What is an LLC and how does it work?

An LLC is a business entity that protects the owners with limited liability protection. An LLC also offers pass-through taxation, which means the company’s profits and losses pass through to the owner’s personal tax level.

Author: Brad Nakase, Attorney

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An LLC is an acronym for a limited liability company. A limited liability company is a type of business entity. An LLC business structure protects its owners from personal responsibility for the LLC’s debts or liabilities. The LLC combines the flexibility and tax advantages of a partnership and the personal liability protection of a corporation.

Yvonne has always wanted to start her own cupcake store, where she will sell fabulous chocolate creations that follow all the latest Instagram trends. Now that she has gathered the resources to finally start her small business, she is confronted with many important administrative concerns. Primarily, she must pick an entity type for her business. Yvonne has heard that LLCs are popular among entrepreneurs, largely because they will protect her, as a business owner, from liability. Yvonne likes this idea. In the event a customer gets sick from her Mega Chocolate Triple Bypass Cupcake (a bestseller), Yvonne does not want to lose her home or car in a lawsuit. She wonders what other benefits come with having an LLC.

What Is the Point of Having a Limited Liability Company (LLC)?

A limited liability company is a type of company in the United States that provides a business owner with protection from liability and pass-through taxation. An LLC is often referred to as a hybrid entity that has the characteristics of both a corporation and a sole proprietorship. Like a corporation, an LLC is a separate legal entity from its owners. This means that owners of an LLC cannot be held responsible for business obligations or debts. It also means that an owner’s personal assets are protected in the event of a lawsuit. An owner’s car, home, and personal savings will be safe from judgement, meaning that he or she cannot lose them in the event of a lawsuit.

An LLC is also eligible for pass-through taxation, similar to a partnership, because its income is not taxed at the entity level. That said, if an LLC has more than one owner, then it must still file a tax return. The business’ income or loss will be passed through to the owners, and the owners will need to report the income or loss on their personal tax returns and pay any taxes owed.

State statutes allow limited liability companies to exist, and the regulations that govern these entities vary depending on the state. Owners of LLCs are typically called members. Often, states do not restrict ownership, which means that anyone can own an LLC: individuals, corporations, foreigners, other LLCs. However, certain types of entities cannot become LLCs, such as insurance companies and banks.

An LLC is easier to create than a corporation and it is popular due to its flexibility and the protection it offers investors.

How to Make an LLC in California

Small business owners often like the concept of a limited liability company (LLC) because it offers liability protection, flexibility in terms of management, and specific tax advantages. There are both advantages and disadvantages to making an LLC, so business owners should understand how to form this type of company and whether it is best for their particular business needs.

What Are the Benefits of Making an LLC?

It is generally agreed that the advantages of forming an LLC outweigh the disadvantages. Some of the benefits include the following:

  • Limited Liability. Owners of an LLC, otherwise known as members, are protected from personal liability. Whatever the business or other members do is legally separated from the owner in question. Personal assets, such as homes, cars, and personal savings, are protected from creditors. These assets cannot be used to pay business debts. By contrast, the personal assets of sole proprietors and general partners can be confiscated to pay business debts.It should be noted that an LLC can lose its limited liability. This action is known as “piercing the veil.”
  • Flexible Ownership. Owners of an LLC can be individuals, partners, trust, or corporations. There is no limit on the number of owners, or members. By contrast, an S corporation has many more restrictions on who can be a shareholder, and there is a cap on how many owners there can be.
  • Management Structure. Owners of an LLC can manage their business, or they can choose a management group to do it in their place. By contrast, corporations are managed by a board of directors and not the shareholders themselves. If an LLC is managed by its members (member-managed), then the owners themselves manage day-to-day operations. If the LLC is managed by appointed managers (manager-managed), then the LLC works much the same as a corporation. In this case, management of the business falls under the responsibility of directors and officers, not the owners themselves.
  • Pass-Through Taxation. Normally, LLCs do not pay taxes at the entity level. The business’ income or losses are passed through to owners. The owners will then report the income or losses on their personal tax returns. Taxes, therefore, are paid on the individual level. C corporations, by contrast, are taxed at the business entity level and the shareholders are taxed on the distributed income.
  • Increased Credibility. By establishing itself as an LLC, a company can benefit from increased credibility. Consumers and vendors will generally trust a limited liability company more because of the implied legitimacy.
  • Fewer Compliance Requirements. LLCs do not have to worry about state compliance requirements as much as sole proprietorships, general partnerships, or corporations (either S or C type). This is fewer formalities to have to worry about.

