Clear the Confusion: What is an LLC and How Does it Work?

Limited liability companies (LLC) are one of 5 types of business entities. They have a combination of the characteristics of corporations as well as partnerships. 

Key Takeaways 

  • An LLC is a business entity with characteristics of a sole proprietorship/ partnership and a corporation. 
  • It protects a business owner’s personal property. 
  • It has a flexible management style and profit distribution style. 

Characteristics of an LLC

The ‘limited liability limits the owners’ personal vulnerability to the company’s debts or liabilities. 

Limited liability companies are taxed depending on the state it’s registered in. In most states, if a business only has one owner, the income or losses conquered by the company would be used to calculate individual income taxes. 

If multiple partners own the LLC, the amount of income they take home from the company’s revenue will be taxed individually as individual income tax. This is great compared to corporations where the income is double taxed, once as a company and again as the shareholders’ personal income. 

Advantages of Limited Liability Companies

  1. Business owners have limited personal liability.

This characteristic of a corporation makes the business owners’ personal property immune to damages caused by management decisions. Say you’re sued for negligence, and the money you invested in the company may be at risk. However, your home and personal bank account won’t be used to collect debts. 

  1. Double taxation can be avoided. 

Large corporations get double-taxed. The company has to pay corporation taxes, and the shareholders have to pay income taxes on the income they make from the corporation. LLCs are taxed as sole proprietorships or a partnership. 

The IRS classifies LLCs as either sole proprietorships or as partnerships, depending on the number of owners it has. Each owner of an LLC is taxed on the income they take home from the company’s income.

  1. Flexible management style

Corporations require a strict management structure led by a board of directors. Each year shareholders vote to appoint the directors etc. 

LLCs are much more flexible in their management style. They have more freedom in taking business decisions and choosing management. 

  1. Flexible profit distribution

In corporations, the profits are distributed according to the number of shares the shareholders each hold. In limited liability companies, the profit doesn’t have to be shared according to the amount the owners contributed as capital or according to who contributed to the company the longest. 

Registering as a limited liability company is the best choice for a small startup business. This is because not only does it limit the owner’s personal liability, but it also allows owners to take advantage of sole proprietorship and partnership taxation laws. 

It allows for a large amount of flexibility in both management style and profit distribution. The paperwork that must be maintained for limited liability companies is also minimal.

Written by:

Stuart MacPherson

Hi, I'm Stuart. I've been running my own small business since 2019 after leaving a successful career in finance. I created FranchiseTheory to share my enthusiasm for franchising and the franchise business model.

Connect with me: Linkedin | Reddit | Twitter