Should You Use An LLC For Your Small Business?

by: Stephen L. Nelson, CPA

Accountants and attorneys love limited liability companies. But do limited liability companies—LLCs for short—really make sense for small business owners. Probably. And for two almost unknown reasons.

The Big Legal Benefit of an LLC: Limited Liability…

The big legal benefit of an LLC is that limited liability companies provide all the same liability protection as a corporation—but with much less red tape. A regular corporation, for example, requires regular stockholders meetings, a board of directors, regular board meetings, and of course records of all these activities and bodies. But a limited liability company doesn’t.

This legal liability protection provided by an LLC can be extremely valuable. One local attorney I often collaborate with, for example, tells his clients that an LLC protects business owners from the worst case scenario—which in his mind is a “slip and fall” accident on the business property.

With an LLC as the business owner, so says my attorney friend, the “worst case scenario” is liquidation of the LLC. That liquidation means the people who own the LLC wind up with nothing—which isn’t good. But all the owners lose is what they’ve invested in the LLC.

In comparison, without an LLC, the business owner’s “worst case scenario” if there’s a “slip and fall” accident is that the owner can lose almost everything they own. In other words, the business owners could lose not only their investment in the business but many other assets as well.

Let me issue a caveat here, however. You may not get as much legal liability protection from an LLC as you want or hope. Say, for example, that you’re repairing the roof at the business location and that, unfortunately, you happen to drop a hammer onto a customer’s head during the roofing project. Your LLC probably won’t protect you from that sort of tort liability. In other words, the customer can probably look not only to your LLC for payment of damages related to the dropped hammer but also to you personally.

And here’s another example, which unfortunately makes things even murkier. What happens if someone working for you, one of your employees or subcontractors, drops a hammer on the customer’s? The LLC may offer you some protection in this case. But you may still be personally responsible. The customer might reasonably argue that you should have done a better job managing the employee or subcontractor, for example.

If you’re extremely concerned about the asset protection features of setting up and operating an LLC, get an attorney involved in your business planning. An attorney knowledgeable in LLC and business law can help you increase the liability protection that you gain from using an LLC for your business. And this consultation doesn’t need to be particularly expensive. You may be able to buy an hour or two of time from a good local attorney and get all your LLC- and liability-related questions answers.

The Big Tax Benefit: Enormous Tax Flexibility…

A second benefit of LLCs relates to the income taxes that business owners pay on profits and capital gains. A limited liability company can be almost whatever tax entity it wants to be for income tax purposes. A limited liability company that is owned by one person can be a sole proprietorship, a C corporation, or an S corporation. A limited liability company that is owned by two or more persons can be a partnership, a C corporation, or even an S corporation (if the LLC meets the S corporation eligibility requirements). This second benefit of the limited liability company means that an LLC can choose to be taxed in whatever way is most favorable to the business.

For example, a very small real estate business with a single member (LLC owners are called “members”), might decide to be treated as a sole proprietorship for federal income tax purposes. This decision to be treated as sole proprietorship would keep the business’s accounting very simple—and it would also mean that unique tax planning opportunities available to sole proprietorships can be used.

A larger business operation—perhaps one with several partners—might decide to operate as a C corporation or as an S corporation in order to take advantage of some of the unique tax planning advantages of these entity choices. A C corporation, for example, often lets businesses provide rich tax-free fringe benefits to employees including shareholder-employees. And an S corporation often lets a business dramatically reduce the self-employment, social security and Medicare taxes paid on the owner’s profits.

While a limited liability company is not difficult to set up by yourself—you can have the paperwork done less than a quarter hour from now—you should be aware that paying a few hundred dollars to an accountant to pick the right taxation for your new LLC might be the best investment you ever make. It’s common that the right taxation choice for a new LLC can save the owner or owners of a small business $10,000 to $20,000 annually.

The Drawbacks of the Limited Liability Company Choice

When you consider the two big benefits of a limited liability company—limited liability but with less red tape and tremendous tax flexibility—you have almost the perfect business entity choice. So an obvious question is “Why wouldn’t every business use an LLC or limited liability company?”

Perhaps predictably, there are some costs and headaches associated with operating as an LLC.

An LLC may increase your banking, accounting and insurance costs. For example, while the bank account for a sole proprietorship or informal partnership may be free if you keep a large-enough balance, the bank account for a limited liability company probably won’t be free. The bank may charge $10, $20, even more each month.

While a sole proprietorship can keep its bookkeeping and income tax return preparation very simple, an LLC probably needs to file its own tax return if the LLC operates as a partnership, a C corporation or an S corporation. And this LLC tax return may cost anywhere from a few hundred dollars to a few thousand dollars annually.

Finally, it’s worthwhile to note that an LLC may involve several hundred or even a few thousand dollars of startup expense. For example, you may spend money on publications. You may buy the services of accountants and attorneys. You will need to print new letterhead, business cards, and envelopes (if you use these) that use the new LLC’s name in order to show the world that you’re now operating as a limited liability company.

So where does all this leave you? How should you balance the big benefits of forming an LLC with all the costs and drawbacks? Unfortunately, I can’t give you a one-size-fits-all answer. You’ll need to carefully consider the benefits and costs as they add up in your specific situation.

I will share these thoughts, however. In my opinion, an LLC is uneconomical for very small businesses—such as the very parttime, home-based business.

On the other hand, any time you’ve got a business that’s the way you’re making a living, an LLC economically reduces business risk and as an added bonus can even save the owners thousands of dollars a year in income or payroll taxes.

About The Author

Stephen L. Nelson, CPA

Bellevue WA tax CPA Stephen L. Nelson is the author of both Quicken for Dummies and QuickBooks for Dummies and an adjunct tax professor for Golden Gate University’s graduate tax school. Visit hi web site at http://www.stephenlnelson.com