A Primer on LLCs

By Incorporation

The limited liability company (LLC) is a relatively new legal entity which got its start in the late 1980s. As the name implies, an LLC provides limited liability to its participants called “members” while containing the assets and operations of the business enterprise. Please keep in mind that LLCs are regulated at the state level, therefore management and formation matters may vary from state to state.

How to Form an LLC

LLCs are formed by filing an articles of organization (or other similarly titled document) and submitting a filing fee with the Secretary of State.

You’ll have to make sure the LLC’s name complies with applicable state rules or else the Secretary of State will reject the filing. The most common reason a name is rejected is that the proposed LLC’s name is too similar to that of an existing entity, whether the existing entity is an LLC, corporation, limited partnership, etc. Some states can be very laid back with regards what constitutes a similar name, while others are hyper-sensitive sticklers (hello Texas!).

You will also have to appoint a registered agent for your LLC. A registered agent is a business or individual designated to get served when your LLC is a party to a legal action such as a lawsuit or summons. Failure to maintain a registered agent or keep your registered agent’s address updated can produce undesirable effects for your LLC.

The Management and Operations of an LLC

An operating agreement typically determines the management and operational functions of the LLC. This agreement is made between the LLC’s members (the owners of the LLC) and the LLC. The operating agreement will also determine the allocation of income and tax liabilities. These documents can be extremely short or extremely long.

In the typical default management structure, the management of the LLC is vested in the members in proportion to their ownership interest in the LLC. However, the members can agree, either in the articles of organization or operating agreement, to vest management in a “manager” rather than each of the members.

Tax Basics

Thanks to a 1998 Internal Revenue Service ruling, LLCs are a hybrid vehicle which provides the liability protection of a corporation with the pass through taxation benefits of a partnership or S corporation. Pass through taxation means that the members of the LLC pay the taxes of the LLC on their individual 1040 tax return via a Schedule K-1. Thus, the income (or loss) is “passed through” to the members. This allows for the avoidance of double taxation on the LLC’s income.

I highly recommend seeking guidance from your CPA, as there will be tax issues–both personal and for the entity–that may influence your entity decision.

When is the LLC the best choice of legal entity?

Unfortunately, I don’t have a bright-line rule for when to be an LLC. The LLC is a very flexible legal entity combining the advantages of corporations such as limited liability and continuity of life with the advantages of partnerships such as pass through taxation and corporate informality.

Thus, if you are looking for a simple way to enjoy limited liability and you are not too concerned with raising capital or establishing a more traditional management system, the LLC is probably for you. But if you are looking to use various corporate-like methods, whether options or raising capital, the LLC may not be your best option. You can still create some corporate-like incentives for your employees, but I find that most employees have a hard time comprehending what a “membership unit” is as opposed to a share of stock.


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