Explanation Of LLC: What Is An LLC? Why Create One? And How To Do Setup

Seattle CPA Stephen L. Nelson answers the question, "what is an llc"?

By Stephen Nelson

The limited liability company option still triggers questions and confusion among business owners, entrepreneurs and investors, and that’s too bad. One can rather economically provide an explanation of the LLC by answering three questions: what is an LLC, why should one consider the LLC option, and how does someone create an LLC or limited liability company:
What is an LLC?

An LLC is a legal fiction created when someone (perhaps you) files some paperwork with the appropriate state agency asking for permission to create a new limited liability company. If the state grants you permission-which it will if you do the paperwork correctly—you or you and your partners now own an entity that can do a lot of things that, normally, only humans can do.

This sounds confusing, but consider the fact that your dog can’t sign contracts. Nor can your dog own property. Nor can your dog earn income or borrow money.

In a similar fashion, a comfortable leather chair that sits in your living room also can’t do these sorts of things—sign contracts, own property, earn income, borrow money and so forth. As a general rule, only people can do these sorts of things.

The LLC however is an exception to this general rule. An LLC, once it exists, can sign contracts. The LLC can own property. The LLC can also earn income and borrow money—and pretty much do all of the business-y things that a regular human being can do.

Why Setup an LLC?

People setup LLCs, or limited liability companies, for two reasons: liability protection and tax planning.

The liability protection angle is perhaps the easiest to understand: If you operate some business or hold some investment, you can be liable legally for bad things that happen in the business or in the investment by virtue of your ownership. If the business borrows money and then can’t repay the money, for example, you by simple virtue of your ownership may be forced to pay off the borrowed money.

If you own a business or investment through an LLC, however, you aren’t liable for the debts or obligations of the LLC merely because you’re an owner or co-owner. In other words—and this is the part of all this that’s fiction—state laws will say, “Oh, no, it’s not Joe that owes the money. It’s Joe’s LLC… “

Note: A corporation legally protects business owners and investors the same way that a limited liability company. The people who own the shares in the corporation are not simply by virtue of owning those shares legally obligated for the debts of the corporation. As with an LLC, the law considers the corporation to be legally separate person.

Limited liability companies also produce some unique tax planning benefits—specifically the ability to have an investment or business taxed in whatever saves the most tax. For instance, an LLC can be disregarded as a separate taxpayer if that is clear (which means its income and deductions get reported on its owner’s tax return). And an LLC can be treated as a regular corporation or as an S corporation for tax purposes.

How Does Someone Create an LLC?

Procedurally, you create an LLC by filing articles of organization, also sometimes know as articles of formation, with the secretary of state in the state where you’ll operate your LLC. For instance, to create an LLC in California, you file articles of organization with the California secretary of state.

The articles typically name the LLC, identify what the LLC will do, and name the registered agent (a real human being) whom the state can contact if it has questions.

Tip: Many though not all states’ secretary of state websites supply downloadable forms you can utilize to present the articles of llc formation information.

In addition to the articles, people usually create an operating agreement. Akin to a partnership’s partners agreement or a corporation’s bylaws, the LLC operating agreement provides the rulebook for the limited liability company’s activities and specifies how the owners of the LLC operate the LLC.

Finally, in cases where the LLC will employ people or will have multiple owners, the LLC needs a taxpayer identification number from the Internal Revenue Service.

Experienced entrepreneurs and investors as well as small business people operating on a tight budget can often setup an LLC on their own. However, commonly business people and entrepreneurs also work with a paralegal service (if all they do is document preparation) or with a local attorney or accountant (if they need legal or tax advice).

Seattle-area tax accountant Steve Nelson occasionally teaches the LLC versus S corporation graduate tax class at Golden Gate University. He's also the author of the LLCs Explained FAQ article, Explanation of an LLC and the FAQ article, LLC vs LLP.