What Are the Disadvantages of Making an LLC?

Even though generally the advantages of creating an LLC outweigh the disadvantages, it is useful to explore some of the negative aspects.

  • Cost. It is typically more expensive to create and run an LLC than it is a sole proprietorship or general partnership. There is an initial formation fee, as well as ongoing fees imposed by the state. These fees may include annual reports and franchise tax fees. To look up the type and number of fees, an owner should check with his or her state’s Secretary of State office.
  • Transferable Ownership. It is often harder to transfer ownership of an LLC than it is with corporations. For a corporation, shares of stock can be sold to increase ownership, and shareholders can also sell their shares to someone else. However, with LLCs, all members must agree to adding new members or changing existing members’ ownership percentages.
  • Possible Dissolution. If a member of an LLC dies or goes bankrupt, depending on state law, the company may need to be dissolved. By contrast, a corporation continues regardless of the status of its owners.

Forming an LLC: What Are the Steps?

Forming an LLC is generally easier than forming a corporation. Still, there are administrative tasks to be completed and compliance requirements to be addressed. Luckily, the process of forming an LLC can be reduced to a few simple steps.

  • Step 1: Choosing a State

A business owner can choose any state in which to form his or her LLC, even if the LLC will not be conducting business there. Still, generally speaking, owners will choose to form the LLC in the state in which they plan to do business. This is most often the state in which the owner lives. If an owner chooses to register his or her LLC in a state in which they do not plan to do business, they will have to register the LLC as a foreign LLC in its home state. This can increase formation and administration costs.

Cost, taxes, and LLC laws vary from state to state. Some states, such as Delaware, are popular choices with small business owners. The choice of state really depends on what amount of administration costs and duties one in willing to put up with.

  • Step 2: Choosing a Name

A business owner looking to form an LLC will have to choose a name that is unique and available for use. This means that the name cannot already be in the Secretary of State’s records as the name of another business entity. Many businesses operate under a “doing business as”, or DBA. This is a name that can be used in place of the LLC’s legal name.

In order to ensure that a name is available for use, an owner should do an LLC name search on the Secretary of State’s website. If an owner is not ready to complete the formation process yet, he or she may still reserve the name for later use. This is a good idea, because the name might be taken otherwise. Many states will allow an owner to do this for a small fee and for a short time period.

Once an owner comes up with an original and available name, it is also a good idea for them to do a trademark search. This will help the owner avoid intellectual property infringement and confusing customers. For instance, there cannot be two cookie shops names “Jenna’s Baked Goods.” This would confuse customers and potentially violate one of these store’s trademarks.

  • Step 3: Choose a Registered Agent

When an owner forms an LLC, whether in California or another state, he or she needs to have a registered agent in the state of formation or qualification. Don’t worry if you aren’t familiar with this term; in fact, many business owners have not heard of what a registered agent really is.

A registered agent is also known as an agent for service of process. He or she is appointed by an LLC to receive important legal documents such as notices, lawsuits, and tax documents on behalf of the LLC. These also include communications from the Secretary of State, such as annual reports and statements.

Technically, the owner of an LLC can choose to be the LLC’s registered agent. However, there a few good reasons why a business owner should choose a registered service agent provider instead. For instance, if the registered agent is unavailable when time-sensitive documents are sent, or if the documents are mishandled, then the LLC will face big problems. It is best, therefore, to have professionals handle this kind of important matter.

Also, a registered agent should have a physical address in the state and cannot use a P.O. Box. So, if one’s LLC is in California, an owner cannot appoint his cousin Jeff in New Jersey to be his registered agent. Sorry, Jeff! The owner will need to appoint a registered agent in California, and he may want to pick someone a bit more reliable than Cousin Jeff.

  • Step 4: Create an LLC Operating Agreement

Almost every state requires that an owner create an LLC operating agreement. In most states, it can be created orally, but even so, it is a very good idea to have a written operating agreement. This document is an agreement between owners, or members, of an LLC. It details how the company will be operated. Even if an owner is the only member of an LLC, it is still good to have the formality of a written operating agreement. This demonstrates that an owner respects the LLC’s separate existence and can help prevent piercing the veil (losing limited liability status). This can be a chance for an owner to put into writing what will happen in certain circumstances, such as when the owner can no longer manage the business. It is possible for the owner to put in terms regarding how he or she wants the company to be handled after his or her exit.

