What is a limited liability company (LLC)?

A limited liability company (LLC) is a business structure created under state law that combines elements of a corporation and a partnership but is neither a partnership nor a corporation. Many small business owners wonder if they should form an LLC for their business to formalize their operations. It’s an important decision that could have an impact on everything from what you owe in taxes to your legal liability. As a result, it is particularly important to consult with qualified tax and legal advisors when deciding whether and how to form an LLC. Here’s a look at how LLCs work.

What are the advantages of an LLC?

An LLC is generally considered one of the easiest ways to structure a business in the U.S., and the paperwork to start one is relatively simple. Beyond this, LLCs have a flexible management structure. Owners are called “members,” and LLCs can be run by either the members or managers who are not members. Both multi-member and single-member LLCs are allowed by most states, and there is no maximum number of members. There are some restrictions: for example, banks and insurance companies generally cannot be LLCs.

Like a corporation, an LLC generally brings the members personal liability protection from the business’s debts and liabilities — members are generally liable up to their investment in the LLC. LLCs with at least two members are typically taxed as partnerships by default for U.S. federal income tax purposes unless they file IRS Form 8832 and affirmatively elect to be treated as a corporation. If the multi-member LLC is taxed as a partnership by default, it brings flow-through taxation, which means that the LLC does not pay taxes on its income at the entity level; instead, the LLC’s income, deductions, gains and losses flow through to its members, who then report those amounts on their individual tax returns via Schedule K-1. If there are losses, the members may generally use these to offset other income they have earned, subject to certain loss limitation rules. Single-member LLCs are typically treated for U.S. federal income tax purposes as disregarded entities, with the owner reporting the LLC’s gains, credits, deductions and losses on their individual U.S. federal income tax return.

What are the drawbacks to LLCs?

If a member leaves an LLC or dies, the LLC agreement — and in some cases, certain states — may require the remaining members to dissolve the LLC, reestablish it and refile the paperwork. Other states, however, may allow an LLC to continue to operate after an owner dies, particularly if the LLC agreement calls for it. Beyond this, the limited liability protection of an LLC isn’t 100% bulletproof. If the members have not taken other steps to establish the business as a legal entity, like setting up an operating agreement and respecting other governance formalities, someone could “pierce the corporate veil” in a lawsuit and go after the members’ personal assets.

What is required to set up an LLC?

The members will likely need to obtain an Employer Identification Number (EIN) from the IRS and have a unique business name and a registered agent — either one of the members or a third party such as an attorney or accountant who is authorized to receive legal papers for the members. In some states, the registered agent must live in the state where the LLC is being formed. Some states also require members to file what is generally known as a certificate of formation or articles of organization, typically with the Secretary of State or a business agency in that state. These forms generally require submission of the following information:

• LLC name
• The names of the founding members or managers (in some states)
• The name and address of the registered agent
• A statement of purpose for the LLC