with the Secretary of State (or equivalent formation agency) in each state.
- An LLC allows considerable flexibility in determining the organization’s management structure. A written operating agreement among the members controls matters such as how management will be organized, rights of members, allocation and distribution of profits and losses, and transferability of memberships.
- State LLC Acts provide default provisions that will govern the LLC if the members do not enter into an operating agreement or if the operating agreement is silent on a given topic.
- An LLC has several tax classifications to choose from depending on the number of members, their relationship (as husband and wife) and the formation state.
- For a sole proprietor who wants pass-through tax treatment to avoid double taxation plus the advantage of limited liability protection without the additional formation and recordkeeping requirements of a corporation, an LLC is a simple and cost-effective solution.
- For multiple owners seeking limited liability protection not afforded to a general partnership, an LLC offers several advantages over a corporation:
- Members enjoy pass-through tax treatment without having to meet the requirements for shareholders to receive S Corporation pass-through tax treatment;
- Members are permitted to have different percentage allocations of profits and losses in an LLC that are prohibited for shareholders in an S Corporation;
- Members have far greater flexibility through an operating agreement to define their rights and obligations than can be achieved in the corporation context with bylaws and minutes.
- Members of an LLC may be individuals, partnerships, limited partnerships, trusts, estates, associations, corporations, other limited liability companies, or other entities, whether domestic or foreign.
- An LLC may be formed with only a single member, thereby providing the owner with limited liability protection not offered by a sole proprietorship. When there are multiple members, the structure is much like a partnership.
- If the members are in a passive role, a manager is appointed to run the LLC’s business on a daily basis. A manager-managed LLC is more like a corporation with a board of directors and officers.
- With a written operating agreement, the members have great flexibility to define their respective rights and responsibilities, powers, profit and loss-sharing arrangements, and rights or restrictions on transferring ownership interests.
- Certain fundamental rights of members cannot be changed and other rights may be changed only by a written operating agreement. If no operating agreement is prepared, state LLC Acts contain “default” provisions that will apply.
- An LLC is not required to have officers and most don’t. They are permitted, however, and may help define the roles and authority of members in a member-managed LLC.
How It’s Taxed
The tax classifications available to an LLC vary based on the number of members, their relationship and the formation or residency state. Unless an LLC elects to be taxed as a corporation, profits and losses with be passed through to the members in accordance with their percentage ownership interests. The LLC is does not pay taxes as an entity at the federal level.
A single member LLC is automatically treated as a disregarded tax entity, the same as a sole proprietor, giving it pass-through tax treatment. However, a single member LLC may choose to be taxed either as a C Corporation or an S Corporation. This may be done to avoid unfavorable tax treatment in the formation state for an LLC that doesn’t apply to an entity taxed as a corporation. Also, a single member LLC would enjoy the simplicity of the LLC formation but choose to be taxed as an S Corporation to be able to receive a portion of the profits of the business in the form of a salary and a portion as a distribution that is not subject to self-employment taxes.
A multiple-member LLC is automatically taxed as a partnership. A general partner’s allocable share of partnership income is typically self-employment income, which is subject to self-employment taxes.
When an LLC is taxable as a partnership, a member’s eligible share of income may be treated one of three ways: (1) as net earnings from self-employment, (2) as salary or wages, or (3) as distributable shares of partnership income. Self-employment income incurs an additional tax of 15.3 percent.
Can one person operate as an LLC?
Yes. In the early days of LLCs, they were taxed as partnerships and a minimum of two people were required. When the IRS adopted regulations allowing greater flexibility for LLC tax treatment, single member LLCs were permitted and all states now allow them.
Does an LLC provide better limited liability protection than a corporation?
The limited liability protection is essentially identical. In fact, many state laws simple say provide that the liability of members for obligations of an LLC is the same as for shareholders in a corporation. There are circumstances in which both shareholders and members may be held personally liable for the obligations of a corporation or LLC, but these are not common.
What is the difference between an LLC and an S Corporation?
A corporation structure consists of shareholders, directors, and officers. State laws have extensive provisions regulating the rights and limitations of each position in a corporation. An LLC has less statutory regulation, more flexibility in choosing management by members or managers, and more flexibility to defining the role of the parties through a written operating agreement. An LLC has fewer restrictions than an S Corporation for pass-through tax treatment. There are restrictions on the type and number of shareholders that are permitted in an S Corporation that are not imposed on the member-owners in an LLC. Corporations must hold annual meetings of shareholders and follow certain other record keeping requirements not legally required of an LLC.
What is the difference between an LLC and an LLP?
An LLP, or Limited Liability Partnership, is a special type entity that is allowed for only certain types of professionals. These typically include attorneys, accountants, architects, and a few other professions depending on the particular state laws or licensing board regulations. The licensees form an LLP for additional liability protection that would not exist in a partnership where all partners have personal liability for the partnership’s obligations. In an LLP, a partner is not personally liable for the obligations of the LLP unless his conduct created or contributed to the liability.
What is the difference between an LLC and a PLLC?
An LLC is an accepted business form in every state and any type of business is usually allowed to operate as an LLC entity. A PLLC, or Professional Limited Liability Company, is an entity type reserved for certain licensed professionals. Only about 30 states authorize the formation of a PLLC and about 11 of those not allowing a PLLC will allow licensed professionals to operate through a regular LLC.
Is an LLC required to pay tax on its profits?
Unless an LLC chooses to be taxed as a C Corporation, it will be a pass-through tax entity. All profits and losses will be reported by the members on their personal tax returns and they’ll pay income taxes on their share at their individual income tax rate. The LLC does not pay tax at the federal level. At the state level, depending on the state, an LLC may have to pay a franchise tax (usually a privilege tax not based on income or profits) or a gross receipts tax that is based on the LLC income or assets.
Do I have to hold meetings or keep minutes in an LLC?
State laws do not require an LLC to hold annual meetings of members or document meetings in written minutes like a corporation. This is often touted as a significant advantage of the LLC over corporations. However, in a small business corporation, meetings are not required because all actions may be approved by written consent minutes signed by shareholders or directors without any meeting. Also, the types of events or activities for which minutes should be prepared are often greatly misunderstood as being far more inclusive than really necessary. Lastly, while state laws don’t require LLCs to keep minutes, this has no bearing on the IRS where minutes may be an aid in the event the LLC is audited.
Why should I have an operating agreement?
When the states enacted statutes enabling the formation of LLCs, they placed the main responsibility on the LLC members to adopt their own governing document to specify how the LLC would be managed and operated. State LLC Acts are primarily “default” provisions that provide a safety net of sorts with only essential provisions to protect certain rights of members. They do not cover many important topics that members would request in an operating agreement and they often have consequences that the members would not choose in their own customized operating agreement.
A well-prepared, customized operating agreement, like a partnership agreement, will reflect the exact relationship that the members desire for their business, defining their respective duties, responsibilities, rights, powers, profit and loss allocations, and requirements and restrictions on transferring ownership interests.