LLC: Definition, Types and How to Form an LLC

LLC: Definition, Types and How to Form an LLC
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While ubiquitous now, a limited liability company is, in fact, a relatively new form of business structure in the U.S. Prior to 1977, you could not form a limited liability company, commonly referred to as an LLC, because this business structure did not exist in the U.S. However, that same year, Wyoming became the first state to recognize this form of business structure and enacted legislation to support it. Florida followed suit in 1982, and by 1988, an IRS ruling regarding how LLCs were to be taxed saw almost every state in the U.S. enact LLC legislation. These days, forming an LLC is quite common with many companies in the U.S. opting to do so. But, there are still a few commonly held misconceptions surrounding this popular and versatile business structure model.

What Is an LLC?

The terms "sole proprietorship" and "corporation" are likely already familiar to you, but what is an LLC – and what does it do – might not be. LLCs combine aspects of both sole proprietorship and corporations as well as those of partnerships, but are not themselves corporations. LLCs give owners, called members, protection against any personal liability. They are also often treated as noncorporate entities for tax purposes whereby the LLC itself doesn't pay taxes, rather, any profits or losses the company realizes are reported on the owner or owners' personal tax returns.

Owners of an LLC can, however, elect to have the company taxed as a corporation. LLC members can be a corporation, a partnership, a natural person or other legal entity. But, unlike corporations, which only require one shareholder, LLCs used to have to be formed by two or more members before 2003, when the last state that required two members, Massachusetts, enacted legislation enabling the formation of single-member LLCs. Now, all states and the District of Columbia allow for single-member LLCs. LLCs also have one or more managers who are typically elected or appointed by members and have the responsibility of the day-to-day operations and management of the enterprise.

Business Structure Models

This is where things can get a bit confusing, because some aspects of LLCs, partnerships and corporations do overlap, so it is probably in your best interest to do your homework or consult with a legal professional to guide you. But, there are key fundamental differences between these business structure models. Determining which is the best organization for your company depends upon the type of business you engage in, among several other factors.

Although LLCs have to comply with more paperwork and regulations than sole proprietorships, they cannot issue stock and typically do not have to hold annual meetings, nor maintain written minutes like corporations. Both corporations and LLCs protect against personal liability while requiring business and personal finances to be kept separate, but LLCs are highly flexible in their management structures while corporations are not. Corporations are recognized outside of the U.S., unlike LLCs, and are generally preferred by outside investors as well as for initial public offerings.

Different Types of LLCs

Just when you think you may be more familiar with what an LLC is and how it differs from other types of business structure models, you're not out of the woods yet. If you've decided that an LLC might be for you, now you need to navigate the various types of LLCs you can form. First, you need to determine if you would like your LLC to be managed by its members or by a manager. With member-managed LLCs, the owners run the company and can act on behalf of the LLC. Manager-managed LLCs are preferred when there are passive members, such as investors, who play no active role in the day-to-day operations of the company.

Because the formation of an LLC is largely regulated by individual states, each state has its own rules, requirements and statutes that govern LLCs formed within the state. As a result, some forms or types of LLCs are not available in all states. The following are a few of the more popular types of LLCs:

  • Single-member LLC: Single-member LLCs are similar to sole proprietorships in that they are owned and managed by a single member. But, unlike sole proprietorships, LLCs formed with just a single person enjoy limited personal liability for its member. Owners of LLCs are, however, personally responsible for any taxes or debts owed by the business as well as company transactions. Single-member LLCs can choose not to incorporate and are then taxed as a sole proprietorship. If the LLC opts to incorporate, then it is taxed at the corporate tax rate. Single-member LLCs are popular among small or new businesses because of the highly flexible structuring and less paperwork involved than other forms of business structures.
  • General partnerships: When two or more people form an LLC, the general partnership structure is often preferred. With a general partnership, all of the owners have a share in the responsibility for the day-to-day transactions, taxes and any debts owed by the business. Profits and losses also pass directly through to members who then claim them on their own personal tax return. Members may also decide when to sell assets.
  • Anonymous LLC: An anonymous LLC is just that – anonymous. Formation of the LLC is done by a third party, and the private identity of its members are protected by the state. Currently, only New Mexico offers this type of LLC structure, but it is becoming increasingly popular in the current age of readily accessible record-tracking at your fingertips. There are a few states where member privacy is kept strictly confidential, including Wyoming, Nevada and New Mexico. Of these states, New Mexico currently has the most strict protection of member and owner privacy. The state does not maintain records of ownership and cannot be held responsible for divulging this information. To obtain an anonymous LLC in New Mexico, only the name of the registered agent or organizer of the company is listed on the articles of organization. Do your research and find a reputable third-party registered agent if you want to go the completely anonymous route or consult with an attorney.

