Forming a Limited Liability Company: What, Why, and How

We want to provide a birds-eye view of what a limited liability company is, why you may want to form one, and then how you form one. Our 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’s start with the basic question, “what is a limited liability company?”

In a nutshell, an LLC 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’s 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 once created gets to do stuff: enter into contracts, own property, borrow money, and so on.

Let’s 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. (Corporations, by the way, are a relatively old type of “person.”)

A second comment: An entity like an LLC (and this is true for corporations as well) is owned by some other person, whether a human or another legal entity.

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. 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

We mentioned earlier that LLCs have owners. But what we didn’t mention is that the members of an LLC generally aren’t legally responsible for the debts of the LLC merely because of their ownership.

This limiting of liability is really attractive. And the easiest way to see this is to look first at what happens in, for example, a business operated as a sole proprietorship and then compare it to what happens in an LLC.

Example #1

Let’s say you run a small business as an unincorporated sole proprietorship and you end up in a dispute with one of your vendors about a debt you owe. If the vendor secures a judgement against you to pay the debt and the business can’t pay the full amount, you personally 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, except that the business operates within a limited liability company? Well, in that case, the judgment will generally 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 members don’t need to pay.

Let us 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 of, vendor of, or lender to 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 then you, as the LLC’s sole member, personally guarantee the loan, you’re liable because of the personal guarantee—not because of your ownership.

In addition, you can still be held personally liable for acts of gross negligence you commit as an owner of the LLC.

Especially on this last point about negligence, things can get murky. Remember that in this short article we’ve given only the most basic overview of how this liability stuff works. It’s not quite as simple as we’ve made it sound here. (I mean, surely law school exists for a reason, right?) Accordingly, if you’re seriously interested in protecting your legal liabilty with an LLC and want to thoroughly understand the issues, talk to an attorney. It’s worth it.

Another final point about this 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 last point leads nicely to the second and third reasons people (especially attorneys and tax accountants) love limited liability companies.

Reason #2: Easier Governance

It’s probably fair to say that the laws of most states assume that corporations operate independently of their owners. In other words, most 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 the pension fund of the local union, college and university endowment funds, mutual funds, day traders, 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 manage 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 the board oversees these officers, thereby representing the interests of the shareholders, such as the pension fund for your local firefighters union or the endowment fund that pays for your child’s university scholarship.

The approach to governance described in the preceding paragraph makes perfect sense for big giant businesses owned by thousands of shareholders. But for a small business with only one owner who’s also the top manager, all this 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, here’s why LLCs are easier: You don’t have to do this. In other words, with an LLC you don’t need to 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 tax accountants like LLCs, and we’ll talk about that next.

Reason #3: Flexibility Over Tax Treatment

If attorneys like LLCs because of the simpler governance for small business owners, accountants like LLCs because of the tax flexibility. But let us explain the flexibility thing by giving a bit of tax law 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 C 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 individual tax return as “disregarded entity” treatment.)

“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 C 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, 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 C corporation or S corporation.

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 an 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 referred to as “articles of formation”) with a state government.

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 person (often referred to as a “registered agent”), and the names of the LLC’s members.

States usually charge a fee both for initial formation of the LLC and for annually renewing the LLC’s registration. Fees vary but in many states, both the initial fee and the annual renewal fee often run from $100 to $200.

(Note: Some states charge higher fees. California, for example, charges a low initial filing fee, but then charges a minimum of $800 a year franchise tax on the LLC.)

Most states let you form an LLC online. That method usually results in fast turnaround of a few days. But some states require more time. (In some 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 about forming your LLC in the local newspaper.

Two other quick points: First, after you set up a new limited liability company, you usually need to do some other 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, at least for tax reasons. 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 requires 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).

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