What is an LLC, and why do I need one?

LLC stands for Limited Liability Company, and it is a type of business entity that protects the owners of the business from liabilities incurred by the business and vice versa.

So, what is an LLC?

LLC stands for Limited Liability Company, and it is a type of business entity that protects the owners of the business from liabilities incurred by the business and vice versa. What this means (in plain English) is that generally speaking, owners (referred to as Members) of an LLC are not personally responsible for debts owed by the business, and the business itself is not responsible for debts owed by the Members. It is important to note however that certain actions and circumstances may nullify the protection an LLC provides, such as signing a personal guarantee when taking a business loan, or commingling personal and business funds. We will discuss this subject more in a later article.

Limited Liability Companies (LLCs) are relatively new business entities compared to traditional Corporations and Partnerships. As a matter of fact, LLCs weren’t even a thing until around the late 1970s, they haven’t even been around for 50 years but have grown to be the most common business entity in the United States. This is because LLCs provide benefits on par with traditional Corporations and Partnerships, while at the same time being flexible and easy to manage.

Now that we have a general idea of what an LLC is, lets talk about how they compare to other business entities. First, we need to establish the other players in the game…

The Other Players:

Sole Proprietorship
- A sole proprietor is any self-employed individual who does NOT have a separate entity for his/her business.
- This is by far the easiest and cheapest way to run your business. There are no state filings, there are no annual statements, there is no formal structure to adhere to.
- As a Sole Proprietor, you ARE your business. The government makes no distinction between you as an individual and your business as a separate entity.

Partnerships
- You can think of Partnerships as written agreements between two Sole Proprietors to conduct business jointly.
- There are three types of Partnerships: General, Limited, and Limited Liability Partnerships.
- In General Partnerships, the Partners each have unlimited liability for debts of the business, meaning creditors can come after the owners’ personal assets to satisfy debts of the business.
- Limited partnerships and Limited Liability Partnerships are similar, but there are a few key distinctions. Limited Partnerships typically involve one General Partner who is directly involved with the day-to-day management of the business, and one “silent partner” who is not directly involved in the day-to-day management of the business. In a Limited Partnership, the General Partner would have unlimited liability for debts of the business, while the Limited (silent) Partner would only be liable for debts of the business to the extent of their investment in the company.
- Limited Liability Partnerships consist of two or more partners, both having limited liability for business debts, although the extent of this “limited liability” varies from state to state.
- Partnerships are a bit more involved than Sole Proprietorships, both in management and when it comes to taxes.

Corporations (C and S)
- Corporations are the most complex “for-profit” business entities, both in management structure and for tax purposes.
- Although they provide substantial liability protection, Corporations are almost never the ideal structure for small businesses or new startups. Corporations are better suited for larger businesses with multiple shareholders and employees.
- LLCs can elect to be treated as a Corporation for tax purposes, which can provide unique benefits to medium sized businesses.

Non-Profit Organizations
- Non Profits are complex business entities that offer huge tax advantages but come with significant tradeoffs compared to “for profit” entities.
- Nonprofit structures are ideal for organizations whose main goal is to achieve a humanitarian goal or provide some sort of net benefit to society. If your priority is making money and providing value to owners/shareholders, then a Non-Profit is most likely not for you.
- In Michigan, Non Profits are required to have a board of directors consisting of at least 3 unrelated people. This means that no single person can ever have full control over a Non Profit.
- Non Profits can not be sold or wound up the same way For Profit businesses can. If a decision is ever made to dissolve the Non Profit, any assets owned by the Non Profit must be used for exempt purposes. Assets can not simply be distributed to employees or board members of the Non Profit. This is a crucial aspect to consider, as it will have a huge impact on your exit strategy (or retirement) later down the road.

How they stack up…

Right off the bat I can tell you that an LLC would provide you more value than a simple Sole Proprietorship. Before LLCs were created, Sole Proprietorship was the best option for small solo entrepreneurs, however, since we live in 2022 and LLCs exist today, there’s absolutely no reason you should ever run your business as a Sole Proprietor. LLCs offer much better liability protection and the cost to set up an LLC is negligible. You might save $100 by going the Sole Proprietor route, but you’ll be personally liable for all debts, expenses, judgements, penalties, and obligations that occur as a result of running your business which could end up costing you significantly in the long run.

LLCs can also consist of more than one owner or “Member”, which makes them a solid alternative to traditional Partnerships. When it comes to LLCs versus Partnerships, the outcome varies from state to state. Some states do not allow certain professionals to set up LLCs, in which case a Limited Liability Partnership (LLP) is your best bet, however, in Michigan an LLC is usually the best option for most people. In Michigan, LLPs only protect partners against liabilities incurred as a result of the other partner’s negligent actions. Partners in Michigan LLPs have unlimited liability for all other debts, whereas Members of an LLC have limited liability in all circumstances.

Corporations can provide benefits to larger operations that LLCs do not provide, however, since LLCs can always elect to be treated as a Corporation, there really is no reason to stress about which is better. It’s cheaper, easier, and more efficient to simply start as an LLC, and if you reach the point where electing to be treated as an S-Corp or C-Corp would be beneficial, you can make the switch rather easily.

Let’s Talk Taxes

Now that we have an idea of what an LLC is, and how LLCs stack up against their alternatives, lets take a brief moment to discuss taxes. Sole Proprietorships are taxed as Sole Proprietorships, Partnerships are taxed as Partnerships, C and S Corporations are taxed as either C or S Corporations, each business entity has its own guidelines that determine how it is taxed, so it makes sense that an LLC would have it’s own guidelines right?

Wrong. Funny enough, despite being the most common business entity in the United States, LLCs do not have their own guidelines for tax purposes. LLCs are simply taxed as either Sole Proprietorships, Partnerships, or Corporations, depending on the number of Members, and whether or not the LLC has elected to be treated as a Corporation.

By default, LLCs are considered pass through entities. This means that LLCs are not required to file a business tax return or pay corporate income tax. Profits and losses of the business simply “pass through” to the LLC Members based on their interest in the company (unless otherwise specified).

Single Member LLCs are taxed by default as Sole Proprietorships. The Sole Member will file a Schedule-C at the end of the year to report profits or losses of the business. Both Sole Proprietors and Single Member LLCs will pay 15.3% Self Employment Tax in addition to regular income taxes on any business profits (yes, business profits are taxed at a higher rate than regular wages).

Multi-Member LLCs are taxed by default as Partnerships. Partnerships are still considered pass through entities, however, they are required to file an informational business tax return (Form 1065). This informational return is simply to notify the IRS of the total profits/losses of the entity. The Partnership itself does not have to pay any corporate income tax. From there, profits or losses of the LLC/Partnership pass through to the Members/Partners based on their interest in the company on IRS form K-1. Members/Partners will attach this K-1 to their personal 1040 instead of Schedule C. Again, Members/Partners are required to pay a 15.3% Self Employment Tax in addition to regular income taxes on their share of the business profits.

LLCs can elect to be taxed as either an S-Corporation or a C-Corporation. The most common corporate election is an S-Corp election, as S-Corporations can help business owners save on Self Employment taxes. This is a more advanced subject though, and a bit outside of the scope of this article… We will go more in depth on this subject later. For now, just know that you’ll need to be making at least $75,000- – $100,000 per year in net profit to fully realize the tax benefits of these business structures.