What Is an LLC: Requirements, Pros and Cons

A limited liability company (LLC) offers liability protection and operational flexibility, but the costs, paperwork, and compliance requirements differ from state to state. Knowing what your state requires before you file can save you time and money down the line. A financial advisor can help you compare entity structures, work through the tax implications of an LLC, and make sure the decision fits with the rest of your financial plan.

What Is an LLC and How Does It Work?

An LLC is a business structure created under state law that separates your personal assets from your business liabilities. This legal separation means that if your business faces debts, lawsuits or other financial obligations, your personal assets, such as your home, car and personal bank accounts, generally have protection from business creditors.

An LLC combines the most beneficial elements of corporations and partnerships. Like a corporation, it provides limited liability protection to its owners. And like a partnership or sole proprietorship, it offers pass-through taxation and flexible management without the formalities required of corporations. 

Who Can Form an LLC

Almost anyone can form an LLC. The owners of an LLC are known as members. There is no maximum number of members—you can form a single-member LLC by yourself, or you can have multiple members who co-own the business.

Businesses That Generally Cannot Be LLCs

While most businesses can operate as LLCs, certain types of businesses face restrictions:

• Banks and insurance companies: These financial institutions must operate under specific corporate structures due to regulatory requirements.
• Certain licensed professionals: Some states prohibit or restrict professionals like doctors, lawyers, accountants or architects from forming standard LLCs. These professionals may need to form a professional LLC (PLLC) instead, which has additional requirements.

The specific restrictions vary by state, so it is important to check your state’s laws if you operate in a regulated industry.

How an LLC Is Taxed

The IRS does not have a separate tax classification for LLCs. Instead, LLCs can choose how they want to be taxed. If you do not make an election, there are default classifications that apply.

By default, the IRS classifies LLCs based on the number of members:

• Single-member LLCs: The LLC is taxed as a disregarded entity, meaning the LLC itself does not pay taxes. Instead, the owner reports business income and expenses on their personal tax return using Schedule C. The IRS treats the LLC as if it does not exist for tax purposes.
• Multi-member LLCs: The IRS taxes the LLC as a partnership if there are multiple members. It must file an informational return (Form 1065) showing income and expenses, then issue Schedule K-1 forms to each member showing their share of profits or losses. Members report this information on their personal tax returns.

An LLC can choose to be taxed as a corporation by filing Form 8832 with the IRS. This election treats the LLC as a C corporation for tax purposes, meaning:

• The LLC pays corporate income tax on its profits.
• If profits are distributed to members as dividends, members pay personal income tax on those dividends.
• This creates double taxation: once at the corporate level and again at the personal level.

Alternatively, an LLC can elect S corporation status by filing Form 2553. This maintains pass-through taxation but allows members who actively work in the business to be treated as employees, potentially reducing self-employment taxes on some of their compensation.

Pass-Through Taxation

Under the default classification and S corporation election, LLCs enjoy pass-through taxation. This means the business itself does not pay income tax. Instead, profits and losses pass through to the members’ personal tax returns.

For example, if your LLC earns $100,000 in profit and you own 50% of a multi-member LLC, you report $50,000 of income on your personal tax return and pay taxes at your individual tax rate. This avoids the double taxation that C corporations face.

Self-Employment Tax Considerations

LLC members who are active in the business typically owe self-employment tax on their share of the profits. Self-employment tax covers Social Security and Medicare taxes and currently equals 15.3% of net earnings up to the Social Security wage base.

This is an important consideration because while you benefit from pass-through taxation, you pay both the employer and employee portions of payroll taxes on your business income. If you were an employee of a corporation, your employer would pay half of these taxes.

Requirements to Form an LLC

Forming an LLC requires following specific steps and meeting state requirements. While the process is generally straightforward, the details vary by state, and failing to complete these requirements properly can leave your business without proper legal protection.

Choosing a State of Formation

Most small businesses form their LLC in the state where they operate. However, you can form an LLC in any state regardless of where you live or where your business operates. Some states, particularly Delaware, Nevada and Wyoming, market themselves as business-friendly with favorable LLC laws, low fees or enhanced privacy protections.

Keep in mind that if you form your LLC in one state but operate in another, you will need to register as a foreign LLC in the state where you do business. This means paying formation fees in both states and maintaining compliance in both states, which often negates any cost savings.

Filing Articles of Organization

The formal process of creating an LLC begins with filing Articles of Organization (sometimes called a Certificate of Formation) with your state’s business filing office, typically the Secretary of State. This document usually requires:

• The LLC’s name, which must be unique and include “LLC” or “Limited Liability Company”
• The LLC’s principal address
• The registered agent’s name and address
• The names and addresses of the members or managers (required in some states)
• The LLC’s purpose (sometimes just “any lawful business”)

Filing fees range from about $50 to $500 depending on the state. Once the state approves your filing, your LLC officially exists as a legal entity.

