A limited liability corporation (LLC) provides protection for owners (known as members) from personal liability, while at the same time conveying certain tax advantages that other business structures do not enjoy. These are often considered hybrid business structures because they borrow aspects of both corporations and partnerships.
A primary consideration for most business owners is protecting themselves from being personally liable for the debts and actions of the business. Forming an LLC protects the members from having personal assets such as their houses or cars involved in claims against the business. Therefore, members only have at risk what they specifically invested into the company.
However, in what is known as “piercing the corporate veil,” the court may disregard the “shield” of limited liability and hold members personally liable. This most often occurs when it is shown that the members are not truly separate from the company. An example of when this might occur is if a member used a company account to pay personal expenses. It is important to understand and follow the legal formalities of running an LLC in order to ensure the limited liability protection will be upheld.
For federal tax purposes, LLCs are not considered separate entities, meaning the business itself is not taxed. Instead, the income of the business passes to the individual members who report their share of profits or losses on their income tax returns. In a corporation, the company is taxed on any profits earned. The individual shareholders are then taxed on any of those profits that are distributed to them. The avoidance of this “double-taxation” is one of the reasons LLCs are formed instead of corporations.
Forming an LLC
Typically, LLCs are formed by the filing of the “certificate of organization,” which includes some basic information about the company and its organizers. Many states provide a form that serves as the certificate of organization (a link to Pennsylvania’s can be found here). The payment of a fee, which amount varies by state, is also required.
One other important part of forming an LLC is the creation and adoption of an operating agreement. Depending on the state, this may not be legally required. However, creating an operating agreement has significant benefits. First, it helps maintain the limited liability status of the business, particularly in a one-person LLC. If the operating agreement is thorough, it demonstrates that the LLC is a separate entity that functions without the interference of individual members.
Additionally, an operating agreement helps to define the roles and relationships of the LLC members. It is inevitable that disagreements will take place over how profits are shared or how the LLC is managed. A strong operating agreement can help settle those disagreements by dictating how disputes are resolved.
Are You Considering Forming an LLC?
It is important to note that an LLC is just one of many different types of business structures that exist today. Each one has certain advantages and disadvantages that may not be readily apparent to someone not familiar with the intricacies of business formation. There are several issues that should be considered before choosing the form your business will take. At the Philadelphia Small Business Law Center, we can assist you in understanding the various forms of business entities. Please contact us today if you are in the process of forming your business.