- Generally, your business needs to have $5000 (or more) in gross revenue during your first year to justify the added cost of forming an LLC
- A Separate Entity (ie LLC) may or may not offer liability
- A Separate Entity offers choices in tax treatment, including the ability to optimize in ways not available to operating as a sole-proprietorship.
Today I’m going to discuss if you should have a limited liability company LLC or not from an insurance and liability perspective.
I almost exclusively work in the world of commercial business insurance and often have new or soon to be new business owners asking about how to best protect their assets and of course shifting / transferring liability exposure and risk to an insurance company.
For many businesses’ owners, it’s a surprise to find an advocate for operating as a sole proprietorship instead of forming an LLC
In order to understand why an LLC may or may not make sense, lets first take a look at what an LLC is so we’re clear about that.
You can think of a limited liability company as a person in the legal sense. A legal fiction granted, albeit it can sue, and be sued, make contracts, and do all sorts of things, including receiving licenses, fines from the government, just as “real” people can. The difference between the two is one is called a “natural person” – that’s you and me, and as much as we may attempt to avoid it, we can die, while an LLC can, in theory at least, live to be well past the ripe old age of 200+.
So when you wonder why an LLC would ever be considered a person, it’s for the sake of argument of what it can and cannot do, and what can and cannot happen to it. Instead of a mother, an LLC has a state giving it “birth.”
LLCs came about out of a desire to limit the liability (hence the name), without all the work and effort of a corporation. The concept is the newest significant form of entity formation
Thus, a limited liability company takes some of the best attributes of a corporation (limiting investor liability) and sole proprietorship/partnership (less maintenance) business types and combines the two to enable investors to begin and continue a business without requiring a great deal of time, energy, money, and knowledge in the area of corporate structure and continuous rigid formalities.
Because LLCs are generally subject to fewer rules and regulations relative to corporations, much greater management flexibility is afforded, and investors are often able to use default rules created by the state (commonly on the state’s website when filing out the online forms to organize an LLC entity) with very few variables.
Using the State’s defaults can save the business owner money from paying a lawyer to setup the business entity, however, that doesn’t mean it’s a good idea to avoid the legal cost to “do it right the first time.”
Even if you want, or think you want all the default choices, I recommend spending some time with an attorney to discuss the pros and cons. If you don’t want to spend, or don’t have the money to spend on an attorney, look to the local county attorney’s association (called a bar association) and see when they’re having a free attorney clinic.
Most counties offer a clinic at least once per month where anyone with a question can talk to an attorney for 15-20 minutes about any given issue for free. You’re likely to find this occurring at a library or other public venue.
Keep in mind, similar to corporations, management and controlling members owe a fiduciary duty of care to both the LLC (it’s a separate person within this context), as well as the LLC’s investors. Often, the investor, manager, and controlling member is all one person (or husband and wife). As a single member LLC, you’re likely doing everything you can to benefit the LLC, so it’s not an issue.
In every state I’m aware of, a single member LLC default tax treatment is to have income pass-through to the owner and that income is considered “earned income” compared to for example, investment income.
However, there are four possible ways LLCs can be taxed, and this is where some planning, especially with a tax professional, can really save you some money in your tax exposure, liability, cost.
The ways to tax (more correctly characterized as its tax treatment) an LLC include treating the LLC as a complete pass through sole proprietorship, Again, that’s the default tax treatment for a single owner LLC, a partnership (which by definition requires more than one owner/member), and that’s the default tax treatment for a multi-member LLC, S-Corp passthrough, and a a full-fledged C corporation where income doesn’t pass-through and taxes are paid based on income of the LLC, and also dividends are taxed by the investors/members (double taxation).
Both S and C corporation elections require the owner or owners to make an affirmative election to receive either a S or C tax treatment. This tax treatment comes from the IRS and doesn’t impact the fact that your LLC is an LLC, and it doesn’t become a corporation by electing a corporation’s tax treatment. It’s still an LLC in other facets other than how the IRS treats the income.
An important keynote is each state sets up the requirements, fees, and rules regarding LLCs within the state, so what may be the norm in one state, may not be allowed in another.