Registered Agent Requirement

Every LLC must designate a registered agent. This is a person or business entity responsible for receiving legal documents and official correspondence on behalf of the LLC. The registered agent must:

• Have a physical street address in the state where the LLC is formed (not a P.O. box)
• Be available at that address during normal business hours
• Have authorization to do business in the state

You can serve as your own registered agent, appoint another person or hire a registered agent service. Many business owners choose a registered agent service to maintain privacy and ensure someone is always available to receive important documents.

Operating Agreement

An operating agreement is an internal document that outlines how your LLC will be run. It typically covers:

• Ownership percentages
• Distribution of profits and losses
• Management structure and decision-making processes
• Processes for members to join or leave the LLC
• Procedures for dissolving the LLC

Most states do not legally require an operating agreement. But without an operating agreement, your LLC is governed by default state laws, which may not align with your intentions.

Employer Identification Number (EIN)

An Employer Identification Number (EIN) is a unique nine-digit number the IRS assigns to businesses. You need an EIN if:

• Your LLC has more than one member
• You have employees
• You file excise tax returns
• You withhold taxes on income paid to a non-resident alien

Single-member LLCs without employees can use the owner’s Social Security number instead of obtaining an EIN. However, many still get an EIN for privacy and business banking purposes. You can apply for an EIN online through the IRS website for free, and you receive it immediately.

Pros of Forming an LLC

The LLC structure offers several significant advantages that make it attractive for small business owners and entrepreneurs. Understanding these benefits helps you evaluate whether an LLC makes sense for your business situation.

• Limited liability protection: The LLC shields your personal assets from business debts and legal judgments. Creditors generally cannot go after your house, car or personal bank accounts for business liabilities. That said, this protection does have exceptions for personal guarantees, fraud or failure to maintain separation between personal and business finances.
• Flexible management: LLCs allow you to choose between a member-managed structure, where all owners participate in decisions, or a manager-managed structure, where you appoint managers to run operations. Your operating agreement defines how power and responsibility are distributed.
• Tax flexibility: With an LLC, you can select the tax treatment that works best for your situation. Options include default pass-through taxation to avoid double taxation, S corporation election to potentially reduce self-employment taxes or C corporation election if you plan to retain profits in the business.
• Fewer formalities: Unlike corporations, LLCs do not require annual meetings, meeting minutes, boards of directors or stock issuance. This reduced bureaucracy saves time and administrative costs while still providing liability protection.

Cons of Forming an LLC

While LLCs offer many advantages, they also come with drawbacks and limitations. Before filing, consider the costs, compliance requirements and structural restrictions that could affect your business over time.

• Self-employment taxes: Active members typically owe 15.3% self-employment tax on their share of business profits, covering both employer and employee portions of Social Security and Medicare. ¹ This can represent a significant expense for businesses with substantial profits, though S corporation election may reduce this burden.
• State fees and compliance costs: Filing fees vary depending on the state, costing $30 in Louisiana and $500 in Massachusetts. Annual reports cost $0 to $500, and some states charge franchise taxes on top of that. ² These ongoing expenses add up, particularly for businesses operating in multiple states. For the most current fees in your state, check your Secretary of State website directly.
• Limited life in some states: Some states have rules that can complicate ownership transfers or require dissolution when members leave, though most states have modernized their LLC laws. A well-drafted operating agreement is essential to address continuity planning.
• Less attractive to investors: LLCs cannot issue stock, making them poorly suited for venture capital or plans to go public. Membership interests are more complex legally, and they create tax complications for institutional investors and cannot be publicly traded. Most VC-backed companies structure as C corporations instead.

Bottom Line

A limited liability company can combine liability protection, tax flexibility and operational simplicity, which is why it’s one of the more common structures for small businesses and entrepreneurs. That said, self-employment taxes, ongoing state fees, and limitations on raising outside capital may make a different structure a better fit depending on the business. Choosing the right entity comes down to your business type, growth plans, tax situation and how much risk you’re comfortable taking on.

Tax Planning Tips

• A financial advisor can help you compare business structures and figure out which one makes sense for your situation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• One common business tax strategy is to accelerate deductible expenses into the current tax year to reduce taxable income. Examples include prepaying rent or buying necessary equipment before year-end. Here are seven tax-planning strategies, including income and expense timing, for your business.

Photo credit: ©iStock.com/Maks_Lab, ©iStock.com/Ridofranz, ©iStock.com/Jacob Wackerhausen