Forming a Limited Liability Company: What, Why and How
I want to provide a birds-eye of what a limited liability company is, why you may want to form one, and then how you form one. My experience is that many small business owners (especially new small business owners) benefit from knowing this stuff. And in many cases, real estate investors benefit from knowing this stuff, too.
What is a Limited Liability Company
Let me start with the basic question, "What is a limited liability company?"
In a nutshell, an LLC (the acronym people commonly use to refer to limited liability companies) is a legal "person" that state law creates when you file a simple piece of paperwork with a state's Secretary of State.
But let me digress a bit. Anyone who's taken a sex education class knows how human beings create persons. No need to go into that here. But note that once such a "human" person is created, the person can do stuff: enter into contracts, own property, borrow money and so forth.
As a practical matter, obviously, a newborn baby can't or won't be entering into contracts, owning property and borrowing money. The baby needs to "grow up" into an adult both as a practical and often as a legal matter. But for simplicity's sake, let's ignore that. Focus on the fact that mom and dad create a human person that, once created, gets to do stuff.
Returning to the subject of LLCs, you want to think about them as "persons," too. LLC persons aren't humans of course. They don't get created by a mom and dad, but rather by law. But like a human person, an LLC person once created gets to do stuff: enter into contracts, own property, borrow money and so on.
Let me make a couple of other points about limited liability companies, too.
First of all, limited liability companies resemble corporations, another type of "person" created by law because paperwork is filed with a state's Secretary of State. Corporations, by the way, are a relatively "old" type of person and basically date back hundreds and hundreds of years. (Wikipedia suggests corporation-type entities existed in Ancient Rome though you need to take this tidbit with a grain of salt because on topics like this, Wikipedia articles are usually full of errors.)
Note: Corporations get their name from the latin word, "corpus," which refers to a body--another way in which entities like limited liability companies and corporations resemble "persons."
A second comment: An entity like an LLC (and this is true for corporations as well) is owned by some other person. Owning a person obviously (and sadly) occurs with humans though not as often in today's world as in the past. But all LLCs (and all corporations) are owned by some other person.
Note: The owners of a limited liability company are called members, and (as you probably know) the owners of a corporation are called shareholders.
Why Use a Limited Liability Company for a Business or Investment
So, you're thinking to yourself, this LLC thing is a little bit interesting. (Perhaps emphasis on the phrase "little bit.") But what does any of this have to do with the price of tea in China?
Good question--and one that surprisingly, too few business owners and business advisors spend time on.
You want to consider using an LLC for any business or investment ventures for three basic reasons:
Reason #1: Limited Liability of Owners
I mentioned earlier that LLCs have owners. But what I didn't mention is that an LLC's owners, or members, are not legally responsible for the debts of the LLC. Or restated, if you own an LLC and the LLC operates some business or investment, you are not legally liable for bad stuff that happens inside the LLC merely because you're an owner.
This limiting of the liability is really attractive. And the easiest way to see this is to look first at what happens in a business operated as a sole proprietor, an investment (like a piece of rental property) held directly by an individual, or when partnerships operate businesses or make investments.
In any of the preceding situations, the owners are responsible for the liabilities (debts) of the business or investment. If the business or investment can't, for example, pay some debt on its own, out of its operating cash flows or through liquidating assets, the owners do.
Example #1: If you operate a little trucking business as an unincorporated sole proprietorship and catastrophically one of your trucks and drivers runs somebody down, you will be personally liable for any damages. Hopefully the damages can be paid out of the business's profits and assets. And if that's not possibly, hopefully the insurance will cover any remaining sums. But in a worst case scenario, you as owner will be responsible for any damages. For example, if the accident ultimately results in a multi-million-dollar judgment by a jury and only a wee portion of that can be covered by things like insurance and savings within the business, you will need to make up the difference (or at least try to).
