Doug, a 28-year-old tradesman, had worked for a friend’s dad since Doug got out of high school. He learned his trade on the job, for which he had a ton of gratitude. But for the past couple of years, Doug has felt that he could do better on his own. His friend’s dad hasn’t increased Doug’s pay as Doug has grown more skilled. When Doug asked him about it, he said that was all he was going to pay and that if Doug wanted more, he would have to go earn it on his own. Doug had seen other tradesmen go out on their own, usually with their own LLC. Doug thought maybe it was his time. But what was an LLC?
Definition
LLC stands for limited liability company. A company is an artificial business entity apart from the individual or group of individuals who form it. An LLC is a special form of company that limits liability to the entity, protecting the company’s owners, but passes income through the entity straight to the owners. Owners form LLCs under state LLC acts. LLC acts state the laws that authorize and regulate LLCs to ensure that LLCs serve their purposes as an orderly form of organizing and conducting business. An LLC, once properly formed, has the attributes of a legal entity, able to contract, hire, buy, sell, and profit, much as an individual business owner would. Form an LLC, and you’ve formed a distinct legal entity with substantial interests and rights.
Origin
The concept of a business entity is ancient. As far back as Roman times, individuals joined together in partnerships, although the partnerships didn’t exactly have the character of distinct business entities. Medieval guilds and associations of tradesmen at times operated like business entities. Guilds pooled resources to train workers, organize work, offer goods and services, and set prices. Bringing skilled workers together around common interests made their work more efficient, sped technological improvements, and promoted business development. But guilds were not modern business entities. They were more like tight clubs.
Development
The modern company took clearer form with the British and Dutch East India Companies in the early 1600s. The companies had shareholders, which was a huge reform, enabling the companies to amass capital to conduct their business. The companies engaged in diverse business ventures, not just sticking to one trade or profession like a guild. And the companies shared profits among the shareholders, spurring the willingness of many to invest. The Industrial Revolution of the 1800s gave an enormous boost to the interest in forming companies for manufacturing. The rise in the late 1800s and early 1900s of national markets for consumer goods opened new opportunities for companies. These developments encouraged states to adopt corporations laws under which groups of individuals could readily form their own private business corporations, without substantial state involvement such as charters and licenses, which officials could withhold for bribes or wield to promote political interests. Corporations of all sizes multiplied, facilitating and vastly increasing business activity.
Taxation
The limited liability company or modern LLC, though, was a later development, tied closely to the rise and increase of income taxes. As federal, state, and local governments sought revenue, they increasingly turned to both personal and corporate income taxes. Partnerships paid no income tax. Instead, partners paid income tax at the individual level. But governments were imposing income taxes on corporations. And then corporation owners were paying taxes a second time on their income from the corporation, whether in wages, dividends, or gains from sale of the stock. Corporate shareholders correctly saw it as a double-taxation problem. As income taxes rose, corporation owners sought ways to reduce their double tax burden.
S Corps
Corporation owners successfully lobbied Congress in 1958 to enact a law allowing a special form of corporation, an S Corp, to pass income straight through to owners for single rather than double taxation, like a partnership. Many smaller corporations began electing Subchapter S status for their corporations, to avoid double taxation. S corps do not pay income tax at the corporate level. An S corp instead passes all income straight through to the owners who pay individual income tax. Business owners may still choose S corp status today. Some states and cities, though, do not recognize the special S corp status and instead impose state or local income tax at both the corporate and individual level. You might consider an S corp, but an S corp may be a limited solution, and S corps have their own complexities.
LLC Acts
While Congress had offered business owners one solution in the form of the S corp, business owners continued to advocate with their state legislatures for alternative relief from their double-taxation burden. Partnerships didn’t present the double-taxation problem. Couldn’t the states authorize a corporate form with single taxation like the partnership but limited liability like the corporation? States eventually responded with LLC acts, the first of which appeared in 1977. States across the nation soon adopted LLC acts, authorizing business owners to form LLCs that passed income through to the owners for single taxation, like a partnership, while limiting liability to the entity, like a corporation. The LLC was born. LLCs soon revolutionized the legal landscape at the small-business level.
Uniformity
Federal law regulates interstate commerce. But states retain the authority under the Constitution to form and regulate corporate entities, including LLCs. If you decide to form an LLC, it will be under a state LLC act, not federal law. States can differ as to what they require to form and operate an LLC. Yet many states follow the pattern of the Uniform LLC Act offered to the states by the Uniform Law Commission. States may still draft and adopt their own LLC acts. And states adopting the Uniform LLC Act may do so with major or minor adaptations. You can easily find the Uniform LLC Act online. But instead, if you have legal questions, look up your state’s own LLC act, the specific provisions of which will govern your issue, or consult a local attorney familiar with your state’s act.
Simplicity
LLCs swiftly became the preferred solution for small businesses, and no wonder. The advantage of an LLC is its simplicity. An LLC is easy to form. An LLC is also easy to administer. And an LLC is also easy to understand. With an LLC, you can have a business entity apart from yourself that limits business liability to the entity, protecting the owners, while passing the income through the entity to the owners to avoid double taxation. You can have your cake and eat it, too. You’ve got to love the LLC. An LLC may well be for you. Business owners have formed over 20 million LLCs in the U.S. Join the party. Doing so may bring you and your family great excitement and flourishing. But get good advice, and keep your LLC affairs in good order. Let this guide help you do so.
Key Points
An LLC is a business entity apart from its owners.
An LLC passes income through for taxation at the owner level.
An LLC protects owners from business liability.
An LLC is simple to set up and administer.