Quite often, I’m asked by small business owners if they should set up an LLC, and my response is always “Why?”
Their response is usually because someone told them they should.
Somewhere along the line, we have become satisfied accepting business advice from people who have no business providing said advice. Most times, this someone is not qualified to offer such advice, nor do they have personal experience to draw from. It’s usually based on a story they heard from someone else.
Now, ask yourself, “Should I seriously be taking tax or legal advice from someone with no experience in this area of my business that could cost me tons of money or, worse, all my personal belongings???”
Well, in case you haven’t guessed, the answer is NO. And setting up an LLC comes with some legal and tax consequences that I’m sure you didn’t know you needed to consider.
In my experience, most people set up an LLC to try to avoid personal liability in case their business gets sued. Well, you do know LLC stands for Limited Liability Company, right? Key word here is LIMITED. So, it still may not protect your assets 100%.
Now, I’m not here to give you legal advice, but I can tell you the tax ramifications of having an LLC because, you know, tax is one of my areas of expertise; after all, I am an Enrolled Agent.
Let’s start with the owners of an LLC.
They are called members. Single member LLCs are treated the same way for federal tax purposes – as a sole-proprietorship. You file on your PERSONAL tax return using Schedule C to report your business income and expenses. Want to learn more about how to report these numbers correctly? You can check out my online course here.
Do you instantly see how your personal liability could be exposed if you are the only member of the LLC?
This is where I highly recommend making sure you speak with an insurance agent.
An insurance agents job will be to ensure you have the correct liability/business insurance for your industry and hopefully avoid personal liability in case something goes awry. And guess what? You don’t need an LLC to have the proper business insurance coverage.
Another way liability gets compromised is by commingling (mixing) your personal and business transactions in the same account. How is an auditor or judge supposed to limit your liability if your spending habits constantly say “Heyyyy this belongs to me personally and not the business”? As you imagined, it’s quite difficult, so don’t do it!
Now, when you have multiple members of an LLC (including a husband and wife owned business), you are usually treated as a partnership. I say USUALLY because there are some additional rules for those that live in community property states (but we aren’t talking about those today).
For federal tax purposes, Partnerships file a separate tax form, called Form 1065. The partnership must keep track of what’s known in the tax biz as Basis or each member’s investment in the business. This helps avoid personal liability some because the business tax return is now separate. However, partnerships are what’s called a pass-thru entity, so you will get a K-1 from the partnership return to report your individual share of earnings or losses on your personal return via Schedule E.
This is where you need to seek legal advice.
Multi-member LLCs should have an organizational agreement in place that spells out all the roles and responsibilities of the members, who those members are, what happens when/if a member leaves or passes away and more.
Again, I’m not a lawyer, and this isn’t legal advice, but the things spelled out in this legal document also affect your taxes, which is why I recommend having this agreement in place when you go to register that LLC. Not having it registered with your state board increases your personal liability along with the personal liability of every other member of the LLC.
Another thing to consider when setting up an LLC is the cost to maintain the LLC status. In my home state of Maryland, it costs $300.00 a year to keep your LLC in what they call good standing. This ensures no one can use your business name and helps the county/city assess how much in personal property taxes the business will pay. This can be an unexpected cost of doing business for a small business owner who sets up an LLC because someone told them they should.
In my state, there is an option to register the business as a sole-proprietorship for a cheaper price and a longer time. And this method ensures no one uses your business name in the state.
I mention all of this to say the cost could should be a factor in setting up an LLC, especially if your business isn’t currently bringing in any income. However, as your business grows, you have the option of switching entity type – moving from sole-proprietorship to LLC, LLC to Partnership, S or C Corporation. So, the next time you decide you want to start a business, please don’t rely on the neighbor’s cousin’s advice. Seek an accounting professional, like myself, a legal professional, as well as a commercial insurance agent. Starting with advice from this dream team of professionals will be the best investment in the success of your business from the start.
