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How an LLC Works

The limited liability company (LLC) is a very common entity form for small and midsize business. The reason that the LLC is so popular is based upon how the LLC business works. That is, the LLC is organized in such as fashion that it allows for the flexibility in operations and structure that is normally attributed to a partnership combined with the ability to add structural formalities similar to a corporation. Most notably, the LLC business provides limited personal liability protections to the owners of the business. To understand how an LLC works, you need to understand how it is created, what is the ownership and control structure, and how owners receive compensation.

How is the LLC Created

LLCs are created by filing the appropriate documents within the state where the business is organized. The document filed with the secretary of state’s office is the Articles of Organization. This document lays out the name, members (owners), registered agent, business location, and whether the business is member-managed or manager-managed. If the business wishes to conduct business in another state, it must file notice with the secretary of state offices in any state where it will conduct business.

LLC Ownership and Governance

LLCs are governed by a document known as the operating agreement. Owners of an LLC are called members. The members hold some percentage of the LLC ownership (or sometimes membership units) which are recorded in the operating agreement. The operating agreement will lay out the rights and obligations of members.

The obligations of LLC members turn on whether the LLC is member-managed or manager-managed. A member-managed LLC, as the name implies, is run by the members. The default rule is that all LLC members have equity authority and control over the company. The operating agreement can limit any LLC members role or authority. If managers run the daily affairs, members still maintain control rights. The operating agreement will lay out the rights and obligations of owners (and managers, if applicable). Generally, this includes meeting rights, rights to vote, rights to dissent on LLC actions, etc.

Limited Personal Liability

Perhaps the most important aspect of an LLC is personal liability protection. Members of the LLC do not want to be personally liable for the debts and obligations of the business. Personal liability means that the owners personal assets (car, home, bank accounts, land, etc.) could be reached by a judgment creditor of the business. For example, assume that an employee gets into a car accident while doing company work. If anyone is harmed by the employee’s negligence, that person may sue the employee and company. The company is vicariously liable for the actions of its employee. If the plaintiff sues and receives a judgment against the company, she can seek the sale of company assets until the debt is paid. If the company does not have sufficient assets to pay the judgment, the judgment creditor may seek to sell the assets of the owners. The members are protected from losing their assets by the LLC entity form. If, however, the members fail to follow the governance procedures of the LLC, underfund the LLC, or use LLC assets for personal use, they risk losing their personal liability protection. This scenario is known as piercing the veil of protection.

Compensation & Taxation

LLCs provide the greatest latitude in terms of compensation and taxation. The method by which members of an LLC receive compensation for working in or owning the LLC depends upon the company’s tax election. The LLC can choose to be taxed as a partnership or a corporation. If the company choose to be taxed as a partnership, all profits of the business flow through to the owners. The business entity itself does not pay taxes on any profits. Interestingly, if the members of the LLC work in the LLC, they cannot receive a salary. Any compensation for their work must be done through an additional draw from LLC profits.

If the LLC business chooses to be taxed as a corporation, it can choose to be taxed under subsection S or subsection C of the Internal Revenue Code. Taxed as an S-corporation, the profits of the LLC again flow through to the owners of the business. The owners receive a large advantage as the funds are not subject to medicare and social security taxes. Also, as of 2018, any profits from the business receive a 20% discount for taxation purposes. Any member working for the corporation must receive a reasonable salary for their services before they can receive any flow-through profits as owners. This is done to make certain members don’t avoid medicare and social security taxes by taking a flow-through distribution rather than a salary.

Lastly, if the company is taxed as a C-corporation, the business entity itself is a taxpayer. Where the partnership and S-corporation allow profits and losses to flow through the business entity directly to members, the C-corporation tax election requires the LLC to pay taxes on any profits. Once taxes are paid, the LLC business can then decide whether or not to distribute any of the profits to members. If the LLC business does make a distribution (called a dividend), the members receiving the dividend will pay taxes on the distribution at a dividend rate.

An LLC business can be a very simple or very complicated form of business entity. If you decide to organize your business as an LLC, talk to the professionals at LawTrades about how they can assist you.

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