Therefore, it’s important to seek competent professional legal advice when it comes to matters that are legal in nature. My purpose is to speak about LLCs from the context of if they’re worth the extra effort and expense as a liability mitigation tool, especially when viewed as an either or as a replacement for insurance coverage, and even then, the best you can get is a general across the board overview because each state’s laws are unique, as well as your specific situation.
Ok, so that’s what a LLC is, and hopefully my explanation will help you understand why in some cases, you don’t want one, or perhaps if you already have one, it may not offer the amount of liability protection or other qualities you were under the impression having one offers.
I also want to add there’s a whole lot more to this, however, for an overview, we’re doing well.
And again, everything within the decision-making tree is based on relative importance, because like many things in life, it’s not black and white, albeit rather many shades of grey.
The first easy reason not to organize your business as an LLC is the cost. In some states including California I believe, the cost of having an LLC can be easily become much greater than the profit.
I believe at the time of writing California charges a minimum of $800 per year as the minimum income tax a LLC will owe. This is considering the “cost” of having limited liability. In my mind, that’s not really fair for several reasons. Other states may include public notices, which can add significantly to the cost above and beyond the filing and legal expenses.
First of all, when I consider California’s $800 minimum income tax on LLCs, I can’t help but think it’s akin to a protection racket where some guy comes around a neighborhood and tells the shopkeepers they better pay up to ensure “nothing bad happens.” I don’t think the state should treat business owners as “marks” to be squeezed, and for many small business startups, a state bill for $800 when the LLC made less than $1000 income for the year just doesn’t sit well with me.
Also, it puts the screws to creditors who may otherwise collect from the debtor because the state decided to collect its protection fee.
Regardless if the cost is super high, or so low it’s immaterial, there’s a cost in the formation in every state I’m aware of, and I would be very surprised to find any state that doesn’t use the formation as a revenue source beyond the state’s actual cost to some degree.
Next reason is greater accounting required, and this can vary greatly on the tax treatment elected. A C corporation treatment will have much more accounting requirements than a sole proprietorship. Often this will require different software to calculate the apportionment of income passing through to members, thereby increasing the maintenance cost. Plus, you may need an accountant, where you otherwise could have done it all yourself.
Another reason is an LLC makes many of the financial procedures more complicated. Instead of having one checking account for both your business and personal affairs, you likely have to setup two or more, and then jump through all the hoops the bank requires to have your LLC setup banking. It used to be that corporations weren’t allowed to receive interest on their checking accounts, however that rule has (thankfully) been eliminated. An LLC must keep it’s financial dealings separate from the owners, even single member LLCs or risk losing the limited liability status.
Separate credit lines is another. If you have a personal line of credit, say for example a line of credit on your home, the LLC will need to have it, right along with credit cards, debit cards, etc..
Some health insurance cost savings may not be available to you. I don’t want to get too complicated here, and what I’m referring to may have even been changed, albeit up to recently when I last checked, there was a strategy that some couples could employ including one spouse hiring the other spouse and deduct their combined health care costs. This didn’t apply to many people on a relative basis at the time I last looked into it, and that hasn’t likely changed if the strategy still works (I have no reason to believe it doesn’t and if you want to learn more, I suggest leaving a comment or asking your tax advisor).
So, in short, the reasons for not creating an LLC is additional cost, time, effort, and maintenance in creating and keeping an LLC.
But wait, there’s one more potentially significant reason not to create an LLC, and this “gotcha” can become painful for some. If your LLC becomes a party to a lawsuit, regardless if plaintiff or defendant, there’s a strong chance you may not represent the LLC in court, and you’ll have to hire an attorney.
This can become significant because, for example, let’s say you have someone file a frivolous lawsuit that’s just above the small claims limit. And you know the case doesn’t have merit, and you feel the matter is relatively simple and you could handle it yourself. Well, in every state I’m aware of, the LLC will have to be represented by an attorney. In Wisconsin, my state of residence, and California an LLC can be represented by an LLC officer in small claims.
While an eviction is normally handled in small claims, a suit alleging discrimination may not be. With small claims limits relatively small (hence the name), you could easily find yourself paying a lawyer to appear for your LLC when you may otherwise do so.
