What Is an LLC? Limited Liability Company Explained

How an LLC Works

An LLC is created by filing articles of organization with the secretary of state in the state where you want the business to be domiciled. Once the state issues the certificate of formation, the LLC becomes a separate legal person: it can own real estate, sign contracts, sue, and be sued in its own name. The members sign an operating agreement that governs how the business is managed, how profits are split, what happens when a member leaves, and how disputes are resolved.

Unlike a corporation, an LLC has no required hierarchy. It can be member-managed (every owner has equal authority to bind the company) or manager-managed (members appoint one or more managers, who may or may not be members themselves). There is no requirement for a board of directors, officers, annual meetings, or written minutes in most states, though we recommend documenting major decisions anyway to preserve the liability shield.

Liability Protection: What an LLC Actually Shields

The defining feature of an LLC is the liability shield codified in every state's LLC act. If the business defaults on a vendor invoice, gets sued by a customer, or owes a court judgment, creditors can pursue only the assets owned by the LLC, not the personal assets of the members. Your home, your car, your retirement account, and your personal bank account are off-limits. This is the same protection that a corporation provides to shareholders.

The shield is not absolute. Courts will pierce the corporate veil and hold members personally liable when they treat the LLC as an alter ego rather than a separate entity. The most common veil-piercing factors are commingling personal and business funds, undercapitalization (forming an LLC with no money to operate), failure to observe formalities like signing contracts in the LLC name, and using the LLC to commit fraud. Members are also personally liable for their own torts (you cannot hide behind an LLC if you punch a customer) and for any debt they personally guarantee, such as a small business loan.

How an LLC Is Taxed

By default, the IRS uses pass-through taxation for LLCs: the company itself pays no federal income tax, and profits or losses flow through to the members. A single-member LLC is treated as a disregarded entity, with profit reported on the owner's Schedule C alongside their personal Form 1040. A multi-member LLC is treated as a partnership, filing Form 1065 and issuing each member a Schedule K-1 showing their share of income.

The LLC can also elect to be taxed as an S-corporation by filing Form 2553, which lets working owners pay themselves a reasonable salary subject to payroll tax and take the rest as distributions free of self-employment tax. This election saves money once profits exceed roughly $40,000 per owner per year, which is why many profitable single-member LLCs convert to S-corp tax status. An LLC can also elect C-corporation status, but this is unusual outside of venture-backed startups.

The Eight Steps to Form an LLC

Choose a state. Most owners form in their home state. Delaware, Wyoming, and Nevada are popular for holding companies but rarely save money for operating businesses.
Pick a name that is unique within the state and includes a required designator (LLC, L.L.C., or Limited Liability Company).
Appoint a registered agent with a physical address in the formation state to receive service of process.
File articles of organization with the secretary of state and pay the filing fee.
Sign an operating agreement template even if your state does not require one.
Get an EIN from the IRS at no cost. Read our eIN walkthrough.
Open a business bank account in the LLC's name and never deposit personal funds into it.
Comply with annual filings, which may include a state report, franchise tax, and federal tax returns.

LLC vs Sole Proprietorship vs Corporation

A sole proprietorship is the default for any unincorporated owner: no filing, no fee, no liability shield. All business debts are personal debts. A corporation provides a shield like an LLC but requires a board of directors, bylaws, annual meetings, and double taxation by default. The LLC sits in between: full liability protection without the corporate formalities, and pass-through taxation by default with the option to elect corporate tax treatment later.

For most service businesses, freelance consultancies, real estate holdings, and small-to-medium operating companies, the LLC is the right answer. For founders raising institutional venture capital or planning to issue stock options to many employees, a Delaware C-corporation is usually the right answer.

Common Mistakes to Avoid

Using personal accounts. The fastest way to lose your liability shield is to deposit a customer payment into your personal checking account.
Skipping the operating agreement. Without one, your state's default LLC act fills in every term, including how disputes get resolved.
Forgetting the annual report. Most administrative dissolutions happen because owners miss a $25 to $200 annual filing.
Forming in Delaware unnecessarily. If you operate in California, a Delaware LLC must register as a foreign LLC in California and pay the $800 franchise tax anyway.
Not signing in the LLC name. Sign every contract as "[Your Name], Member" or "[Your Name], Manager" on behalf of the LLC.

Skip the boilerplate operating agreement

Generic template operating agreements miss the cap table, voting thresholds, capital-call mechanics, and exit terms that determine what the LLC is actually worth at sale or in a dispute. The Legal Tank attorney-drafted LLC operating agreement service covers all of this at a fixed price.

