How an LLC Works

by John Barron

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There are numerous forms of organization by which an enterprise can conduct its business affairs. Prior to the advent of the limited liability company, or LLC, most enterprises were organized as either partnerships, corporations or sole proprietorships. Each of these traditional forms of doing business had unique advantages as well as distinct limitations. The principal distinguishing characteristic of an LLC is that it represents a hybrid form of organization that combines the limited liability attributes of a corporation with the favorable pass–through income taxation aspects of a partnership.

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Features

Members of an LLC are normally shielded from personal liability for the debts of the enterprise in the same way that shareholders of a corporation are protected. In addition, in most jurisdictions, an LLC does not need to follow the rigors of corporate formalities, such as holding annual, shareholder and board of directors meetings. This can be a significant advantage, as a corporation’s shareholders who fail to comply with corporate formalities may lose their limited liability status under certain circumstances.

Tax Advantages

One of the principal advantages of an LLC is the favorable tax treatment afforded to the earnings of the enterprise. In most corporations, dividends are taxed at the corporate level, and then upon distribution to individual shareholders once again as personal income. An LLC avoids this “double taxation” problem by its pass-through treatment of the earnings of the business. The enterprise itself pays no tax, but rather passes through the earnings to its individual members who then report their share of distributed profits on their individual tax returns.

Flexibility

An additional benefit of forming an LLC is the choice available to its owners in terms of how the enterprise will be taxed. An LLC can elect to be taxed in one of four ways: as a sole proprietorship, as a partnership, or either as an S or a C Corporation. This affords the members of an LLC greater flexibility in terms of business tax planning than that allowed for by most other forms of organization. Owners of the LLC must elect their taxable status 75 days after formation of the company.

Operating Agreement

Though generally not required by state statute, members of an LLC may wish to stipulate the manner in which the business shall be managed and controlled by executing an operating agreement. An operating agreement will typically state which members shall manage the business, as well as how the earnings of the business will be distributed among its members and/or managers. Operating agreements may also provide for transfer restrictions on the sale of ownership interests as well as an accounting method for valuing a member’s ownership interest in the business.