A limited liability company, or LLC , is a hybrid business entity that includes some features of corporations. For example, both corporations and LLCs provide their owners protection against the debts of the business. There are some crucial differences, however, that should be considered when choosing the best form for your business.
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Unlike a corporation, an LLC does not issue stocks and is not owned by shareholders. Instead, an LLC is owned by members, who are equivalent to the partners of a partnership. Many LLCs have an operating agreement, which, though similar to corporate bylaws, functions more like a partnership agreement to spell out the rights and responsibilities between the members. Making an operating agreement can prevent the application of state default ownership rules by allowing the percentage ownership of each member to be set in any proportion, unlike a corporation, which is owned in proportion of stock ownership.
Unlike a corporation, an LLC is usually a pass-through entity for federal tax purposes. By default, a single-member LLC is treated by the IRS as a sole proprietorship and a multiple-member LLC is treated as a partnership. In either situation, this means the profit or loss of the business is reported on the individual tax returns of the members. A corporation, by contrast, is a separate taxable entity, hence its profit is taxed twice — once at the corporate level and then again as capital gains or dividends to the shareholders. An LLC, however, can elect to be taxed as a corporation to take advantage of lower corporate tax rates.
Another important tax difference between corporations and LLCs is that LLC members are potentially liable for self-employment tax. If the LLC is taxed as a sole proprietorship and the member reports income from the business on 1040 Schedule C or F, she is liable for income tax on business income. Members of an LLC taxed as a partnership are generally liable for self-employment tax on distributions from the business. Shareholders of a corporation are not considered self-employed.
Unlike a corporation, an LLC has far fewer formalities that must be observed. For example, LLCs are not required to hold annual meetings of the owners like corporations do, and there is therefore no need to record minutes of such meetings. Certain formalities, however, should be observed to preserve the members' limited-liability protection. Such factors as whether the business is adequately funded and whether business and personal funds are kept in separate accounts have been used to "pierce the veil" of limited liability and attach liability for LLC debts to individual members. State statutory formalities should also be observed to ensure limited liability.