As a whole I think people like to provide helpful advice. Often if you have business or rental activity someone tells you should have a Limited Liability Corporation. Sometimes that advice is spot on. Sometimes it is not. Sometimes, along with that advice, they share information that may create false expectations. You can save on taxes (maybe). You can protect yourself legally (maybe). You’ll be way more cool (absolutely).
For this article we are focused on LLCs, but some states have some other similar entities, so portions of this article may be helpful information for those as well.
The three reasons I typically see people setting up LLCs are because someone told them to, to save on taxes, and for legal liability protection. Because someone told you to isn’t a good reason, unless one of the other reasons are valid. I will start with legal liability.
Starting the LLC for legal protection
Usually the thought here is to protect personal assets from anyone trying to sue you from a legal perspective. Another common reason is a desire to borrow money as a “company” instead of as an individual who is personally responsible for the debt.
I will tell you that most people I’ve encountered and most of my clients who have LLCs are personally responsible for the debt they have acquired that is associated with the LLC. This is because lenders typically want to make sure they get paid and that they get something if the lender isn’t paid. If the business entity doesn’t have a track record of income and paying their bills and/or assets that a lender sees as adequate then they won’t lend to just the business. This isn’t my area of expertise, but I know what I see. If you are setting up an LLC for borrowing then maybe it would be wise to speak to lenders to see what it would take to make that work for you.
If you are shocked that I am not a lending expert, then you’ll be shocked to hear that I am not a legal expert. I suspect that lawyers view this non lawyer giving legal advice in a manner similar to how I view non tax professionals giving tax advice. Hopefully the lawyers will be okay with me listing some questions you should consider and get answered when you are looking at setting up an LLC. And with the qualifying statement that consulting a lawyer before you set up an LLC and to do the actual set up of an LLC is a very, very good idea. As I have indicated, I am not a lawyer, so I may be missing some good questions and considerations. Here is my list of questions/considerations:
- Is my proposed business or rental activity required to have an LLC or other business entity? I expect the answer in most cases to be no. There might be an activity out there for which there are benefits for operating as an LLC. Perhaps for certain contracting opportunities for example.
- What are the initial and annual costs for having this entity? Sometimes veterans have the initial costs waived by the state, but the annual costs are not waived. Costs vary widely by state.
- What initial and ongoing administrative requirements are there for this entity? These vary by state and by the entity type. There is now a federal Beneficial Owner Information Reporting requirement for many business entities, including LLCs.
- What are the actual liability protections that the entity will provide me? Make sure that you include in this area what if: I am viewed as negligent? I am viewed as being malfeasant? Ask for and look for scenarios and examples so you fully understand what liability protection you have. The level of liability protection can vary by state considerably, because these entities are formed under state law.
- Can I still be sued personally and have to pay a bunch of legal costs even though I should be protected from a particular lawsuit with the business entity? I suspect that I know the answer to this question and that you know the answer as well.
- What do I have to do to have and maintain legal liability protections? This is so important because there are things you have to do. The broad answer is to keep the personal activity separate from the business or rental activity. Think about accounts, transactions, and ownership of assets. To emphasize -lawyers should know this topic best. Lawyer. Lawyer. Lawyer. There are lawyers that specialize in “piercing the corporate veil”. Want to be scared? Do an internet search on that.
- What about if my business or rental activity crosses state lines? Did I mention that each state can have different requirements? In many cases a state may have a foreign LLC registration requirement if you are operating in a state via an LLC registered in another state. If this applies to you, it might mean a different answer is generated for some or all of the previous questions. Has anyone mentioned yet that consulting a lawyer might be a good idea? It (crossing state lines) may mean you need more than one lawyer (I probably have the same reaction to that as you do).
- Will my business activity have additional taxes? This may seem like a weird question to ask on the legal side, but if a lawyer is advising you to set up an LLC, they should at least know if it might add to your taxes. In some cases, in some states there are revenue or excise taxes for LLCs and other business activities. There may be other taxes, including local taxes. These might be in addition to income taxes.
- What if I will have a partner or partners for the business or rental activity? There are loads of great legal reasons to establish a multi member LLC when doing business with other partners. For some activities in some states it may be required. I look at it simply. It is good to have rules in place when in business with others. A multi member LLC defaults to a partnership at the federal level, but can elect S corp or C corp status. A multi member LLC has increased administrative and legal requirements. It typically also has increased compliance costs. We’ll look at those more under the tax discussion. We’ll also discuss what spouses who want to set up a partnership just between themselves should consider.
- Can I get my rental property or other property under the LLC? If the rental property isn’t owned by the LLC then most likely that will impact what legal protections the LLC can provide. Some lenders may not permit you to transfer a property to an LLC. As we’ve already determined I am not a lending expert or lawyer, and those two types of experts would be able to help you with this consideration.
