What is a Limited Liability Company (LLC)?
A limited liability company (LLC) is a business structure for private companies in the United States that combines aspects of partnerships and corporations. Limited liability companies benefit from the flexibility and flow-through taxation of partnerships and sole proprietorships while maintaining the limited liability status of corporations.
If you’re looking to start a company, make sure to check out CFI’s introduction to corporate finance course!
Advantages of an LLC
Limited liability companies offer flexibility and protection. It makes the corporate structure appealing to business owners. Rather than shareholders, business owners of limited liability companies are referred to as members.
An LLC can choose between different tax treatments. They can choose to adopt the tax regime of sole proprietorships, partnerships, S corporations, or C corporations. It provides the company with the option of being treated as a flow-through entity, so long as it does not choose to be treated as a C corporation.
The income of a flow-through entity is treated as the income of its owners. It means that owners of an LLC are able to avoid double taxation. With double taxation, income gets taxed both at a corporate level and also when distributed as dividends to owners. Instead, income is taxed at an individual member level rather than at the company level.
If the company chooses to be taxed as a partnership, its income can be allocated across members in forms other than ownership percentage. Members agree upon this in the operating agreement.
The operating agreement of the company acts similar to the bylaws of a corporation. Below is a comparison of terms between an LLC and a corporation:
The document governs the company’s finances, organization, structure, and operations. Unlike corporations that are required to appoint officers or a board of directors, an LLC is more flexible with its management structures. It, too, is decided in the operating agreement.
Limited liability companies additionally benefit from the advantages of corporations. The largest benefit is the company’s limited liability status. The company exists as its own legal entity. This protects members and owners from being held personally liable for the operations and debts of the business.
A simple example would be if an employee of the company is found conducting illegal environmental activities. Legal action can be threatened against the company to pay for damages. The court can go after the assets of the firm, but not the owner to pay for the damages. The exception would be if the owner was aware of the illegal activities and allowed them to happen.
Disadvantages of an LLC
The main disadvantages of limited liability companies are the fees and taxes associated with the business structure. However, as such companies are governed differently by the state, regulations also become a disadvantage.
1. Fees and Taxes
Though owners of a limited liability company benefit by avoiding double-taxation, they are also required to pay self-employment taxes. These taxes are paid twice as the owner is both the employee and the employer.
Some states also demand an annual fee for the limited liability benefits that LLCs provide their members. This fee is sometimes referred to as a franchise tax. For example, the state of California charges an $800 annual fee that increases with net income for limited liability companies.
As mentioned previously, an LLC is governed by state law, which can drastically change how the company behaves in different scenarios. As an example, when a member of the limited liability company passes away, some states may dissolve the company. In other states, the company will continue to exist and the deceased member’s membership shares are passed to their executor.
Fortunately, these cases are the default resolutions set by the state. Members of an LLC can decide how they want the company to proceed in situations like the above through the operating agreement. As you can see, the operating agreement is a critical document that members should not ignore when creating the company.
It is also important to consider how the company might function in international markets. For example, an American LLC is likely to be treated as a corporation in Canada, as the distinction between the two is not recognized in Canada.
Looking into starting a business? Corporate Finance Institute offers other resources that will help you expand your knowledge and achieve your goals. Check out the links below: