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What is an LLC? The Misunderstood Legal Entity

You've probably heard about LLCs and their advantages, but do you truly understand what they are?


In essence, an LLC is intended for collective ownership, where multiple individuals share the responsibility and benefits of the business. However, many people attempt to establish an LLC on their own, unaware that doing so makes them a disregarded entity in the eyes of the law.


Let's delve into the true meaning of an LLC and why it's crucial to understand its intended purpose.


What does LLC stand for?

LLC stands for "limited liability company," is a business structure allowed by state statute. Each state may use different regulations, you should check with your state if you are interested in starting a Limited Liability Company.


What is a limited liability company?

A limited liability company (LLC) is an unincorporated association, recognized by state statute, that offers a flexible business structure with certain legal protections.


Here's what an LLC is and isn't:


What it is:

  • Formed by filing articles of organization with the state's secretary of state office.

  • Unique in its state, with no more than one active LLC having the same name.

  • Treated for federal tax purposes as a partnership, corporation, or disregarded entity separate from its owner.

  • Can have two or more members (multi-member) or one member (single-member).

  • May have an unlimited number of members, including individuals, corporations, other LLCs, or foreign entities.



What it is not:

  • Incorporated or required to file articles of incorporation. Incorporation involves being granted a charter that legally recognizes the business as a separate entity with distinct privileges, rights, and liabilities.


Limitations of an LLC

Despite the benefits of LLCs, they come with drawbacks, too. Owners need to weigh operational costs, registration, and legal compliance against an LLC's other tax advantages and disadvantages.


The main disadvantages include:

  • State-by-state restrictions. Some states impose extra fees on running an LLC. Additionally, certain states restrict professions like doctors and dentists from working through an LLC.

  • Increased cost. LLCs cost more to start and maintain than a general partnership or sole proprietorship. Annual reports and franchise tax fees further increase the price.

  • Restrictions on transferability. Unlike a corporation, all LLC members must approve each new member and membership transfer.

  • Extra taxes on split income. All income an LLC earns could be subject to self-employment taxes or payroll taxes.


Articles of organization

The articles of organization are legal documents that are filed with the Secretary of State when you form your LLC. The articles of organization outline the basics of your LLC.


Articles of organization include:

  • Business name and address

  • LLC's registered agent

  • Names and important information on LLC members


Articles of organization are also used to set up how the new company will be run, including the rights, powers, duties, liabilities, and other obligations each LLC member has. Having the guidelines in an official document can help your LLC run smoothly as your business moves forward.



Types of LLCs

LLCs include single-member, multimember, multi-member,-managed, manager-managed, and PLLCs—professional limited liability companies.


The individuals who own and run LLCs are called members. Limited liability companies' members invest capital, or membership interest, to claim a stake in the business. The number of members involved and their managerial approach determines the type of LLC they run. We've outlined the main LLC types below to break down the differences in limited liability companies.


Single-member LLCs

If you're the sole owner of an LLC, it's a single-member entity. Single-member firms benefit from low startup costs and minimal paperwork compared to other LLCs. However, you are held personally responsible for legal compliance, debt payoffs, and tax filing.


Multiple-member LLCs

An LLC with more than one member is known as a multiple-member or LLC. All members must sign off on the firm's written operating agreement to run legally. Besides that, setting up this type of LLC is similar to its single-member counterpart.


Member-managed LLCs

An LLC is member-managed when members manage the business themselves. These members can act on the company's behalf so long as they adhere to the operating agreement.


Manager-managed LLCs

Manager-managed LLCs involve members hiring managers to run operations. This allows owners to place leadership decisions in trusted staff's hands. The details of a manager-managed corporate structure should go in the operating agreement.


PLLCs

A professional limited liability company runs like other LLCs but focuses on certain professions. PLLCs form when states with regulatory board licenses on specific professional services or trades prevent these professionals from forming normal LLCs. In these cases, accountants, legal advisers, or medical workers often work under PLLCs instead.



State-by-state LLC requirements

An LLC must qualify to run in any state where it conducts intrastate business. Some states also require qualification if you conduct interstate business from that location.


Registering as a foreign business in other states is similar to registering in your home state. We've included a table summarizing important registration information, including for foreign entities, below.


Filing as a single-member LLC

If your business is a single-owner LLC, the Internal Revenue Service, or IRS, views it similarly to a sole proprietorship for federal tax purposes. That means the LLC doesn't need to file a return with the IRS. However, as the sole owner, you must report all profits and losses when you file your personal taxes with the Internal Revenue Service.


According to the Internal Revenue Code, in order to file taxes, report your operating results by submitting Profit or Loss Form Business (Sole Proprietorship) (Form 1040, Schedule C) with your 1040 personal tax returns.


Filing as a multi-member LLC

In the case of a multiple-member LLC, the IRS views your business as a partnership. Therefore, the co-owned LLC doesn't pay income taxes. Instead, each LLC owner pays taxes on their share of the profits on their income tax returns.

File the return on Form 1065, U.S. Return of Partnership Income. Each owner should show their pro-rata share of partnership income, credits, and deductions on Schedule K-1.


Distributive shares refer to each member's share of the LLC's profits. Members must report this sum on their own personal income and tax returns. The IRS reviews each member's tax return to ensure that LLC members report their income correctly.


Filing as a corporation

Single-member and multimember LLCs can also elect to file taxes as a corporation, which may reduce the amount your LLC owes. LLCs that file as corporations gain access to tax breaks and write-offs other structures can't use.

File Form 1120, U.S. Corporation Income Tax Return. The 1120 is the C corporation income tax return, and there are no flow-through items or flow-through taxation to a 1040 or 1040-SR from a C corporation's federal tax return. If your LLC files as an S corporation, it should file Form 1120-S, U.S. Income Tax Return.




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