What Is an LLC, Really?
I have a friend who’s been doing consulting for years. Started as one project, grew into a second income stream that now equals about half what he makes at his day job. He’s still running it as a sole proprietorship. No structural liability protection for something that’s become a major income source for his family.
He’s not alone. Hardly a week goes by where I don’t talk to a small business owner who says “I have an LLC” like it’s the end of the conversation — like it’s a get-out-of-jail-free card. But when I ask follow-up questions, they don’t know how it’s being taxed, what it’s protecting them from, or what they need to do to keep that protection in place.
This post is for both groups: the people who should have formed one a long time ago, and the people who have one but don’t really understand what they have.
What an LLC actually is
An LLC — a Limited Liability Company — is a creature of your state. You form it by filing paperwork with your state government, usually the Secretary of State. It creates a legal entity separate from you. Liability protection rules vary by state, which is why local legal advice matters.
But here’s what most people miss: the IRS doesn’t recognize “LLC” as a tax category. Once you have an LLC, you still need to tell the IRS how you want it taxed. That’s a separate decision.
So when someone tells me “I have an LLC,” they’ve only given me half the picture. The LLC is the state-level structure. The tax classification is the federal piece. You need both to understand what you actually have.
The federal tax classifications
Once you have an LLC, here are your options for how the IRS treats it.
If you’re a single-member LLC and don’t elect otherwise, you’re taxed as a “disregarded entity” — essentially a sole proprietorship. Your income flows to Schedule C. You pay self-employment tax: 12.4% Social Security up to the annual wage base (adjusted each year), plus 2.9% Medicare on all net earnings. That’s 15.3% total on most of your profit.
If your LLC has two or more owners and you don’t elect otherwise, it’s taxed as a partnership by default. The LLC files an informational return (Form 1065), each partner gets a K-1, and profits pass through to your personal returns.
If you want to be taxed as an S-Corporation, you have to elect that status by filing Form 2553 with the IRS. For calendar-year businesses, the deadline is generally March 15 of the year you want the election effective (adjusted if that date falls on a weekend or holiday). If you miss that deadline, late election relief is often available under Rev. Proc. 2013-30 for up to three years and 75 days.
With an S-Corp election, you pay yourself a reasonable salary — subject to payroll taxes — and then take remaining profits as distributions, which aren’t subject to self-employment tax. That’s where the savings come from. You’ll need to run payroll, which adds some complexity. But payroll services are cheap now, and the tax savings can add up fast.
One important caveat: the IRS requires S-Corp owners to pay themselves a “reasonable salary.” If you artificially keep your salary low to avoid payroll taxes, the IRS can reclassify distributions as wages and assess back taxes and penalties.
Conventional wisdom says the S-Corp election makes sense once you’re earning $50,000–$60,000 in net profit. I think it’s worth looking at earlier — even $15,000–$20,000 in some cases, depending on your situation. The math isn’t complicated: run the numbers on your expected profit, estimate the self-employment tax savings, and compare that to the cost of payroll service and additional bookkeeping.
Finally, there’s the C-Corporation election. The corporation pays taxes at the corporate level, then shareholders pay taxes again on dividends. This “double taxation” doesn’t make sense for most small businesses unless you’re planning to raise outside investment or sell the company.
The key insight is that your LLC can grow with you. You can start simple, taxed as a sole prop, and elect S-Corp treatment later when it makes sense. If you revoke S-Corp status, you generally must wait five years before re-electing it without IRS consent.
My own example: Romano Associates
I recently started another company — a small consultancy focused primarily on pro bono work, with occasional paid projects. I formed an LLC because I wanted the liability protection. But simplicity mattered more than tax optimization at this stage. So I kept it as a single-member LLC taxed as a disregarded entity.
Sometimes simple is the right answer. The LLC can provide liability protection — if maintained properly. And if the paid work grows, I can change the election later.
What an LLC gets you
It can provide liability protection — if you maintain the separation properly. If someone sues your LLC or your LLC can’t pay its debts, your personal assets — house, car, savings — are generally protected. The LLC is a separate legal “person.”
It gives you credibility with some clients and vendors who take you more seriously if you’re operating as an LLC rather than just “John Smith, consultant.”
It gives you flexibility. You can change how you’re taxed as your business evolves.
And it gives you succession options. It’s generally cleaner to transfer ownership interests in an LLC than to unwind and sell a sole proprietorship. This is a bigger deal than most people realize — we’ll cover it in a future post.
What an LLC doesn’t get you
It doesn’t automatically save you taxes. Forming an LLC alone does not reduce self-employment tax. You have to make an election — like S-Corp — to get tax advantages beyond what you’d have as a sole proprietor.
It generally won’t protect you from liability for your own professional negligence or misconduct. If you personally do something wrong — fraud, malpractice, negligence in your professional work — the LLC won’t shield you from the consequences.
It doesn’t protect you if you sign personal guarantees. If you personally guarantee a lease or loan, you’re on the hook regardless of the LLC.
And it doesn’t protect you if you don’t maintain the separation. This is the big one.
The big mistake: piercing the veil
The liability protection only works if you treat the LLC as a separate entity. This is called “maintaining the corporate veil.” If you don’t, a court can “pierce the veil” and come after your personal assets anyway.
How do people screw this up? The most common way is commingling funds. Everything goes into one checking account — personal and business mixed together. Or worse: business income goes into the LLC’s account, but then personal expenses come out of it regularly.
Other ways: not keeping basic records, no operating agreement, no separation between you and the business on paper. Or starting the LLC with essentially no money in it and running everything through personal accounts.
The rule is simple: if you have an LLC, you need a separate business bank account. Business money stays in business. Personal money stays personal. It’s not complicated, but you have to actually do it.
When do you need one?
You probably don’t need an LLC if your side income is under $5,000–$10,000 a year, you’re doing something low-risk like selling jewelry on Etsy, or you’re just testing an idea and not sure it’s going anywhere.
You should probably form an LLC if your side business is becoming a real income source, you have meaningful liability exposure (clients could sue you, you’re doing professional services, you own rental property), or you want the flexibility to elect S-Corp treatment later.
LLCs are relatively inexpensive in most states. Filing fees range from about $35 to $500 depending on your state — Massachusetts is unfortunately at the high end with a $500 filing fee and $500 annual report. But even at the expensive end, compared to the protection you get, it’s usually worth it.
A note on rental properties: I had a client with two small rental properties — not getting rich on them, but they’re a key part of his income. Both were under one LLC. Sometimes it makes sense to have separate LLCs so they’re firewalled from each other. A little harder on the bookkeeping, but cheap insurance. And remember: an LLC is not a substitute for liability insurance. The structure helps, but insurance is what actually writes the check if something goes wrong.
The bottom line
An LLC is not a destination. It’s a starting point.
It doesn’t automatically protect you. It doesn’t automatically save you taxes. But if you understand what it is, maintain it properly, and make the right elections as your business grows, it’s one of the most flexible and useful tools a small business owner has.
And if all you know is “I have an LLC” — it’s time to learn the rest.
You might also like:
“Why Everyone Should Have a Side Business” — the case for having one
“How to Hire Your Kids” — where LLC structure matters