Limited Liability Company (LLC): Definition, Pros & Cons (w/ Examples)

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Since the early 1980s, small-business owners have been reaping the benefits of limited liability companies and relishing in their simplicity. Though it may seem like most small businesses fall into this category — a favorite because of its liability protection — it’s not a one-size-fits-all solution. A limited liability company (LLC) has just as many cons as they do pros. So, what is an LLC, and how do you actually form one?

What Is an LLC?

An LLC is a legal business entity that combines the liability protection of a corporation with the tax benefits and flexibility of a sole proprietorship or partnership. Plus, it’s one of the simplest business structures because it requires minimal record keeping and a simple tax return. This legal entity is a favorite among small businesses across the United States, from landscaping businesses and travel agencies to real estate holdings and coffee shops.

Different Types of LLCs

There are two different types of LLCs: domestic LLCs and foreign LLCs. Basically, you automatically get a domestic LLC for the state in which you file, but you might have to register a second time if you’re going to do business in other states. The second registration is called a foreign LLC.

For example, a touring rock band (yes, rock bands can be LLCs too) may need to register a foreign LLC to tour across different states, particularly in California. Similarly, a chain restaurant would need to register a foreign LLC if it is opening outposts in states other than where it is headquartered.

Tax Advantages of LLCs

One of the main advantages of an LLC is the way they’re taxed. You’ve probably heard the phrase “pass-through business” during Donald Trump’s sweeping tax overhaul, which offered a 20% standard deduction to all pass-through businesses until 2025. A limited liability company is considered a pass-through business entity because the profits go directly to its members without being taxed by the IRS at a corporate level. Instead, the LLC members only pay federal income tax on their personal income tax returns.

On the contrary, most corporations have what’s often referred to as double taxation. This means they’re taxed twice — once on the corporate level and once on the personal level on distributions to shareholders.

Pros of an LLC

The tax advantages are only a small piece of why many business owners find running a limited liability company beneficial. This type of business structure offers protection that a sole proprietorship lacks while offering flexibility not found in a C corporation. It’s basically the best of both worlds. Some of the main benefits include:

  • Protecting your personal assets: LLCs offer personal liability protection not found in sole proprietorships. Basically, this means your personal assets — like your home, cars, bank account and other investments — are off limits to creditors in the event of a bankruptcy. You’re not personally liable for the company’s business debts like you would be in a sole proprietorship as long as you keep your business finances completely separate from your personal finances.

  • Flexibility with ownership and management: Though they’re taxed similarly, LLCs offer more flexibility than S corporations. For example, an S corporation is limited to 100 shareholders, but there’s no restrictions on how many owners an LLC can have (though it would be pretty strange for an LLC to have 100 partners). Similarly, LLCs offer flexibility with management. Unlike corporations, which have a strict management structure with a voted-on board of directors, LLCs have the freedom to manage their business in various ways.

  • Flexible profit distribution: Unlike corporations, which distribute profits to shareholders based on the number of shares they hold, LLC owners can distribute profits however they want. They can split things evenly or not. Equal partners sometimes opt to give one owner a greater share of profits because he made a larger initial investment or put in more hours. 

In addition to liability protection and flexibility, LLCs generally require less paperwork, making them an easier solution for busy business owners who are spread a little bit thin. In some states, LLCs don’t even need to file an annual report.

Cons of an LLC

LLCs are one of the most popular small-business structures, but they’re not always the most beneficial. They have their downsides, like additional taxes on your personal return. Even liability protection only goes so far. The cons of LLCs include:

  • Limits of limited liability: Forming an LLC is meant to protect your personal assets, but this can be ruled against in court under certain circumstances, like if you’re running the business in a fraudulent way that causes losses to others. This could be as simple as not clearly separating business transactions from personal transactions. Always, always use a company credit card and company bank account.

  • Self-employment taxes: LLC profits don’t get taxed at a corporate level, but LLC owners are responsible for self-employment taxes on their personal income tax return because the IRS views LLC owners as self-employed. This means you’re responsible for paying the company’s share of Social Security and Medicare taxes. Currently, a typical employee only pays 7.65% of income on combined Social Security and Medicare, but LLC owners pay 15.3%.

