What Is an LLC?

What an LLC means in plain words

When you start selling without registering anything, you and the business are the same person in the eyes of the law. That is a sole proprietorship, and the US Small Business Administration warns that as a sole proprietor you can be held personally liable for the debts and obligations of the business.

An LLC puts a legal wall between the two. The company owns its own bank account, signs its own contracts and owes its own debts. The same SBA guide says LLCs protect you from personal liability in most instances. LLC is a US term. Other countries have their own versions with different rules, so if you are outside the US, look up the local equivalent.

How an LLC works

• Formation: the IRS describes an LLC as a business structure allowed by state statute. You form one by filing a document with a state, often called articles of organization, and paying that state's fee.
• Owners: owners are called members. An LLC can have one member or many.
• Operating agreement: a written agreement between members that says who owns what, who decides what and what happens if someone leaves. Write one even if your state does not require it.
• Tax: per the IRS, an LLC with one member is treated as disregarded as separate from its owner for income tax, and an LLC with two or more members is classified as a partnership, unless it elects to be treated as a corporation. In both default cases the LLC itself is not taxed as a corporation. State tax rules are separate and vary.
• Upkeep: many states ask for a regular report or fee to keep the LLC active. Check what your state requires.

A worked example

This is an illustration, not a real case. Say you run a home cleaning business through an LLC. The LLC has $8,000 in its bank account and owns $3,000 of equipment. A client sues the business for $30,000 over damage to a floor and wins.

When a first-time founder should form an LLC

Not on day one. Forming an LLC means a state filing, a fee and some ongoing paperwork, and it does nothing to tell you whether anyone wants what you plan to sell. Spend your first weeks on validating the idea and talking to customers. Registration is a launch task. In Fonda's journey, Legal and setup sits in the Launch phase, after the Verdict on your idea.

Good moments to form one:

• You are about to sign a lease, a loan or a large client contract.
• Your work could injure someone or damage property.
• You are bringing in a partner and need ownership in writing. If you are still looking, see how to find a co-founder.
• Customers or suppliers ask for a registered business.

Add the filing fee and any yearly fee to your budget with the startup cost calculator. If you plan to raise venture capital, ask a lawyer first. The SBA notes that corporations have an advantage in raising capital because they can sell stock, and switching structure later costs time and fees.

Common mistakes

• Mixing money. Paying personal bills from the business account weakens the wall an LLC is meant to build. Open a separate account.
• Thinking it replaces insurance. An LLC limits what you can lose. Insurance pays the claim. Many businesses need both.
• Skipping the operating agreement. With two or more members, an unwritten deal becomes a dispute later.
• Forming it before the idea is tested. If the idea changes, you have paid to register the wrong business.
• Forgetting the upkeep. If your state asks for a regular report or fee, missing it can put the company's standing at risk. Check what your state requires and put the dates in your calendar.

Related terms

• Sole proprietorship: the default structure when you have registered nothing.
• Vesting: how co-founders earn their ownership over time.
• Business model: how the company makes money, whatever its legal form.