How Does An LLC Protect You?

By now you're aware that LLCs give the owners and members limited personal liability for the company. If you are a small sole proprietorship and just starting out, this may not be as important to you depending on your business. But as your business grows, and you find yourself in more positions where you have to assume more liability, the limited liability that an LLC affords is invaluable. For example, if you own a small coffee shop, the limited personal liability of an LLC can provide protection against you being sued or held personally liable in the event a customer slips and injures herself. This means you're unlikely to lose your personal assets were you to be sued.

LLCs are typically taxed as pass-through entities. This helps you avoid double taxation – a situation that can arise with other forms of business structure – in which the company is taxed, as well as the owners who also must report money received through the company on their individual tax return.

The ease of transferring an LLC also makes it a popular business structure. You can leave your share of interest in the LLC to heirs, or sell it more easily – and with less paperwork – than other types of business structures. A member can also place her interest in an LLC into a living trust, while LLC assets can also pass directly to remaining members in the case of family LLCs.

Disadvantages of an LLC

Although LLCs are widely known for protecting their members and owners from personal liability, there is a legal concept known as "piercing the veil." The LLC veil can be pierced in certain situations, which means members and owners can be held legally and personally responsible or liable for the actions of the LLC. Typically this is done in cases of fraud or corruption and member information can be requested by a judge. However, because LLCs are a relatively new way to structure a business, there isn't enough case law addressing the issue to set true precedence for when an LLC's veil can be pierced. Basically, you won't know if the members of your LLC could be exposed to this liability until you find yourself in court, although a completely anonymous LLC does provide further protection. In addition to an anonymous LLC or one formed in one of the states with more privacy options, observing corporate formalities such as having regular meetings and keeping meticulous meetings goes a long way toward maintaining this limited liability safety net, even if not required by the state.

Another drawback of starting an LLC arises when you decide you might need some outside investment to expand your company. LLCs can't issue shares, so if you want outside investors, they will have to buy in as members. Raising capital is difficult with an LLC because of the pass-through nature of this structure. Meaning, outside investors are more likely to invest their money in a C-Corp or S-Corp.

Setting up an LLC

Starting an LLC is a lot easier than in the earlier days because you can do so online. Many reputable companies such as LegalZoom offer services that allow you to form an LLC entirely online. In order to form an LLC, you must first choose a name for the company and file paperwork with the state you'd like your business to be located. Choosing a state in which to form the LLC is one of the most important steps. Every state has different fees, member anonymity protection, as well as filing and reporting requirements that make them more attractive to those seeking this sort of business structure.

Next, each state requires that all LLCs formed within its borders must name a registered or statutory agent. This is the person who maintains a physical address in the state and receives any paperwork, mail, lawsuits or any official documentation sent to the LLC. This information is then passed on to the appropriate LLC member. Registered agents allow LLC members to form an LLC in states in which they do not live. But, registered agents can also be anyone who is a resident of the state, including a member of the LLC, as long as he is available during normal business hours and over the age of 18. You can also pay for registered agent services from attorneys or other agencies that offer these services for a fee.

After you have found a reputable registered agent, you need to have an LLC operating agreement prepared. This agreement lays out how the LLC will run and operate. Member voting rights, how meetings will be held and what happens if the business is to be dissolved are all covered in the operating agreement. Some states do not require an operating agreement, but it is still a good idea to draw one up so everything is defined beforehand should future issues or member disagreements arise.

Now you need to file the articles of organization for the LLC. These vary widely from state to state, so it's best to consult with a qualified professional to assist you. Different departments handle the articles of organization, but in most states, you can expect to file these with the secretary of state.

After filing the articles of organization, you will receive a certificate from the state that formally recognizes your LLC. After receiving this certificate, you can then begin to handle matters such as obtaining a bank account for the business and a tax ID number. Lastly, if you do business in multiple states, you might have to register with these states. The registration process is similar to that of forming your LLC initially and you will have to have a registered agent for each state in which you're planning or authorized to do business.