To LLC, or Not to LLC - That is the Question

Of all the things small business owners get wrong, I think the concept of a Limited Liability Company (LLC) ranks near the top of the list. Many excited would-be entrepreneurs hop on LegalZoom and have an LLC within 5 minutes and quickly proclaim that they're officially a business owner. Congratulations! But....Let's set the record straight on a couple of items.

Myth - Becoming an LLC will allow you to take more tax deductions.

Realty - Nope. Nada. Absolutely not. Erase that idea from your mind forever and all time. If that's why you created the LLC you probably just wasted a couple hundred dollars, plus annual fees in some states. Sorry to be the bearer of bad news, but that LLC won't do what you wanted it to.

Deciding to become an LLC could be the right decision for your company, but it is a LEGAL decision, not a TAX decision. An LLC provides some legal protection for your personal and other business assets not owned by the new LLC - IF you follow all the rules and don't give any cause to pierce that corporate veil. You should think of it as an additional insurance policy, should your business get sued.

Here's an example:

Annie Artist has opened a business downtown and has purchased a building from which she will create her artwork and teach classes. She will also rent out any extra space to other tenants. She decides to purchase her building in a newly created LLC, but has decided that creating an LLC for her art business is not necessary due to the low probability of being sued by students. The LLC owns the building and pays the mortgage, upkeep, insurance and other bills related to the building itself. Annie's art business rents space from the LLC at FMV and she has drafted a rental agreement with her attorney to ensure everything is handled properly from a legal perspective.

The winters in Annie's area are cold and icy and Annie doesn't get into the shop early enough to clear the sidewalk in front of the building before a pedestrian happens by. This individual slips on the ice and sustains injuries that result in some not insignificant medical bills. The pedestrian's attorney notifies Annie that she is being sued to cover the hospital and other bills and that if she doesn't have enough insurance to cover the bills they'll take any assets she has to make the injured party whole.

The purpose of the LLC is to protect any personal assets Annie has from being seized in this situation. Annie touches base with her attorney to discuss this and to ensure that the only asset at risk is the building owned by the LLC and not her home, vehicles, or investments.

Where things go wrong:

Fortunately, Annie was extremely diligent and purchased the building in the LLC name and had a written rental agreement between the LLC and her art business. She also kept all of her financial transactions separate between her LLC, art business, and personal accounts. That will help her attorney keep her other assets out of any conversations regarding losses this pedestrian sustained. 

Often small business owners fall into the trap of thinking of their business as an extension of themselves (especially when they're the sole owner) and they commingle assets such as bank accounts or fail to properly purchase assets in the LLC name. When this happens, the LLC filing becomes little more than an expensive piece of paper that may not provide the protection you had hoped for.

How to get it right:

1. Keep separate bank accounts for each entity and don't commingle! Deposit LLC income (rent from the business and other tenants) into its own bank account and pay any expenses related to the building from the LLC bank account. The art studio should pay any expenses relating to that business from its own bank account and deposit any fees from students or sale of artwork into that account as well. Annie should then pay herself as cash allows by transferring money from her business accounts to her personal account. Any personal expenses should be paid directly from her personal account, NOT from either of the business accounts.

2. Draft up the appropriate legal documents. Make sure there's a rental agreement prepared between the LLC and the art studio business. This shows the public (and attorneys) that the businesses were being run independently of each other and are truly separate legal entities.

3. Purchase assets in the LLC name. Many business owners forego purchasing assets in the business name because it's more difficult to get bank funding or insurance premiums may be higher. However, it later becomes almost impossible to prove that an asset should be treated as a business asset if there is no paper trail to prove it.

4. Use an attorney. LegalZoom is inexpensive and "easy", but are you sure all of the documents were filed properly for your state and situation? And who will you call when you do have legal questions? It's best to have a professional in your corner from the beginning that is guiding you and watching your back.

Notice I Didn't Mention Taxes?

From an IRS and tax standpoint, you can take the same deductions whether you're a sole proprietor (no LLC) or you've filed the legal paperwork to become an LLC with your state. You have to pick up all of the same income and you're able to deduct all of the same expenses on your tax return. And it's even reported on the same forms. If you're the sole owner, then you report this activity on your Schedule C (for businesses) or Schedule E (for rental property) under your Social Security Number.

If there are multiple owners, then you've created a partnership (whether you realized it or not) and you should most definitely engage an attorney and have legal documents in place, LLC or no LLC. But that's a discussion for another day.