The Limited Liability Company, or “LLC”, is the most popular business entity type in the United States. LLCs are simple and flexible business structures that combine the tax treatment of a sole proprietorship with the personal liability protection of a corporation.
Despite LLCs being so common, you might not know exactly what an LLC is. Moreover, if you are looking to form an LLC, you probably want to know exactly how they work.
Here we breakdown what LLCs are, how they work, and how to best structure an LLC.
What Is An LLC (Limited Liability Company) ?
An LLC, or “Limited Liability Company”, is a type of business structure that provides liability protection for its owners. The laws of the state where the LLC is registered uphold these protections. LLCs create a layer of separation between a business and its owners, who are called “Members”.
LLC Members receive limited liability protection from the debts or liabilities of the business. This means that creditors cannot go after a Member’s personal assets, like their home, to settle a debt owed by the business. In short, LLC members can only lose their investment in the business. LLCs are the ultimate tool for small business owners to grow their business while securing their personal assets.
What Is The Purpose of an LLC?
Business owners form LLCs to safeguard their personal assets from business liabilities. When business owners manage an LLC properly, the structure can make it difficult for a business creditor to gain access to the Member’s personal assets. These may include houses, cars, or other personal possessions.
People use LLCs for many purposes beyond just operating businesses. Individuals also use LLCs to hold passive or income producing assets. An LLC itself is a legal person that can own assets like real estate or intellectual property and trademarks.
Why Do People Use LLCs?
The Delaware LLC is the most popular business entity type in the United States. There were over 1.3 million Delaware LLCs as of 2021 according to the Delaware Division of Corporations. This is because LLCs are flexible, versatile, and easy to manage.
Here are some of the most common reasons why people form LLCs:
- Operate a small business;
- Operate a subsidiary company of a corporation;
- Form a holding company for other businesses and assets;
- Own real estate properties;
- Own and protect trademarks or intellectual property;
- Engage in service contracts;
- Operate investment funds and syndicates;
- Operate management companies;
- Operate a loan out company for services.
These are just a few examples of LLC usage.
How Does LLC Formation Work?
Forming an LLC requires preparing two important documents:
- The Certificate of Formation
The Certificate of Formation is a document filed with the Secretary of State’s office. The Certificate of Formation is the document that brings the LLC to life by creating a public record of the company’s existence.
Formation documents for LLCs differ in each state. Delaware calls this document a “Certificate of Formation”, however, some states refer to the same document as “Articles of Organization”.
Each state requires different information to appear on an LLC’s formation document. For example, Delaware does not require the name of LLC Members to appear in the company’s Certificate of Formation. Delaware only requires the name of the company and the address of its registered agent to form an LLC.
Some states, like Florida, require LLCs to list the names and addresses of their Members in the company’s publicly filed formation document. Some states go even further by requiring LLCs to specify whether they are member-managed or manager-managed.
- The LLC Operating Agreement
The LLC Operating Agreement is the private company document that governs an LLC’s internal affairs. An LLC’s Members agree to terms provided in the Operating Agreement that establish their individual ownership percentage, their management responsibilities (if any), and their voting privileges within the company.
LLC Members do not need to make the Operating Agreement public, as it is a private document.
Should I Form an LLC or a Corporation?
Business owners are typically better off forming their business as an LLC rather than a corporation. LLCs are more flexible and easier to manage than corporations. Business owners should really only consider registering as a corporation if they anticipate that the company will need to sell corporate stock to attract large, outside investors. LLC Members can vote to convert an LLC to a corporation at any time. You can accomplish this by filing a Certificate of Conversion in the LLC’s state of formation.
LLCs provide business owners with the same limited liability protections as corporations but without any of the administrative hassle. State laws require corporations to have rigid structures that involve many rules and procedures. For example, Delaware law requires corporations to hold annual board meetings and file annual reports. Certain fiduciary duties also bind directors of Delaware corporations, limiting the decisions they can make. In addition, making changes to a corporation’s ownership structure often requires making additional public filings.
The Members of an LLC can structure the ownership and management of their company in any way that they want, as long as they consent to the arrangement.
LLCs are structured by a private Operating Agreement. The Operating Agreement is a contract between an LLCs Members that details each Member’s percent ownership interest, as well as their management responsibilities.
Making changes to an LLC’s ownership structure does not require making any public filings. Members simply need to amend the LLC’s current Operating Agreement to transfer their ownership interest in the company.
LLC members can choose to waive any fiduciary duties and can agree to implement provisions in the Operating Agreement to protect their ownership interest. Some examples include the “Right of First Refusal” and “Pick Your Partner” provisions which prevent unwanted individuals from acquiring ownership in the LLC.
Why Form an LLC in Delaware?
Delaware is one of the most popular states to form LLCs because of the state’s business friendly legal environment. Delaware’s Secretary of State often says that “Delaware’s business is forming business”. Delaware LLCs and their Members enjoy protection under the most developed and well-challenged corporate case law in the United States.
The state where you decide to form your LLC becomes the company’s legal home. This means that the state of formation governs the LLC, and any complaints brought against the company are resolved by that particular state’s courts.
Most states bring disputes concerning LLCs to lower courts in front of judges who are not experts in corporate law. The State of Delaware has a dedicated business court called the “Court of Chancery”. The Delaware Court of Chancery, however, is globally renowned for its expertise and for resolving disputes quickly and fairly.The Court’s Chancellors respect the rights of LLC owners and rarely ever pierce the “corporate veil” by passing business liabilities and debts on to Members.
When forming an LLC, business owners are able to shop around for the jurisdiction that benefits them the most. Entrepreneurs from all over the world form Delaware LLCs. A company does not have to be located nor do business in Delaware to form as a Delaware LLC.
Is an LLC a Corporation?
An LLC is not a corporation. Both LLCs and corporations provide limited liability protection for the personal assets of their owners. However, they are two different types of business entities with different internal structures.
People mistakenly refer to LLCs as “limited liability corporations”. The acronym is actually short for “limited liability company”. Shareholders own corporations and appoint directors to make decisions on the company’s behalf. Corporations issue physical stock certificates to their shareholders to represent their ownership interest in the company.
LLCs are contractual entities that are owned by Members. LLCs do not issue corporate stock to Members. Rather, Member’s divide ownership in the company amongst one another on a percentage basis. The LLC’s Operating Agreement details the ownership structure of the company and validates the ownership interest of each Member.
Can You Convert an LLC into a Corporation?
Yes, it possible to convert an existing LLC into a corporation. In Delaware, this is done by filing a “Certificate of Conversion” with the Delaware Secretary of State’s office.
A registered agent, like IncNow can help you convert your Delaware LLC into a Delaware C-Corp. or S-Corp. This is a useful business strategy that many entrepreneurs do not know about, but should consider. Often, business owners find it more advantageous to start their company as an LLC to benefit from the flexibility for which LLCs are popular.
As the business grows, the LLC Members can vote to convert the company to a Delaware C-Corp. The company can then begin to raise investment by selling corporate stock.
What Does it Cost to Form an LLC?
Forming an LLC often involves paying an initial filing fee as well as some annual fees. For example, the State of Delaware charges a filing fee of $110 to form an LLC. Delaware requires all LLCs formed in the state to pay the Delaware Annual Franchise Tax. The Delaware Annual Franchise Tax, a flat fee of $300, is due on June 1st each year after forming the LLC.
Most LLCs also appoint another company to serve as their registered agent. This requires paying an additional registered agent fee. IncNow provides Delaware registered agent services for $109 per year.