What Is an LLC? Here’s How It Works.

On Jun 8, 2023

Are you a small business owner that has been asked if their company is an LLC, and you don’t know what that means? Or maybe you are an entrepreneur in the initial phases of opening a new business, and your head is swimming with all the options ranging from a sole proprietorship to an LLC to a corporation.

Keep reading for everything you need to know about an LLC and whether it is the right option.

What is an LLC?

A Limited Liability Company (LLC) is a business structure that provides the owners with protections that are usually only available to corporations but keeps the simplicity of a sole proprietorship.

This entity also provides pass-through taxation as it is run through a separate entity that isn’t restricted to a specific number of shareholders and isn’t heavily regulated.

What are the benefits of an LLC?

There are benefits to every business structure. From a corporation, general partnerships and sole proprietorships each offer unique advantages.

The benefit of forming an LLC is that it takes the pros of each business structure and combines them into one.

How can an LLC provide asset protection?

One of the main advantages of an LLC is that it protects your personal assets.

For any business debt or lawsuits that your business may run into, the owner has no personal liability. This ensures that their personal assets cannot be taken as payment as they are completely separate from the company.

What tax options does an LLC have?

An LLC provides more tax options than other business models.

For tax purposes, they are either taxed as a sole proprietorship or a partnership, depending on the management structure and how many members are involved in the company.

Members report their share of the business income and expenses on their personal tax return and then pay personal income tax on the profit.

Members who also work in the business are then considered self-employed and must state this on their federal income tax return and then pay self-employment taxes on their share of the profits.

If the company doesn’t want to be taxed as a sole proprietorship or partnership, it can also choose to be taxed as an S-corporation (S-corp) or a C-corporation (C-corp).

A C-corp pays corporate tax, and the owners pay tax on their distributions. An S-corp is what is known as a pass-through entity which means it doesn’t pay corporate tax, but each owner does pay personal income tax on their share of the profits.

It is important to note that not all LLCs qualify for S-corp taxation as they must meet certain IRS (Internal Revenue Service) requirements.

A single-member LLC can also be designated as a disregarded entity. What this means is that it will be disregarded or ignored concerning federal income tax.

Does an LLC provide flexibility?

As LLCs are not required by law to have annual shareholder meetings or even require a board of directors, they provide greater flexibility than other business models.

Rather, members of an LLC are free to organize the company as they see fit and be member-managed, as administrative requirements like most corporations don’t bind them.

Does an LLC designation make your business more credible?

When you structure your business as an LLC, you receive exclusive rights to use your business name as a business entity.

As most states don’t allow a business to use an existing business name, you can create a public record of your name, making it unavailable.

The LLC designation at the end of the company name can also lend credibility to a business.

How are profits distributed in an LLC?

One main advantage of an LLC is that members can decide how the profits are divided.

Typically, corporations issue dividends, and partnerships usually split the profits among the partners, but owners of an LLC can choose how the profits are divided up.

Remember that the IRS has rules about the special allocation of profits, and you might have to show proof of profit sharing or legitimate economic need to prove it is not simply an attempt to avoid paying taxes.

Are there disadvantages of an LLC?

While an LLC has specific benefits, it also has some notable disadvantages.

The profits are subject to high LLC tax

The profits of an LLC are subject to social security and Medicare taxes. In some cases, owners of an LLC can even end up paying more taxes than a corporation does.

Also, both salaries and profits of an LLC are subject to self-employment taxes which currently equal approximately 15.3%. Whereas with a corporation, only the salaries are subject to taxation, not profits.

This disadvantage hits owners who take a salary of less than $97,500 the hardest.