Let’s say you’re running a small business from your home or in-town office. Maybe you’re a freelance worker, self-employed or just making money in your spare time. Many small business owners and other individuals eventually form LLCs (limited liability corporations); however, is such a move right for you? Sure, having the LLC distinction on your business may look snazzy, but is it worth the trouble? To answer this question, let’s first consider what an LLC actually is (and isn’t).
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A really brief history of the LLC
Way back in ancient 1977, Wyoming businesses petitioned the state to create a commercial enterprise system similar to the German Gesellschaft mit beschränkter Haftung (GmbH or, in essence, a company with limited liability), which itself had been around since 1892. In response, Wyoming passed the LLC Act, which was modeled on the GmbH. What did the German GmbH and the American LLC have in common? Both enterprises allowed businesses to be taxed and run like partnerships while being protected from personal liability like corporations. This new corporate model quickly spread and was enacted across all states. In 1997, the IRS allowed the LLC distinction to be applied not only to partnerships but also sole proprietorships, further validating this business model.
How does the LLC fit into the corporate world?
There are four main types of business entities: sole proprietorship/partnership, LLC, S-corporation and corporation. Here are their distinguishing features:
Sole proprietorship/partnership: You and your partners are the business and are personally responsible for all of its debts and liabilities. Business profits are “passed-through” to you and taxed as your personal income.
LLC: You have limited personal liability for your business’s financial and legal liabilities. Business profits are still “passed-through” to you and taxed as personal income.
S-corporation: This more formal business entity can include you and your partners (also known as shareholders) as well as investors (e.g., venture capitalists). As with an LLC, you are not held personally responsible for business debts and liabilities. Also as with an LLC, profits are subject to Medicare and Social Security taxes unless they are paid out in the form of salaries.
Corporation: This entity is akin to the S-corporation except that profits are taxed twice: once under the corporation, then again when paid out in the form of a salary to you and other corporate shareholders.
Why is the LLC so popular with businesses?
Imagine that, in your spare time, you make rechargeable hand warmer mittens (a personal invention idea of mine). These mittens sell like hot cakes (no pun intended) during the football and hunting seasons, when lots of people are out in the cold for long periods of time. You’re making a handsome profit on these mittens when one of your customers reports that your product shorted his house circuits and set the place on fire. Now that customer is going to sue you over the loss of his house plus hospitalization costs. You end up losing the lawsuit and have to pay damages totaling half a million dollars. Suddenly, your business has cost you everything, including your personal savings and possessions.
How could this situation have been avoided? Had you created an LLC for your hand warmer business, the LLC would’ve been sued, not you. After losing the court case, the cash and assets of only your LLC would’ve been used to pay off the court’s award to your customer. Your own savings and possessions would’ve remained untouched.
Because many businesses have a high risk of being sued, the LLC has become rather popular in recent years. Likewise, businesses that have multiple partners also form LLCs because this insulates members from the possible bad business decisions of the other members. Other LLC advantages include the following:
Credibility: People and businesses are more likely to treat you as a real business when you carry the LLC designation than when you are only a sole proprietor/partnership. It’s also easier to obtain business loans from banks, credit unions and associations.
Less formality: With corporations, there is an excessive amount of legal and accounting paperwork and record-keeping. The LLC, meanwhile, is more of a “safe haven”, simply protecting you from personal liability.
Separate entity: The LLC is regarded as a separate entity and can be sold, transferred or inherited. When you die, the business does not die with you but lives on.
Different profit/loss structure: You and/or your partners can receive different portions of the company’s profits or losses regardless of how much actual company you or they own. This option is not available to shareholders of an S corporation, for example.
Lower tax liability: Business losses can be deducted from your personal income taxes, lowering your tax liability.
Some disadvantages of the LLC include:
Costs: A yearly state fee must be paid in order to maintain the LLC status. Forming the LLC can cost up to $1,000, especially in states like California which charge $800 to submit the business’s Articles of Organization.
Taxes: If you have employees, you must pay unemployment compensation on all those employees, including yourself. Business profits that are retained in the LLC (as opposed to being paid out as salaries) are subject to Social Security and Medicare taxes. You must also file a tax return for the LLC itself.
IRS scrutiny: Because the IRS may wish to audit your business, separate bank and credit card accounts for the LLC are a must. Creating monthly/yearly fiscal statements for your LLC is also a good idea.
The LLC: To form or not to form?
If your business carries a lot of debt because of capital expenditures and investments, you can best protect yourself by forming an LLC. Likewise, if your business has many partners, an LLC distinction shields you from legal repercussions on account of bad business decisions or even fraud by your partners.
You should also consider how much “dollar-cost-averaged” tax you will pay for the LLC. Since this type of business is treated as a “pass-through” tax entity, business earnings are taxed as your personal earned income. Social Security tax on the first $90,000 is subject to a 15.3% tax. A Medicare tax of 2.9% kicks in for all income above $90,000. This means that, if your LLC is earning under $100,000/year, you’re paying a higher tax rate. However, if the LLC is earning over $100,000/year, your “dollar-cost averaged” tax rate is lower.