What Is an LLC and How Does It Work? A Detailed Guide

what is an llc and how does it work limited liability company

There are over 32 million businesses across the United States.

Due to the benefits owners get through asset protection, a good chunk of these businesses exist as Limited Liability Companies. While there are several other options on the legal structure you can pick for your business, what you settle on depends on your objectives.

If you’re asking yourself, “What is an LLC and how does it work?” Here is a guide to help you understand this legal structure better.


What Is an LLC and How Does It Work?

A Limited liability company is a business structure created by state law that exists as a legal entity that is distinct from its owners.

An LLC combines aspects of a sole proprietorship, a corporation, and partnership to create a structure that ensures the owners are not personally liable for its liabilities.

You can form an LLC to own certain assets (for example, real estate, houses, boats, vehicles, etc.) or use it to run a business.

The owners of an LLC are known as members. You can have a Single-Member LLC that’s owned by one person or a Multi-Member LLC owned by two or more people.

Once you pay a filing fee and successfully file the LLC formation documents with your state, you can become a member.

An LLC exists as a separate entity from its owners. As such, in the eyes of the law, you as the owner are not the same as the LLC. That's essential because it helps manage asset protection and is arguably one of the most significant benefits of an LLC.

For example, let's say you are a member of an LLC and happen to accrue a business line of credit worth $50,000,000 that goes unpaid beyond its tenor. When the lender decides to take legal action to recover their money, they will not come for your personal assets.

Instead, they will file a case against the LLC, and the entity will have to use its assets to repay the loan. In that sense, what you own as an individual remains safe.

When you own place assets or a business under an LLC, the ownership moves from you to the entity. Therefore, all legal documentation will show that the owner of the asset or business is the LLC.


How Do You Form an LLC?

When forming an LLC, you begin by selecting a business name for it. Don't forget that the name you choose must be in line with your state’s rules.

Once you have the name, you must prepare the Articles of Organization (known as Certificate of Formation or Organization in some states). You can file the documentation with the Secretary of State by mail or through some of the best online LLC formation service providers.

If you plan to conduct business in another state other than the one the LLC’s registered in, you’ll need to register in the state of interest. Just like when registering with your state, you will also need to appoint a registered agent for your LLC in the state you plan to operate in.

There are several regulatory and tax requirements you need to be aware of when forming an LLC. These are:

Employer Identification Number: The EIN is mandatory for Multi-Member LLCs, even if you don't plan on hiring any employees. In the case of a Single-Member LLC, an EIN only becomes necessary when you want to hire employees or choose to be taxed as a corporation.

Sales and Employer Taxes: There are cases where you will need to pay sales and/or employer taxes. It’s wise to consult a tax professional during the registration stage to discover what obligation you’ll be responsible for.

Business Licenses: Depending on your area of operation, there are licenses you may need to acquire from the state or local authorities. Consult the necessary state agencies to confirm all the licenses you need to get, so your LLC becomes compliant.

In many states, once your LLC is operational, you will need to file annual reports along with a filing fee.


How Do LLC Owners Get Paid?

When forming an LLC, every owner puts in something of value that will help run the organization. Typically, this is money or other assets.

Every member's contribution goes to their capital account and is a part of the total capital available. The capital account will show any changes in the LLC’s ownership.

Your capital account begins with your capital contribution, grows with your potion of the business income, and decreases due to withdrawals or business losses.

When the LLC makes a profit, your share goes into your capital account (as do any losses). You get paid out of your share of the profits through a business check, which reduces the amount in your capital account. That’s referred to as a draw or distribution.


Do LLC Owners Get Taxed?

Since you are an owner and not an employee, you don't receive a salary. As such, what you get paid isn't directly taxed like a salary would be. The tax you pay is tied directly to your share of the profits or losses that the LLC makes.

However, this tax applies to your entire profit or loss portion, whether you withdraw it or not. Let's say you earn $10,000 in profits and only withdraw $2,000 from your capital account. You will still need to pay tax on the entire $10,000.

If you are a Single-Member LLC owner, taxation happens slightly differently. The Internal Revenue Service (IRS) treats all Single-Member LLCs as sole proprietorships. Thus, any losses or profits the LLC makes pass on to you.

Consequently, you won’t need to file a separate tax return for the LLC, as in the case of Multi-Member LLCs. That's because all the LLC's income or losses will be reported on your personal federal tax return.


Protect Yourself From Personal Liability With an LLC

Many business owners are partial to forming an LLC because it protects their personal assets from any liabilities the business incurs. An LLC comes with other requirements you also have to pay attention to for it to succeed. Before forming one, ask yourself, “What is an LLC and how does it work?” To get a more in-depth understanding of how to operate under such a legal structure.

Are you looking for more ideas on how to start and run a business? Check out more of our content for top tips that can make you a better entrepreneur.