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What is a Limited Liability Company (LLC) and Why it’s Great for Small Businesses

what is a limited liability company and why it's great for small businesses like this coffee shop

If you have a side gig and are thinking of turning it into a “real” business, then people have probably suggested that you should run it as an LLC. So, what is a limited liability company (LLC)? Is it really as great as people say it is?

Why, yes, the LLC is actually pretty great. It is a newish type of business format that is highly popular among small businesses. It’s easy to set up and maintain. Filing taxes as an LLC is fairly easy, and the LLC protects its owners from business liability.

Whether you’re a one-person business or a multiple-owner/multiple-investors business, the LLC is likely a great business format that meets all your needs. Read on to find out what the LLC can do for you.

What is a Limited Liability Company?

It’s not easy to define in just a few words what an LLC is. Instead, we’ll describe the various characteristics of an LLC, so you can have an overall sense of what is a limited liability company.

The limited liability company is often abbreviated—and maybe even better known as—the LLC. Note that the c stands for company, not corporation. A corporation is a very different type of entity, governed by a different set of laws.

The LLC is a business format recognized in the US but not yet widely accepted around the world. The details of what you can or cannot do as an LLC depends on the state where you formed your LLC. For instance, in some states, the LLC must dissolve if you want to add or remove members.

You can override some of these laws by having an operating agreement, much like how you can override default partnership laws through an operating agreement. We’ll go into the details of an operating agreement in Part 3 of our series on LLCs.

Who Can Own an LLC?

The LLC can be owned by one person or multiple people. It can also be owned by other LLCs, corporations, or partnerships. Each owner is called a member.

When an LLC has just one owner, it’s often called a single-member LLC. And, yes, when an LLC has many owners, it’s called a multi-member LLC.

Although some exceptions exist, the LLC can usually own other LLCs, corporations, or partnerships.

The LLC Limits the Personal Liability of its Owners

One of the major advantages of doing business as an LLC is that it limits the business liability of its owners.

The law treats an LLC as a “person” separate from its members. So, just like a real person, an LLC can go into debt, sign contracts, sue or be sued, declare bankruptcy, and similar.

Because the LLC is an entity separate from its owners, the owners aren’t (usually) held personally liable for the LLC’s liabilities.

Once Set Up, an LLC is Easy to Maintain

To set up an LLC, you’ll have to file some documents with the state. We’ll go into the mechanics of filing these documents in Part 2 of our LLC series.

Once the documents have been approved, you can start running your business as an LLC. To maintain the LLC, depending on the rules of your state, you might have to file a document every year or two to tell the state that the LLC is still an ongoing business.

Another part of maintaining an LLC is mostly internal. Since the law treats the LLC as a separate person, you (and your co-owners, if any) will need to treat the LLC as a separate person too. This means setting up a bank account for the LLC and, if you have owner meetings, keeping meeting minutes.

Other than these record keeping requirements—which you should be doing anyway as good business practice—there are not a lot of internal formalities for an LLC (unlike that of a corporation).

Paying Taxes as an LLC

Federal Taxes

As to paying taxes, the LLC is highly flexible. For a single-member LLC, by default, the IRS treats you like a sole proprietorship. This means the LLC doesn’t pay income taxes. Instead, you pay taxes on the LLC’s income as a part of your personal tax return (Form 1040, Schedule C).

For a multi-member LLC, the IRS, by default, treats it like a partnership. The income of the LLC is divided among the members. Each member then pays taxes on their share of the income on their personal tax return.

The LLC can also elect to be treated as an S corporation or a C corporation by filing specific forms with the IRS.

Note that, instead of paying taxes at the end of each year, no matter how you elect to be treated by the IRS, you’ll have to pay your taxes on a quarterly basis. This is called estimated taxes.

State Taxes

In addition to taxes to the IRS, the LLC often must pay some sort of state tax. The details on how much and to which state agency depends on your state. In some states, it’s a straight percentage of your revenue. In other states, there’s a formula on how much you have to pay, but sometimes you pay nothing.

For instance, in Texas, the LLC has to pay a franchise tax every year, but your payment is $0 if your margin is less than $1.18M for 2021 (this threshold changes every year). So, for a small business LLC in Texas, often this means you pay $0 in franchise taxes.

There may be other types of taxes you have to pay to or collect for your county, city, or state (e.g. sales tax), but those taxes are not because you’re an LLC as opposed to, say, a sole proprietorship. These taxes depend on the type of goods or services you sell or the physical location of your business.

How to Sign Documents as an LLC

Ordinarily, only a managing member of an LLC can sign documents for the LLC. Sometimes, a non-member can be authorized by the managing member(s) to sign. The authorization has to be documented and kept as a part of the company’s records.

A signature block for an LLC might look something like this:

Aspen A. Shepherd
Managing Member
Kibbles Shack, LLC

There are actually no real rules on the title of LLC owners/members. You can call yourself the CEO, the General Manager, or the President.

Still, when signing official documents, it’s safest to use Managing Member. You can use CEO, General Manager/Manager, or President if you’re a non-member, have that title, and have been formally authorized to sign for the LLC.

What are the Advantages of an LLC?

The key advantage of an LLC is its ability to pass through taxes while still limiting the liability for its members.

The LLC Allows for Flexible Tax Structures

On taxes, the LLC is highly flexible, and the owner(s) can pick how they want to be taxed. By default, the IRS calls a single-member LLC a disregarded entity and treats it as a sole proprietorship. By default, the IRS treats a multiple-member LLC as a partnership.

This means the LLC does not file any taxes. Instead, each member files their own taxes, just like sole proprietors or partners in a partnership would.

The IRS can also treat your LLC as either a C corporation or an S corporation. Simply file the appropriate paperwork with the IRS, and it will follow your wishes.

The LLC Limits Liability Just Like a Corporation but with Less Fuss

As to limiting business liability, the LLC limits the business liability of its members, usually with less stringent paperwork requirements compared to corporations. For example, a corporation needs to hold shareholder meetings at least once per year. This can’t be skipped. In an LLC’s operating agreement, you can agree that annual meetings aren’t required.

So, as long as an LLC keeps up with other practices that treat it as a separate entity from its members (e.g. LLC has a business bank account, business assets not used for personal purposes), then the liability limitation should hold up in lawsuits.

What Are the Disadvantages of an LLC?

There are some disadvantages to an LLC, but, overall, its benefits far outweigh its disadvantages.

The LLC is Not Recognized Around the World

The LLC business format is recognized in the US but not around the world. So, if you plan to do business regularly outside the US, you might want to form a corporation instead.

International laws governing corporations are more robust. These laws can give you more certainty on what your business can and cannot do when doing business outside the US. This might become especially important where it comes to international tax treatment and limitation of legal liability.

Formal Investors Likely Prefer the Corporate Format

Lastly, while an LLC can take on investors, it’s best fitted for friends and family investors. It isn’t designed to deal with investors the caliber of venture capital firms.

So, if you have stars in your eyes and want to be the next Wall Street IPO sensation, then you should probably skip the LLC and form a corporation instead.

The LLC is a Great Business Format to Run a Small Business

So, what is a limited liability company? It’s a new-ish but highly flexible business format. Whether you just want to run a small business by yourself or work with a few investors, the LLC is a great way to limit personal liability without being bogged down by corporate formalities that are required for a corporation. Other than the fact that you’ll have to invest some money upfront setting up the LLC and might have to pay some additional state taxes, there is almost no reason why you shouldn’t either start off as or graduate to an LLC as you build your business.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

DISCLAIMER: This article does not constitute legal advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer. Only lawyers properly licensed in your state/country are qualified to give you legal advice.

Questions? Comments?