A limited liability company, or LLC, is a type of business organization where the owners -- called members -- have a very limited personal liability for any debts owed by the business. There are several advantages to setting up your business as an LLC, including tax advantages and liability protection, but there can also be disadvantages to this business structure, including difficulty setting up a multi-state LLC and a lack of case law governing liability of LLC members.
Limited liability companies are taxed on a “pass-through” basis. This means that any profits earned by the LLC can be reported directly on members' individual tax returns. This prevents double taxation, where the business pays tax on its income and the owners also pay tax on their earnings. Money earned by members who actively participate in running the company, called managing members, or earned through regular guaranteed payments is classified as earned income. This allows certain tax benefits, such as being able to deduct any business losses and health insurance costs on personal income tax returns. Managing members' income is subject to self-employment tax. Money earned by members who are not managing members is not subject to self-employment tax, and these members are limited in the amount of company losses and expenses they can deduct from their personal taxes.
Ownership Pro and Cons
An LLC can have any number of members, including just one. If an LLC has only one member, it is taxed as a sole proprietorship. The members do not usually all need to be citizens or residents of the United States, and in some states, an LLC or corporation can be a member or owner of another LLC. Limited liability companies are not required to have a board of directors or shareholder meetings, and there is generally less paperwork and record-keeping required than with corporations. Members can determine aspects of business relationships, such as what ownership and management structure they want, profit distribution and which members have voting rights.
One key advantage to an LLC is that members are not usually held personally liable for company debts that they have not personally guaranteed. This means that members' personal assets, such as savings accounts and houses, are generally protected in the event the LLC become bankrupt or is sued. However, members of LLCs may not be able to rely on this protection in all cases through a process called “piercing the corporate veil.” This comes into play when courts find members personally liable for fraud and illegal acts, and the areas where courts will order the veil to be pierced and members to be held personally liable is constantly changing and expanding. The lack of precedent in this area of the law makes it difficult to predict under what specific circumstances the veil may be pierced.
Ease of Transfer
In most states, the LLC's operating agreement can be used to determine how ownership interests are sold or transferred to a third party. This makes it easier for a member to leave her shares to her heirs, or sell her shares, as there is less paperwork and administration. Some families set up LLCs specifically to hold family assets, such as real estate. In this case, when one family member dies, the assets pass directly to the remaining members, usually without the need to pay inheritance taxes. Membership interest in an LLC can also be placed in a living trust so that it passes directly to heirs.