Example #2: What if the facts are the same as in example #1 in the preceding paragraph except that the business owner operates as a limited liability company? Well, in that case, the large multi-million-dollar judgment will fall only on the business. Probably a large judgment against a small company will destroy the company (unless the company carries lots of insurance). But if, even after gutting the LLC, some unpaid portion of the judgment remains, the LLC's owner doesn't need to pay.
As noted earlier, with an LLC, "You are not legally liable for bad stuff that happens inside the LLC merely because you're an owner."
Let me add a couple of clarifications here, though. First of all, while an LLC member may not be liable by virtue of ownership, an LLC member might be liable on other grounds.
For example, if you provide a personal guarantee to some customer or vendor of the LLC, you aren't liable by virtue of ownership. But you are liable by virtue of the personal guarantee. For example, if your LLC borrows money from the local bank but them you, as the LLC's sole member, personally guarantee the loan, you're liable because of the personal guarantee--not because of your ownership.
And let me make another clarification about liability, too. In the earlier example of a little trucking business injuring someone with a company truck, I described a situation where some employee of yours is driving the truck. But if you're the one driving the truck, you're going to be liable not because you're the LLC owner but simply because your hands were on the steering wheel.
One final point about the limited liability stuff. LLCs are not the only entity that businesses and investors use to limit liability. People also commonly use corporations. And a handful of other, more specialized entities exist, too, including limited liability partnerships and limited partnerships.
And this point leads nicely to the second and third reasons people (especially attorneys and accountants) love limited liability companies.
Reason #2: Easier Governance
I think it's fair to say that the laws of most states assume that corporations operate independently of their owners. In other words, mostly the laws of states implicitly assume that a corporation is owned by a bunch of people whose only involvement with the corporation is ownership of shares. People like your elderly aunt who happens to a widow, the pension fund of the local union, day traders, mutual funds, and so on.
With these types of absentee owners, obviously, the state laws that control how a corporation works need to protect the shareholders and also provide structure about how the corporation operates and who is in charge.
Commonly, for example, the shareholders meet annually to elect a board of directors. Then this elected board of directors meets either monthly or quarterly to elect and then supervise the corporate officers who actually "run" the company on a day-to-day basis. For example, the board elects a president, vice president, and then other officers like a secretary and treasurer. And then board oversees these officers, thereby representing the interests of the shareholders. Remember that this group, in our example, includes your elderly aunt.
The approach to governance described in the preceding paragraph, let's be fair, makes perfect sense for big giant businesses owned by thousands of shareholders. But for a small business which, for example, you own and operate, all the stuff about shareholders meetings and regular board meetings and corporate officers is too much. (Note that to really do all this right, you'd need to be keeping minutes of all the meetings these various groups have... Ugh.)
So now that you know all this stuff, let me tell you why LLCs are easier. You don't have to do this. In other words, with an LLC you don't have annual owner meetings (documented with copious minutes). You don't need to set up a board of directors and make them meet at regularly scheduled intervals (or, again, document all of this activity in tedious detail via board meeting minutes). You don't need to elect corporate officers and then get the board to supervise these people.
With a limited liability company, in effect, you get the liability limitation when you set up the LLC up. And then the members just get to run, or "operate," the venture in whatever they want. (By the way, the way that the members want to "operate" the LLC should be documented in the LLC operating agreement.) But the rules and procedures documented in the agreement can be very lean and simple--especially when the same person owns and runs the LLC.
Summing up, one of the big reasons that attorneys like LLCs is that they allow for really easy, clean governance.
But there's another reason accountants like LLCs, and I'll talk about that next.
Reason #3: Flexibility Over Tax Treatment
If attorneys like LLCs because of the simpler governance, accountants like LLCs because of the tax flexibility. But let me explain the flexibility thing by giving a bit of tax history.
Slightly more than thirty years ago, the first states began creating the laws that allowed people to set up these new-fangled LLC entities that required way less governance. And that was really good. But the tax laws didn't really know how to treat these things.
For a while, initially, tax authorities tried to work with a set of complicated rules that basically said, well if the LLC mostly looks like a corporation, we'll treat it as a corporation for tax laws. But if the LLC mostly looks like a partnership, well, then we'll treat it as a partnership. Of course, this partnership treatment didn't make sense if the LLC only had a single member.