It is very important that LLCs with multiple members have an operating agreement in writing. The document will detail the division of ownership, as well as profits and labor. The agreement can thereby help prevent disputes between owners. The document also lists who has what authority, and how votes should be conducted among members. It also lists how membership interests can be transferred, how new members will be added, and how profits and losses will be distributed. In order to be sure all bases are covered in the agreement, it is a good idea to have an attorney look over it.

  • Step 5: File with the State

An LLC does not officially exist until LLC formation documents are filed with the Secretary of State’s office. These documents are known as a Certificate of Organization, Certificate of Formation, or Articles of Organization. Filing fees will vary based on the state.

You may have heard of LLCs being “incorporated.” Technically, the correct way to talk about an LLC’s formation is to say that it has been “formed” or “organized.” “Incorporation” or “Articles of Incorporation” refer to the creation of a corporation.

Each state will have different requirements when it comes to the formation of an LLC. That said, there are certain common elements, which include the following:

  • Name, main location, and purpose of business
  • Registered agent’s name and address
  • Will the LLC be member-managed or manager-managed

Standard Articles of Organization are available from each state for owners’ use. The person forming the LLC must sign the document. Depending on the state, the registered agent may also need to sign.

When the Articles have been approved and filed, the state will respond by issuing a certificate or other document providing confirmation. This certificate functions as legal proof of the company’s status as an LLC. The certificate may also be used to open a business bank account, get an EIN, etc. Sometimes, it is necessary for a business to also publish a notice in a newspaper declaring the formation of the LLC. This will depend on the state in which the Articles are filed.

  • Step 6: Get an EIN

Once an owner establishes his or her LLC, they must apply to the Internal Revenue Service (IRS) to receive an employer identification number (EIN). An LLC will use this number on all of its bank accounts and tax filings. If an LLC wishes to do business in another state, then it must apply to that state’s tax department for a sales tax identification number. It must also register with that state’s labor department.

  • Step 7: Open a Bank Account for the Business

While this step is not legally required, it is a good idea for any LLC owner. Because the business is now a separate legal entity from the owner, it is essential to separate person finances from business finances. When a court considers whether to “pierce the veil” and potentially remove limited liability, it will look at this factor – whether finances are separated. Therefore, it is crucial that an LLC owner opens a business bank account. A business credit card can help keep personal and business expenditures separate, and it can also help build business credit.

Banks will generally request certain details: formation date, business type, as well as owners’ names and addresses.

  • Step 8: Register in Other States (Optional)

Sometimes an LLC will want to conduct business in a state(s) other than that in which it formed. In this case, the owner will have to register, or foreign qualify, in each of the other states. This process requires filing an application with the Secretary of State. Often, a Certificate of Good Standing is also required. The company will also have to appoint a registered agent in the “foreign” state.

There are several factors used to assess whether an LLC is actually conducting business in a state and needs to “foreign qualify.” Some of the guidelines include whether the company:

  • Has a physical location in the state
  • Has employees in the state
  • Accepts orders in the state

Each state will have different criteria for what qualifies as conducting business.

LLCs Versus Other Business Types

An important step in creating a business is to decide on a business structure that suits the company and owner. There are several types of businesses, each with its own advantages and disadvantages.

  • LLCs Versus S Corps

Both an S corporation and an LLC have pass-through taxation. That said, S corporations do not have the same flexibility in distributing income to owners – LLCs have this advantage. An LLC can also offer different classes of membership interest, while an S corp can only have one class of stock.

  • LLCs Versus Sole Proprietorships and Partnerships

The big difference between LLCs and proprietorships and partnerships is liability. The owner of a sole proprietorship, or the owners of a partnership, are liable for actions taken by the company. This means that if the company faces a lawsuit or owes a debt, the owner or owners could lose their personal assets in a judgement.

Both LLCs and partnerships are permitted to pass through their profits, in addition to their responsibility for paying taxes on those profits. If an LLC has organized itself as a partnership, then it will file a Form 1065 come tax season.

