How to Understand an LLC

By David Ingram

Limited liability companies combine the advantages and disadvantages of corporations and private partnerships. Understanding an LLC involves discovering which aspects of this unique form of business organization resemble traditional models. LLCs can be an ideal business form for particular companies and industries, but their limitations make them a model that is not suited to every situation.

Step 1

Understand the concept of limited liability. In private companies, such as sole proprietorships and partnerships, business owners can be held personally liable for their business's debts and any legal judgments. This can be potentially devastating to entrepreneurs, since company debts and lawsuits can dwarf an owner's personal resources. Corporations offer liability protection for owners, meaning that only the business can be held liable for its obligations. LLCs borrow this limited liability provision from their traditional corporate counterparts.

Step 2

Differentiate LLC members from private partners and corporate shareholders and understand how members distribute company profits. LLC owners are referred to as members and members are set forth in the original LLC operating agreement. Members can be added or eliminated at any time and there is no maximum number of members an LLC can have. LLC members can be other corporations in addition to individuals, creating unique opportunities.

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Step 3

Understand the tax structure of the LLC form of organization. An LLC with only one member is treated as a disregard entity by the IRS. This means that the LLC does not pay taxes and does not have to file a return with the IRS. Multi- member LLCs are treated as partnerships for tax purposes. Like one-member LLCs, co-owned LLCs do not pay taxes on business income; instead, the LLC owners each pay taxes on their share of the profits. LLCs can also elect to be taxed as corporations, whereby income is taxed at the business level, then again at the individual member level.

Step 4

Understand the limitations of LLCs. One way in which LLCs differ from traditional corporations is the fact that they cannot issue shares of stock to the public. Stock offerings provide corporations a powerful fundraising tool and an LLC's inability to tap this resource can be a pronounced disadvantage.

Step 5

Learn about an LLC's ability to protect parent corporations. Since corporations can be members of LLCs, and since LLCs offer liability protection, large corporations can create LLCs to compartmentalize facets of their operations. As an example, an automobile manufacturer may choose to separate their customer-finance department into a separate LLC, with the parent corporation as a member. This way, if the LLC struggles financially from an excess of loan defaults, the loss will not pull money from other parts of the business.

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When Is it Better to Form an LLC Instead of a Corporation?

References

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