Of course, this is a double-edge sword that could save you. In a given situation where you “think” you can handle it, you may find hiring an attorney saves your bacon because you’re unknowingly over your head. If you’re in a state that doesn’t even allow you to represent your LLC in small claims court (I’m not aware of any, and I welcome you to leave comments advising of any), it can become a significant additional cost, especially for landlords.
But that’s not all. There’s another liability concept for single member LLCs that it appears many people don’t fully appreciate.
As an agent for the LLC, and in this context, an agent means anyone acting on behalf of the company/LLC, which is much more expensive than a person who is an officer or employee, is usually personally liable for their own tortious conduct, including negligence. Your state may have a statute or statutes limiting liability for employees and agents to only the company, albeit don’t count on it.
The concept where a business is liable for acts by employees and agents is called vicarious liability, or sometimes “the doctrine of respondeat superior (which means let the superior answer).”
In other words, let’s say you own a single member LLC and you’re working on a roof and you drop a hammer off the roof. As the hammer falls, instead of hitting the grass, it hits a child in the head.
Unless there’s a statute limiting the liability to only the LLC, the LLC and the person who actually dropped the hammer are both liable. This quickly blows up the notion that having an LLC is an appropriate replacement for insurance coverage.
If you’re making a product in your single member LLC small business operating out of your home, for example candles and you’re selling them on the internet, than you can and should count on personally being held responsible for anything that goes wrong regarding negligence, as well as strict liability defects, including design defects, warning defects, and manufacturing defects.
As you can see, forming an LLC may not offer any real protection against the most significant liability risks possible, even if it could possibly protect against some liability exposures.
And even your not exposed to liability as an agent, you may still have personal liability for your LLCs debts if a plaintiff is able to “pierce the corporate veil.”
The piercing of the LLC veil is beyond the scope of this, albeit I’ll follow up with more about this legal maneuver and why insurance is your only true protection if this happens.
Ok, so that’s a lot to worry about and for many, an LLC may not be nearly as attractive as it was before today. However, let’s take a look at the positives for a balanced look.
This is also a good time for me to mention that I’m not against LLCs or other liability limiting strategies, I’m only against those strategies that won’t work in a given situation. For many people, and again, this depends on the state statutes and where the business operates, an LLC is a great way to limit your personal liability.
First positive is the most obvious and it’s the ability for member investors to limit their liability. What a wonderful thing to be able to invest in a business and not have to risk more than the dollars you invested.
This doesn’t mean the risk is eliminated, what it really means is the members are able to shift or transfer some of the risk of liability onto society and others that are either willing or in the case of negligence, unwilling but forced to engage with the LLC.
If you get a loan and don’t have a personal guarantee, generally, you’re not going to have to worry about personally paying the loan if the LLC isn’t able to do so.
Also, multi-member LLC owners have much lower risk than general partnerships. If your partner/agent causes an accident, an LLC entity can protect you against personal liability, even if the LLC and/or the agent isn’t able to pay the debt incurred.
An LLC can personally protect LLC members against liability caused by the negligence of employees hired. This protection in my mind is the most important level of protection by LLCs that have employees working.
Going back full circle to the tax treatment. Having an LLC is almost surely going to save the owners/investors money on their tax exposure due to the various tax strategies available to an LLC that aren’t available to sole proprietors and general partnerships. As an LLC makes more money this becomes increasingly more important.
At the time of sale, for example, when the owner wants to retire, having an LLC can make the sale simpler and/or more attractive to a potential buyer for many reasons, including again, the tax treatment, intellectual property, and organization inherited within an LLC structure versus trying to make sure there’s a clear separation.
Finding investors is easier with an LLC because there’s something to actually “buy” compared to changing a sole proprietorship into a partnership. Along the same lines, an LLC is more attractive, all else being equal, because investing in an LLC limits the investors liability.
So, you should have basically two takeaways. The first is in order to protect your personal assets, insurance really is the key. The second, is you want to understand your operation from the context of profitability and liability exposure in order to make an informed decision on if jumping through the LLC hoops is worthwhile.