Commonly Asked Questions

What Are Some Examples of LLCs?

In fact, LLCs are quite common nowadays. The parent company of Google is an LLC, as is Exxon, and Johnson & Johnson. Of course, there are also many smaller LLCs, including sole proprietorship LLCs, family LLCs, and member-managed LLCs.

What forms are required to start a limited liability company?

A business owner that wants to turn his company into an LLC will need to file Articles of Organization with the state in which he or she does business. This document may also be referred to as a Certificate of Organization. There are filing fees and franchise taxes that must be paid at the same time as filing.

Are there restrictions on who can form an LLC?

There are generally no residency or legal restrictions when it comes to who can create an LLC. A few states, however, require that members or owners of an LLC be at least 18 years of age or older.

Is an attorney needed to form an LLC?

An attorney is not required. A business owner can file the Articles of Organization themselves. That said, the onus is on the owner to research what his or her state requires for these forms. As ever, if an owner feels lost or confused as to what move is best, he or she should consult a lawyer.

How do I decide on a name?

A name is an important aspect of forming an LLC, or any company. One should pick a name that reflects the purpose of the business, or the values or goal. A name is the company image. It may be a good idea to pick a name with unique spelling, or some quality that is easy for customers to remember. On the legal front, the name should not be “deceptively similar” to another business’ name. This means that you should probably not name your burger restaurant “McRonald’s.”

Also, one should include a suffix to indicate that the business is an LLC. This would mean putting either “Limited Liability Company” or “LLC” at the end of the name.

How many people are required to create an LLC?

There is no maximum or minimum number of members required to form an LLC. One-member LLCs – having one owner – can receive pass-through taxation, according to the IRS. That said, taxation of LLCs can vary by state.

What is taxation like for LLCs?

Like partnerships, LLCs have pass-through taxation. Single-member, or single-owner, LLCs do not have to file an informational tax return. Multi-member, or multi-owner, LLCs do have to file an informational tax return. In both situations, profits and losses are “passed through” the business to the owner or owners. The owner will then report the profits or losses on his or her own tax return. The tax due, therefore, is paid at the individual tax level.

An LLC may also choose to be taxed like a corporation, which means the profits of the company would be taxed at the business level. Depending on the state, the state income tax treatment of profits and losses may be different than the IRS’ treatment.

LLCs are also subject to the state of incorporation’s franchise taxes. A franchise tax is just a tax that is imposed on an LLC that does business in a particular state. The tax amount will vary by state, and it is typically paid annually. In California, LLCs must pay a minimum franchise tax of $800 per year, and the first payment needs to be paid within three months of the LLC’s formation.

How is an LLC organized?

An LLC’s ownership is composed of members. These are the equivalent of shareholders in a corporation or partners in a partnership. If an LLC has managers running the show, then members will be closer to shareholders in that they will not participate in the day to day running of the company. If an LLC does not have managers, then members will be closer to partners in function, because they will have more of a say in decisions affecting the company. Just as shareholders have stock in a corporation, members have membership interest in an LLC.

How is an LLC managed?

Depending on preference, an LLC can be managed by managers or by its members. If an LLC is managed by its members, then it will be run similar to a partnership. The members will make the decisions affecting the company. However, the members can also choose managers to function similar to a corporation’s board of directors. In this case, the assigned managers will be in charge of the company’s operations.

Member-management is the typical default. This means that unless managers are selected in the Articles of Organization, members will automatically be in control of company operations.

What is a publication requirement?

A few states, such as Arizona and Nebraska, require that an LLC announces its formation in a local newspaper. This notice is referred to as “The Published Notice of Formation.”

Does an LLC need a registered agent?

Having a registered agent is a legal requirement for an LLC. It is possible to hire a registered agent through a service.

What is a single-member LLC?

A single-member LLC refers to an LLC that has only one owner. In terms of taxes, this kind of LLC is considered a “disregarded entity” by the IRS. An owner will report taxable income and business expenses using Schedule C and bring that information over to his or her personal Form 1040. The LLC still offers protection of personal assets, so the owner does not need to worry about losing his car, home, or personal savings, etc., should the company face a lawsuit or take on debt.

What is an LLC operating agreement?

An LLC operating agreement is the contract that details the guidelines of an LLC. It essentially explains how the LLC will be run, or operated, in a formal sense. It is usually put together by the LLC’s members in their first meeting. One can find template agreements online.