  • Members can’t leave:  This isn't totally true because members can leave, but there’s a cost. In some states, an LLC must be dissolved if a member leaves, whether that person quits, dies or goes bankrupt. This means the remaining members are now responsible for whatever financial or legal loose ends have to be tied up before the business can be terminated (i.e., you have to suddenly pay off those business loans or open accounts). In states with this rule, members must also form a brand-new LLC to continue operations.

In addition to these cons, the major downside of an LLC is that there’s a limited potential for growth. LLCs can’t issue shares of stock, so if you’re launching a startup that plans to make an IPO, this isn't the best option. Thankfully, you can always change your business structure later.

How to Start an LLC

Forming an LLC can be done in a few steps, but you’ll need to have all of your paperwork settled in advance. Thankfully, you can register online quickly via a service like LegalZoom or BizFilings, though you can also deal with the secretary of state’s office on your own. To form an LLC, you must:

  • Choose a business name: Most states don’t allow two businesses to have the same name, so you’ll need to run a search to see if your business name is unique. This name doesn’t have to be the name you use publicly, but it must be the name you use in your tax filings. Remember that a unique name will protect you from potential copyright or trademark infringement lawsuits and give you a solid brand identity.

  • Pick a registered agent: LLCs are required to have a registered agent, who is basically the person who handles all official documentation (things like lawsuits, subpoenas or even eviction notices) on behalf of the LLC. Most LLCs pick a member or officer as the registered agent, but it can typically be any resident of the state who is over the age of 18.

  • Create an operating agreement: LLCs don’t need articles of incorporation, but they do have to create an operating agreement that shows how the LLC will be run. This includes mapping out the responsibilities of the members, how profits and losses will be shared, how meetings are governed, the rights of members in the event that someone leaves or dies and how the company plans to dissolve if it’s going out of business. This isn’t always required by state law, but it’s important because it can prevent disagreements down the road and make sure all of the LLC owners fulfill their expected responsibilities.

  • File the paperwork: Each state is different, but you’ll generally have to file some sort of articles of organization with the secretary of state’s office. Some states have a separate department for this, but they do allow you to file online. Each state charges a different filing fee.

  • Get your certificate from the state: After your LLC application is approved, you’ll get a certificate that confirms your business entity has been officially registered. Once you have this, you can do things like get an employer identification number, a business license and a business bank account.

LLC Pricing and Timeline

Forming an LLC is cheap, easy and quick, which is why so many small businesses choose this type of business structure. The costs vary from state to state, but the initial filing generally costs less than $500. For example, in Arizona it costs $50 to file your articles of organization, but in Illinois, it costs $500. Most states fall somewhere between $70 and $150 for the initial filing.

Starting an LLC doesn’t take a lot of time either. When it comes down to it, you can file within 10 minutes online, and the state will typically process your request within four to six weeks. Occasionally, a state will take a little bit longer, but you can also file for expedited or rush processing. Though it’s not available in every state, it will reduce your wait time to around 10 business days or less.

Renewing Your LLC

LLCs require annual renewal, which means you’ll have to file an annual report with the secretary of state in the state where your business operates. Depending on where you are located, it may be called:

  • An annual report
  • An annual certificate
  • An annual registration fee
  • A biennial report
  • A franchise tax report
  • A periodic report

Regardless of the name, you can file your report online through the secretary of state’s website, but you’ll need to know your employer identification number and pay a renewal fee, which is typically around $100. You can also file via mail by printing out the form on the secretary of state’s website and mailing it to the secretary of state’s address with a check or money order.

Failure to renew an LLC may result in the dissolution of your company, which means you’ll have to pay an extra fee to reinstate it, and you’ll risk losing your business name.

Paying Taxes as an LLC

The way an LLC is taxed depends on the number of members. If it’s a single-member LLC, it’s taxed like a sole proprietorship using Schedule C on the owner’s personal tax return. Multimember LLCs will pay taxes like a partnership using IRS Form 1065. In that case, partners would fill out a Schedule K-1 to add the income to their personal return.

References

About the Author

Mariel Loveland is a small business owner, content strategist and writer from New Jersey. Throughout her career, she's worked with numerous startups creating content to help small business owners bridge the gap between technology and sales. Her work has been featured in publications like Business Insider and Vice.