Entrepreneurs often cite the tax benefits and/or the limited liability as reasons why they chose to create a limited liability company (LLC) for their business. Others will merely say that they followed the advice of a sister, who is a CPA, or an uncle, who is a lawyer. Still, some will blindly do whatever the Internet tells them.
Yes, the tax benefits of an LLC make sense: the business’ revenue is taxed at the owner (or “member”) level. This is often called “pass through taxation.” On the other hand, corporations face “double taxation” which means that its owners pay taxes at both the business level (for revenue earned by the business) and the member level (for income earned by an owner). By establishing an LLC, an owner pays taxes on his or her receivables from the business, just like any other employee. Similarly, sole proprietors are taxed in this manner. Of course, tax specialists are a great resource for determining the most appropriate and beneficial taxable entity for the LLC.
So why bother going through the exercise of setting up an LLC if you’re just going to be taxed as if you were a sole proprietor? The answer is simple: limited personal liability. Creditors can only access the business’ assets, such as inventory, computers and bank accounts, in the event the business cannot afford to pay them. As a result, your personal assets (property, bank accounts, etc.) are protected from creditors. While most, if not all, business owners don’t expect to run into this problem, savvy ones are prepared for the worst while working hard for success.
Sounds easy and logical, right? Well, there are some pitfalls that can result in personal liability if the business owner is not careful. These triggers will be discussed later in this blog entry.
LLC owners enjoy benefits beyond those related to taxes and liability. By establishing an LLC, you have given your business a greater opportunity to raise capital. One option for financing the business is through selling ownership. Of course, a business owner will likely want to retain some percentage over 50%, usually 51% to maximize the amount of capital that can be collected. Non-LLC entities (for example, C-corporations) must share records, notify shareholders of meetings, and observe other formalities. If an LLC’s articles of incorporation are written properly, many of those formalities can be legally avoided, thereby saving the owner valuable resources, especially time.
All business owners want to be perceived as legitimate, professional and trustworthy by potential customers and clients, especially those within their target market. Having the initials “LLC” next to a business name can provide that instant credibility because it demonstrates that the entity’s existence is on record with the State Corporation Commission. An inference can be made by potential clients that the business has its affairs in order and is worthy of being taken seriously since it has taken the proper steps.
In addition, the life of the LLC is set forth in the articles of organization. Often times, this attribute achieves a business owner’s desire for the business to continue with the same name, assets and goodwill. For sole proprietorships, the business simply folds when the owner retires or is no longer able to manage the business.
Putting all those benefits aside, let’s get back to the topics of limited personal liability and the pitfalls that can jeopardize this protection. In many ways, business owners feel indistinguishable from their business, which is understandable due to the sacrifices they’ve made and the “sweat equity” (or the time and energy) they’ve invested into the business. Nevertheless, business owners need to draw a clearly defined line between themselves as individuals and the business. If a court finds that a business owner failed to “observe corporate formalities,” creditors can obtain a judgment in which they can stake a claim on that business owner’s personal assets, including real estate, automobiles, and bank accounts.
One of these corporate formalities is to establish and maintain separate bank accounts. Mixing personal and company funds, commonly known as “commingling,” is the easiest way for creditors to reach a business owner’s personal assets. Members are also expected to keep the business sufficiently funded, which includes acquiring sufficient insurance. When marketing the business’ services and/or products, the owner should act as an employee of the company. Using official letterhead for all business-related communication can assist with establishing a clear line between one’s personal activities and business dealings.
Another formality is entering into agreements as an agent of the LLC. Although it is difficult (if not impossible) to get a loan for a new LLC without making a personal guarantee, members should sign most other contracts as an agent on behalf of the LLC. In short, if lines are blurry between one’s business and personal activities, the business owner might become personally liable for claims and debts against the business.
If you are thinking of starting a business, we can help. If you already have a business but are concerned that it might not fully protect your personal assets, we can assist with mitigating your risk. Email us at email@example.com to inquire about our services.