That’s my list for the things to consider and ask regarding the legal aspect of an LLC. Hopefully it makes the lawyers happy because if there is one thing in life I want to do, it is to make the lawyers happy.
Starting the LLC for tax purposes
It so happens I am a tax expert. However, you should know that I am going to generalize some. Which means you won’t get 100% of the applicable information. I won’t share all possible exceptions when there are possible exceptions. This means it would still be smart to consult a tax professional before setting up an LLC. Preferably the right tax professional. Here are some tax facts regarding LLCs. Mixed with just a touch of opinion.
A Single Member LLC (SMLLC) has virtually no tax benefit, when compared to operating without any entity. If you are operating a business as a sole proprietor or own rental property directly as a landlord and then decide to establish an LLC and place the assets and operations under the LLC – if all that is done you have the exact same treatment on your federal income tax returns and and any state income tax returns that I can recall. The SMLLC is a disregarded entity for tax purposes. It is like it doesn’t exist. The income and expenses are still counted on your personal return. The only slight tax benefit is that you now have LLC expenses to deduct such as set up costs and annual fees. And as I mentioned before, there may actually be higher taxes in states that have an LLC excise tax. There generally aren’t any special things you can deduct as a SMLLC that you couldn’t deduct as a sole proprietor or individual direct landlord.
How about a Multi-Member LLC? First I want to mention that one exception to considering business activity with multiple participants as a partnership that requires filing a partnership return is when it is rental real estate activity with multiple owners. Typically in that situation each owner could file a schedule E with their appropriate share of income and expenses.
For other business activities, whether there is an LLC or not, if there are multiple owners then the IRS views it as a partnership by default and the partnership requires filing a partnership tax return. For business or rental activities that only involve spouses there may be other options. To clarify, I mean two people married to each other.
Generally, if you establish a multi-member LLC it defaults to a partnership. This means that it has its own federal tax filing requirement. That tax return, the 1065, is normally due on March 15th. A partnership means more complicated tax filings and it means increased tax filing costs and potentially increased compliance costs. It also means it is more important to keep personal and business activities and transactions separated. If you are in business with people other than your spouse, then likely it makes sense to accept those costs.
But if your only partner is your spouse, maybe it doesn’t make sense to accept those costs. But what other options do you have? For community property states a multi member LLC with only spouses as partners can elect to be treated as a single member LLC. This will permit the spouses to avoid filing a separate partnership return. Otherwise, if you are in a partnership or a multi-member LLC with your spouse you are filing that partnership return.
Another alternative for spouses may be to have a Single Member LLC set up as one spouse being the member and then transferring the house to that LLC. Then the tax situation is the same as not having an LLC, but there may be an LLC that provides some liability protection. “May” because I don’t know, refer to above in the list of legal considerations. Don’t forget to note number 10.
But if a Single Member LLC works for the lender and the lawyer, then likely it is optimal regarding how complicated the tax filing is and the compliance costs.
Are there tax savings for a partnership? In most cases they don’t have more or better deductions or tax savings as compared to what you can do without a partnership. However, it can be situational and a tax professional should be consulted for tax planning.
Well what if we just do an S corp? Everyone says they are great anyway.
An S corp can be great if we are talking about a sole proprietorship or single member LLC filing on a schedule C versus S corp, when income is high enough that it makes sense. That is usually the big determining factor for when to establish an S corp -when income is high enough. And when that happens is another “depends” answer that I won’t address here. Sometimes an S corp makes sense for a multi-member LLC too.
But for rental activity that would otherwise be reported on a schedule E or in a partnership tax return, it is usually a bad idea to have an S corp. An LLC elects S corp status. In most cases if you elect S corp status you are choosing to change your rental activity income that is not subject to self employment taxes into income that is at least partially subject to self employment taxes. Perhaps a bigger problem is that it can make avoiding capital gains taxes difficult. And there are other tax considerations that tend to make S corps a poor choice for most rental activities. But not all, there are exceptions.
It is important to note that an S corp typically has more complicated administrative and compliance requirements than SMLLCs and partnerships. And a more complicated tax return with both similarities and differences to a partnership return and more compliance costs.
To summarize federal tax considerations for creating an LLC: Unless you fit the profile of someone who would benefit from having an S corporation, in most cases for most of us there is little to no direct tax benefit to having an LLC as compared to having no entity. But there are exceptions. One example in some cases is for partnerships and situations where the state offers an election for a pass through entity tax.
In most cases a multi-member LLC with just your spouse is a partnership.Usually this creates more costs without much, if any, tax benefit. If you have a partnership tax return and IF that partnership does not own an asset you want to depreciate, then the partnership will not be depreciating that asset.
I hope you found all of this helpful. I don’t know if an LLC is right for you. But this article should be a good starting point to help you figure out if one is right for you.