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Frequently Asked Questions

What does an LLC actually do?

A limited liability company creates a legal separation between you and your business. Once your articles of organization are filed with the state, the LLC owns its own assets, signs its own contracts, and is sued in its own name. If a customer sues the business or a vendor wins a judgment against it, creditors can generally only reach the LLC's bank accounts and property, not your personal house, car, or savings. The LLC also gives you flexibility on taxes: by default the IRS treats a single-member LLC as a disregarded entity reporting on Schedule C, and a multi-member LLC as a partnership filing Form 1065, but the LLC can elect S-corporation or C-corporation tax treatment by filing Form 2553 or Form 8832.

What are the pros and cons of an LLC?

The main advantages are personal liability protection, pass-through taxation that avoids the double taxation of a C-corp, fewer formalities than a corporation (no required board meetings or minutes in most states), and the ability to add or remove members without dissolving the business. The disadvantages are state filing fees (typically $50 to $500 to form, plus $0 to $800 in annual franchise or report fees), self-employment tax on all profits unless you elect S-corp treatment, the loss of liability protection if you commingle personal and business funds (a doctrine called piercing the corporate veil), and slightly more complex tax filings than a sole proprietorship.

Does an LLC need to make money?

No, an LLC is not required to generate revenue or profit to remain in good standing. You can operate at a loss, and many founders form an LLC during the planning or pre-revenue stage to establish brand ownership, sign contracts, and build credit history. However, the IRS distinguishes between a business and a hobby: under Section 183 of the Internal Revenue Code, an activity is presumed to be a business if it generates a profit in three of the last five years, and losses from a hobby cannot offset other income. The state will also expect you to keep filing the annual report and paying franchise fees regardless of revenue, or the LLC will be administratively dissolved.

At what point should you start an LLC?

Most attorneys recommend forming an LLC as soon as you start signing contracts, taking on customers, or generating meaningful revenue, because liability for any business activity attaches to whatever entity exists at the time the activity occurs. If you operate as a sole proprietorship and a customer is injured by your product or sues over your service, your personal assets are exposed for that incident even if you form an LLC the next day. Other common triggers are taking on a partner (you need an entity to define ownership and profit splits), hiring employees (you need an EIN and worker liability insurance, both of which are easier with an LLC), or accepting outside investment (most investors will not put money into a sole proprietorship).

How much does it cost to start an LLC?

State filing fees for articles of organization range from $35 in Montana to $500 in Massachusetts, with a national median of about $130. On top of that, most states charge an annual report fee or franchise tax: California has the highest minimum at $800 per year, while Wyoming and New Mexico charge nothing. Many founders also pay for a registered agent service ($100 to $300 per year), an operating agreement (free if drafted from a template, $300 to $1,500 if attorney-drafted), and an EIN (free directly from the IRS). The total first-year cost typically falls between $150 and $1,500 depending on state and whether you hire help.

Is an LLC the same as a corporation?

No, an LLC and a corporation are different legal entities under state law, though both provide limited liability. A corporation is owned by shareholders, governed by a board of directors, and required to hold annual meetings, keep minutes, and adopt bylaws. By default it is taxed as a C-corporation under Subchapter C of the Internal Revenue Code, meaning the corporation pays tax on its profits and shareholders pay tax again on dividends. An LLC is owned by members, can be member-managed or manager-managed, and has minimal corporate formalities. It is taxed as a pass-through by default. Many small businesses prefer the LLC for its simplicity, while startups raising venture capital usually choose the C-corporation because investors are more comfortable with stock and standard governance.

Can one person own an LLC?

Yes, a single-member LLC is recognized in all 50 states and is the most common structure for solo founders, freelancers, and consultants. The IRS treats it as a disregarded entity by default, meaning profits and losses flow through to the owner's Form 1040 Schedule C exactly like a sole proprietorship, but the state-level liability protection still applies. To preserve that protection, the single owner must observe formalities: keep a separate business bank account, sign contracts in the LLC name, never pay personal expenses from the business account, and document major decisions in writing even though no formal meetings are required.

Form your LLC the right way

Generate a state-compliant LLC operating agreement creator in minutes, or have one of our attorneys draft a custom version with member buyout provisions and capital contribution schedules. Already a multi-owner business? Pair it with a partnership agreement template for clean profit-split rules.