This was obviously a little crazy, given the uncertainty such an approach creates. Taxpayers and the IRS were fighting all the time.
Finally, in 1996, the Internal Revenue Service gave up and, in effect, said, "Hey, taxpayer? You know what? Geez, we don't care how you treat your limited liability company for tax purposes. Seriously, let's stop fighting and arguing about this. From now on, what we'll do is this:"
"If you're a single member, or one owner LLC, you can just report your income and deductions on the your regular tax return (this might be an individual 1040 tax return or a form within such a return such as the Schedule C or the Schedule E) but if you want to be treated as a corporation or as an S corporation, just let us know. That's fine, too."
Note: Tax law often calls the sort of tax accounting where the LLC's income and deductions are reported on the owner's tax return as "disregarded entity" treatment or "disregarded entity" status.
"If you're a multiple member, or multiple owner LLC, though, we'll treat you as a partnership meaning you need to report your income and deductions (and probably other information, too) on a partnership return. But again, let's stop the bickering, if you want to treat your multiple member partnership as a corporation or S corporation, no problem. Just let us know."
Summing up, then, since 1996 LLCs provide business owners and investors with massive tax flexibility. With a limited liability company, assuming you meet any eligibility rules, you just select the tax treatment you want. Typically, predictably, you pick the tax accounting treatment that saves you the most tax.
And just to make one other comment. You can even change the tax treatment your business or investment uses--such as going from "disregarded entity" status to a corporation or S corporation--if that will save tax.
Note: Converting an LLC from a corporation or S corporation to disregarded entity or partnership tax accounting would usually trigger negative tax consequences because the change would be treated as a corporate liquidation.
So, summing things up, LLCs are very attractive tax options for business owners and investors: You get limited liability. But without all the red tape and bureaucracy that comes with a traditional corporation. And then, as a sort of extra bonus, you get extreme tax flexibility.
How to Form a Limited Liability Company
To form a limited liability company, you file articles of organization (sometimes also known as articles of formation) with the state where the LLC will operate.
Typically these articles fit on a single page and simply name the LLC, provide its address, and then give a small amount of additional information such as the purpose of the LLC, a contact name (referred to as a "registered agent") and then, in some states, the names of the LLC's owners, or members.
States charge a fee both for initial formation of the LLC and for annually renewing the LLC's "status." Fees vary but in many states, both the initial fee and the annual renewal fee often run from $100 to $200.
Note: Some business-unfriendly-states like California and some states in the Northeast charge higher fees. California, for example, charges a low initial filing fee, but then charges a minimum of $800 a year for renewal.
Most states let you form an LLC online (and in my LLC do-it-yourself kits I usually emphasize this approach) and that method usually results in fast turnaround of a few days. But some states require more time. (In same cases, a few weeks.)
Finally, just so you know, a small handful of states also have a public notice requirement where you need to post an announcement of your LLC in the local newspaper.
Two other quick points (and I talk more about this kind of stuff in my do-it-yourself kits): First, after you set up a new limited liability company, you usually need to do some other set up stuff, too, like getting the new LLC a tax identification number, a business license, and a bank account. So that's something to remember if you do this.
Second, people sometimes wonder which state they should pick for the LLC since you can form your LLC in any state. Usually this question isn't worth spending much time on, though. And here's why. Yes, you can use a (say) Nevada LLC for your California business or investment. That's allowed.
But while that means Nevada LLC laws will control the formation of the LLC, you'll still be subject to California laws and taxes if the business or investment operates in or owns property in California. For example, if a Nevada LLC operates in California, California can and does require that the Nevada LLC register as a "foreign LLC" operating in California. And California will require the Nevada LLC to abide by California laws (such as disclosing LLC members) and to pay California income and franchise taxes (including the $800 a year LLC franchise tax).
For most investors and businesses, you want to form the LLC in the state where the LLC will operate.