One of the biggest challenges when starting out in business is deciding on the right corporate structure for your company. Do you want to be a sole proprietor? A partnership? A company? Your answer will have lasting implications for how you file your tax returns, what happens to your profits, and how much financial risk the business owner assumes.
A limited liability company (LLC) is a structure that separates companies and their owners. It prevents individuals from being liable for the company’s financial losses, debts, and other liabilities. In the event of legal action or business failure, liability is assumed by the company rather than its constituent partners or shareholders.
Examples of limited liability companies
LLCs can be individuals or global corporations such as Pepsi-Cola, Sony, and Nike. LLCs owned by individuals are known as single-member LLCs. They are taxed in the same way as sole proprietorships. Multi-member LLCs may choose to pay taxes as either S corporations or C corporations, provided they meet the necessary qualifying criteria.
SMBs would generally file as S corporations. This is because C corporations have more complicated reporting requirements. Many types of business in the SMB sector find that limited liability is more favorable than a sole proprietorship. These include:
- professional services like accountants or solicitors
- cafes, bars, and restaurants
- handypersons, builders, and contractors
Advantages and disadvantages of limited liability
Benefits of an LLC
- liability protection for business owners and shareholders
- flexible business structure with a variety of trading options
- may result in a lower overall tax liability
Disadvantages of an LLC
- company accounts will be made public
- accounts are more complicated, even sole traders might need an accountant
The limits of liability protection in an LLC
In simple terms, working under an LLC only protects owners from contractual liabilities. It does not protect them from tortious liabilities. Contractual liabilities are liabilities incurred as a result of regular business practice. Tortious liabilities are liabilities incurred due to acting in bad faith.
For example, say your LLC defaulted on a business loan. If you filled out the application honestly and did your best to pay, you would almost certainly be protected. If you made false claims on the application and/or deliberately tried to avoid paying, then you would not be protected.
Frequently asked questions about limited liability companies
How is an LLC different from an LLP?
There are subtle but important differences between LLCs and LLPs. Two stand out. Firstly, all states allow LLCs and treat them the same way. By contrast, some states do not recognize LLPs at all and limit them to certain professions. States that recognize LLPs set their own rules for them. As a result, an LLP created in one state may or may not be recognized in another.
Secondly, in an LLC, owners are viewed as members, whereas they are viewed as partners in an LLP. This means that the protection against personal liability tends to be more robust in an LLC than in an LLP. In an LLC, the default assumption is that owners will not be held personally responsible for a business’ liabilities. In an LLP, it’s quite common for partners to assume some level of liability, at least for their own work.
What is an operating agreement?
An operating agreement is a document that ensures that an LLC’s operations are suited to the needs of its members. It is part stockholder agreement and part corporate bylaw. There are only a few states where it is mandatory to have an operating agreement. It is, however, considered best practice to have one even if it’s not specifically required.
What is unlimited liability?
Unlimited liability means that business owners can be held personally responsible for liabilities incurred as a result of their work. It generally applies to sole traders and partnerships operating outside of the LLC structure.