Benefits of an LLC - How & Why They Work So Well
Your business structure impacts every aspect of your company, so how do you choose the right one? Each comes with its own set of pros and cons.
Limited liability companies (or LLCs) are one of the most popular business structures in the US [1], and for good reason. We look at the benefits of an LLC and break down exactly how they work, to help you decide whether an LLC is the right business structure for you.
How do LLCs work?
A limited liability company (LLC) is a business structure that legally distinguishes between the business owner and the company itself. In layman's terms, the owners of the LLC are not responsible for the company’s debts or liabilities. If the LLC should run into severe debt or face a lawsuit or bankruptcy, the personal assets of the owners cannot be seized and used to settle the dispute.
Choice of internal structure
When you form an LLC, you can do it with just one person or any number of members. In fact, you can have a corporation as a member of your LLC [2]. There are a few different names used to refer to the owners and managers of an LLC that depend on their internal structure. LLCs can have ownership structures or management structures.
In ownership structures, the owner is referred to as a member. If there’s just one owner, it’s a single-member LLC. If there are two or more owners, it’s a multi-member LLC.
In management structures, there are designated managers that handle daily operations, while members (owners) are in charge of making decisions.
In small businesses, it’s common for members to also be the managers. This is known as a member-managed LLC. In large, multi-member LLCs, there tend to be managers who are non-members. In this case, they are a manager-managed LLC.
What are the benefits of an LLC?
Some of the greatest advantages of an LLC come from how this model is structured itself.
Hybrid business structure
Limited liability companies are known as hybrid business structures since they share aspects of other common business structures, like corporations, partnerships and sole proprietorships. For the same reason, LLCs are deemed as being one of the ‘safer’ business structures.
Like corporations, assets and debts associated with LLC businesses are viewed as separate from that of the owner - i.e. owners have ‘limited liability’. The personal asset protection offered by LLCs makes them a popular choice of many first-time entrepreneurs.
Flexibility around tax
If you form a single-member LLC, you can be taxed as a sole proprietor. LLCs are flow-through entities - they don’t pay corporate tax. This means that income is passed straight to members, shareholders and investors. For that reason, these individuals (and not the LLC itself) declare revenue on their personal tax returns. This helps avoid double taxation, which is what happens when a corporation’s owners and the corporation itself are taxed twice. With double taxation, the corporation (the entity itself) and the corporation owners are taxed.
With pass-through taxation, income is taxed only at the member’s individual tax rate for ordinary income. This flexibility around how LLCs pay tax makes them similar to sole proprietorships, partnerships and S corporations.
The LLC’s managing member or members can deduct 100% of health insurance premiums paid, up to their prorated share of the LLC’s net profit. This rule only applies because the profit is considered earned income [3].
Special allocation of profits
In a multi-member LLC, you can use special allocation of profits. This is when an LLC divides profits and losses in a way that does not correspond to the members’ percentage interests in the business. You might want to use special allocation of profits if one member initially adds more capital to the business than the other.
For example, say you and your friend set up an LLC, but only you find funding to start the business. Your friend may sign a promissory note to contribute their share in installments over the first two years of the business. Your operating agreement declares that you both have 50% ownership interest in the business. It says that you will be allocated 75% of profits and losses for the first two years, and your friend will be allocated 25%. After two years, the agreement says that both members will split LLC allocations of profits and losses 50/50 in proportion to your ownership interests. This aspect is what likens LLCs to partnership entities.
Easy to form and manage
You can start an LLC in just a few steps. Each state has its own regulations and fees, but they generally follow the same process.
- To create your LLC, you must file articles of organization with your Secretary of State. This typically costs around $100. All you need is the LLC's name, the name and address of its registered agent, and basic information like the names of the LLC owners and management plans.
- LLCs are required to have a registered agent. This is an individual or company that agrees to accept legal papers on behalf of the LLC if it is sued. Most states maintain a list of private service companies (commercial registered agents) that will act as agent for service of process for a fee. An LLC member can act as registered agent for the LLC.
- Additional tax and regulatory requirements may apply to your LLC. These include an EIN, business licenses and permits, and sales and employer taxes [4].
In terms of running your LLC, there are no requirements to hold annual meetings of members or to keep minutes of any other meetings. Most states don’t require proof of an operating agreement, although they are strongly recommended alongside your business plan. However, many states request an annual report with a filing fee.
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