What is a Professional LLC (PLLC)?

A professional limited liability company is an LLC created to offer professional services in fields that need a state license in order to practice.

How do you get an EIN for an LLC?

To receive an EIN, a business can apply for one by filling out Form SS-4 and filing it with the Internal Revenue Service (IRS).

When to Hire an Attorney

Hiring a business attorney, or lawyer, can save time and prevent headaches when creating an LLC. Typically, the costs of hiring a business lawyer range from $200 to $5,000. While a business owner may be hesitant to open his or her wallet, there are benefits to having a lawyer on one’s side during the organization process. A lawyer can deal with administrative issues that a business owner may be too busy or nervous to manage. These include:

  • Creating the LLC Operating Agreement

An LLC operating agreement explains how a company will be run once it is registered. It is an internal document that lays out the company’s rules, as well as the rights and responsibilities of members. In some states, this document is a legal requirement.

  • Creating Articles of Organization

Articles of Organization is a document that lists the LLC’s management structure, the date of the company’s formation, and the registered agent. It is essentially an overview of the company’s basic information that is filed with the state.

  • Acting As the LLC’s Registered Agent

An LLC will need to appoint a registered agent in order to be created. A registered agent is a person who agrees to receive legal forms and tax documents on behalf of the company. They are also responsible for service of process, which means that they notify the business when someone is filing a lawsuit against it. As part of their business formation services, some lawyers offer to serve as registered agents for a client company. This means that they will receive an LLC’s legal documents at their physical address. This is a nice benefit, because it allows a business to move locations without missing or losing important documents.

  • Keeping Records

A lawyer hired to help form an LLC can also keep detailed records. This is important in the event the business ever faces a lawsuit or audit. A business owner may be too busy managing the company to keep track of these kinds of details, which is where a lawyer comes in handy.

  • Filing

A lawyer can also file fees and register information with the correct parties. Again, this saves a business owner the headache of figuring out things on his or her own.

  • Registering a Business Name

Naming a business is not quite as simple as it seems. A name not only needs to express the company purpose and values, but it must be unique and available for use. This means that it cannot already appear on the Secretary of State’s naming database. Essentially, no two companies in the state can have the same name. This can be a headache for a business owner, and it is a space where a business attorney can help. Let’s say the owner has an idea for a name. He can tell his lawyer the name, and the lawyer will do all the leg work, checking its availability and any similarities to other businesses.

  • Filing Documents

A business lawyer will make sure that all important administrative boxes are ticked. This means that he or she will complete and file all legal and formation documents with the appropriate departments, whether the Secretary of State or the IRS.

Depending on the attorney, some firms offer online services for setting up an LLC, while others may have a set fee. Other firms may offer consulting, or advice on particular matters, for a small fee.

If the company in question is small and being run by just a few people, then most likely an owner can set up the LLC on his or her own with few problems. However, if the company has many people and partners involved, complex assets, or financing, then it may be a good idea to hire a business lawyer to guide the owners through the organization process.

Finding a Lawyer After LLC Formation

Perhaps an owner is able to start an LLC with any difficulty on his or her own. Great! But let’s say he or she runs into problems down the road, or needs advice related to running the new business. This is an opportunity to bring on board a business lawyer experienced in getting LLCs up and running, as well as ironing out any kinks. A business owner in this position may want to consider the following types of attorneys.

  • Employment lawyer: creates employment contracts and HR policies
  • Intellectual property lawyer: reviews a company’s products and services to ensure they are protected
  • Tax lawyer: reviews income tax and tax returns
  • Business lawyer: helps an owner change the business structure to an LLC, S corporation, or another business type. Can also help review business contracts or other business matters
  • General lawyer: reviews state law compliance, state fees, and annual fees
  • Real estate lawyer: advises on commercial leases or real estate purchases

While handling these matters on one’s own will save money, a lawyer can be a good investment in the long run when problems inevitably arise. That said, a business owner should choose only what he or she needs and can afford. Perhaps they can consider bringing a lawyer on board when the business is making a profit.

In sum, a business owner is not legally required to have a lawyer to register an LLC. However, if an owner is having trouble with the registration process or has other business-related questions, then hiring a lawyer is a good call and can save time and money.

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