LLCs Explained: When Form a Limited Liability Company?
21st November 2009
by Stephen Nelson
New business managers and entrepreneurs sometimes ask, “What is a limited liability company?” And that makes sense… While most business people know what a corporation is, most of us don’t have any real experience with the LLC.
Well, you can better understand the practical answer to the “what is a limited liability company?” question by knowing three things about LLCs: when they’re used, how they’re created, and why they’re created. But let me explain…
When does the LLC option make sense?
As a practical matter, a limited liability company, or LLC, is a container you can use to hold a business or hold investments. In other words, while you might run a business as a sole proprietorship or hold an investment in a partnership, you can also store a business or investment within an LLC.
With a limited liability incorporation, the LLC operates the business or owns the investment and the LLC owners (who happen to be called members) own an interest in the LLC.
How are limited liability companies created?
You trigger the creation of a limited liability company by filing articles of LLC formation with a state’s Secretary of State. For example, to create an LLC in Ohio, you file articles of formation with the Ohio Secretary of State. And to create an LLC in Pennsylvania, you file articles of formation with the Pennsylvania Secretary of State.
Typically, by the way, you also pay a modest fee at the time of filing the formation documents, though sometimes the fee isn’t modest. Some business-unfriendly states charge absurdly high fees.
Note: For most states, the generalizations of the two preceding paragraphs are true. Some states add one or two other llc creation requirements, however. For example, some states require the llc to have an LLC operating agreement. And some states require the limited liability company to issue a public notice about the filing of LLC articles. (Normally, any “public notice” is done via a newspaper advertisement or two.)
Why form a limited liability company?
Two reasons exist for forming a limited liability company. First of all, a limited liability company limits risks. Specifically, the owner of a business or investment “held” inside a limited liability company doesn’t have liability for what goes on with the business or investment because of his or her indirect ownership. Note that with a sole proprietorship and partnership, an owner does have liability because of his or her ownership.
A second reason also exists for forming a limited liability company: Rather uniquely, a limited liability company gives its owners noteworthy flexiblity in how the tax accounting gets handled. For example, limited liability companies can be taxed as traditional corporations or as Subchapter S corporations.
Seattle tax accountant Stephen L. Nelson writes a FAQ about limited liability companies. Nelson holds an MBA in finance and an MS in taxation. His most recent column talks in more detail about the question, what is a limited liability company.