A limited liability company, or LLC, is one of the most common types of business entities for entrepreneurs and small businesses — and for good reasons. The benefits of an LLC have far-reaching implications that can protect a business owners’ assets, such as their home and retirement accounts, from debt and liability claims. When considering your business structure, it’s also important to understand the tax benefits of LLCs.
We’ll walk you through some of the key benefits of having an LLC so that you can determine if it’s the most suitable type of business structure for your business. But, first, let’s review what an LLC is.
What is an LLC?
Although an LLC isn’t technically a corporation or a partnership, it shares some of the characteristics of each.1 Like a corporation, an LLC creates a barrier between a business’s obligations and the owners’ assets. And, just as with a partnership, an LLC has flexibility in how income is taxed and distributed to members.
Simply put, an LLC formation combines the best of both corporations and partnerships or sole proprietorships to offer several key benefits for small businesses like yours.
The 7 benefits of an LLC
1. LLCs are easy to establish.
Although sole proprietorships may be the most accessible type of business entity to launch, setting up an LLC is still a straightforward process. Since state statutes govern LLCs, check with your state government on the specific filing requirements. Generally, all states will require you to start by choosing a name that is available for your company and filing articles of organization with your state’s corporate filing office, which will often be the Secretary of State.
By comparison, establishing an LLC does not involve nearly the amount of red tape as filing articles of incorporation for an S corp or C corp.
2. LLCs offer limited liability.
In the business world, things can go sideways. Maybe your business is sued, or you have a financial obligation that you are unable to pay. If something like this occurs, you may lose your financial contribution to the business, just as a corporate shareholder would. However, an LLC’s legal liabilities generally won’t extend to your personal assets, such as your home or savings accounts.
One of the most important benefits of having an LLC is limiting your liability. (It’s in the name, after all.) Forming an LLC separates your business from you by creating a barrier between your personal and professional assets.
This limited personal liability is a form of asset protection not granted to sole proprietorships or traditional partnerships. You should practice good business bookkeeping to guarantee your limited liability protection, such as keeping your personal and business finances separate.2
3. LLCs have management flexibility.
Unlike the established structure of a corporation, owners of LLCs can determine what form of management and ownership work best for them. For example, an LLC offers the discretion to operate as a single or multi-member, member-managed, or manager-managed business entity.
Moreover, unlike corporations, limited liability companies typically don’t require:
- Designated formal roles
- Extensive record-keeping
- Annual reports
- Annual shareholder meetings
Meetings at a coffee shop and minimal phone calls? Suits replaced by video calls from a restaurant on the beach? These are the types of luxuries enjoyed by LLC owners that are seldom available to corporate officers.
It’s important to note, however, that LLCs should have an operating agreement in place that outlines the specific ways that the business will function. Otherwise, your business will default to your state’s rules governing LLCs, which may not be in the best interest of your business.3
4. There are tax benefits to LLCs.
In this world, nothing is certain, save for the fact that everyone loathes taxes. Yet, LLCs at least have the flexibility to choose their specific tax designation, which is one of the benefits of having an LLC.
LLCs have the freedom to decide whether they’d like to file with the status of a:
- Sole proprietorship
- Traditional partnership
- S corporation
- C corporation4
By default, though, the Internal Revenue System (IRS) will categorize an LLC as a sole proprietorship (if there is one owner) or a traditional partnership (if there are multiple owners). As such, profits go directly to the LLC’s owners and are taxed through their individually-reported tax returns to avoid being double-taxed by the IRS. The profits are taxed only once, which is referred to as “pass-through taxation.” Pass-through taxation allows business owners to avoid additional corporate taxes.5
But because LLCs do not belong to any specified federal taxation classification, forming an LLC grants you other options, should you wish to make use of them. One of the benefits of an S corp, for example, is that not all income is subject to a self-employment tax, including payments to shareholders in the form of dividends. Consequently, switching to an S corp classification when your business generates enough revenue can prevent self-employment taxes from draining your profits. Consult with a tax specialist or CPA to determine when that revenue tipping point applies to your LLC.
Tip: If you think your LLC should be tax-exempt, be aware that the IRS issued clarifying guidance to clarify the standards that an LLC must satisfy to be recognized as tax-exempt.6 If you think your LLC may qualify for tax-exempt status under Sec. 501(c)(3), you’ll need to ensure your LLC’s operating agreement and articles of organization follow very specific language. Also, all of the members of your LLC must be tax-exempt organizations or governmental units as well.
5. LLCs offer income flexibility.
Unlike corporations that distribute profits based on ownership or equity, LLCs can distribute income as their members see fit, as long as the company’s operating agreement spells it out.
For example: Several founding members with equal shares agree that another member should receive a more significant portion of the profits. They do this because that member’s initial investment was larger, or maybe the member puts more time into the business. The LLC can distribute a larger portion of the income to that member. Other business entities do not have this flexibility.
6. LLCs boost your business cred.
Generally, an LLC is viewed as a more formal business structure. Like showing up to your high school reunion with a title like Doctor tacked onto your name, the mere addition of an LLC may lend a sense of credibility to your business that may appeal to creditors, investors, suppliers, and customers. This credibility can help your LLC in significant ways, such as when you seek additional funding, which we’ll cover next.
7. Better access to funding with LLCs.
It’s generally easier for LLCs to obtain business financing because lenders tend to look more favorably upon businesses that exist as separate entities from their owners. This is true with both debt and equity financing.7
On the other hand, it can be difficult for sole proprietors to finance business debts. While you might be able to secure a personal loan or credit card, you’ll typically have a lower lending or spending limit and a higher interest rate. Additionally, business debts may negatively impact your personal credit score and will also be your personal responsibility to pay off, whether or not your business succeeds.
Tip: Building your LLC operating business’ credit history will bolster your ability to qualify for additional credit lines and loans.
A word of caution: An LLC doesn’t make you bulletproof
While an LLC protects your assets, it doesn’t cover you from responsibility if you:
- Are responsible for an injury to another party
- Are negligent or reckless
- Engage in an illegal activity
There is no guarantee that your status as an LLC is sufficient to shield you from all liabilities. Thankfully, you have options when it comes to giving your LLC more security. Having the right business insurance in place can protect both you and your business from the financial consequences of third-party claims.
How to protect your LLC
With an LLC, your business is granted flexibility, tax benefits, and financial security — without the excessive administrative commitment required of other business entities. And while an LLC can afford you certain protections, it can’t shield you from everything. That’s why we’re here!
Thimble offers quick-thinking insurance for fast-moving businesses, and we make it radically simple. Purchase a policy by the job, month, or year. Simply click “Get a Quote” or download our free app, answer a few quick questions, and get the coverage you need in a matter of just a few minutes.
- Upcounsel. Is an LLC a Corporation or a Partnership: Everything You Need to Know.
- Bank of America. Why and how to keep your personal and business finances separate.
- U.S. Small Business Administration. Basic Information About Operating Agreements.
- American Express. 4 tax Possibilities for Your LLC.
- IRS. Limited Liability Company.
- Journal of Accountancy. Guidance issued for LLCs seeking tax-exempt status.
- Nav. LLC vs. Sole Proprietor: How to Make the Right Choice for Your Business.