Creating a limited liability company (LLC) is a great way to protect your assets. Whether you transfer your real property to an LLC or create an LLC to form a company to protect your personal assets from creditors, this article will explain the benefits of an LLC and how forming one can protect your assets.
If you have questions about protecting your assets by creating an LLC, contact our experienced business lawyers today.
What is an LLC?
An LLC is a state-authorized business structure with the characteristics of both a partnership and a corporation. Each state has its own rules and regulations regarding LLCs, but the basic structure and the attributes noted here are universal.
States acknowledge an LLC as a separate entity, apart from its owners, with its own rights, responsibilities, and liabilities.Despite jurisdictional differences, all owners of an LLC are referred to as members. States do not restrict ownership, so members can be any combination of the following:
- a single individual
- multiple individuals
- foreign entities
- or other LLCs
Who can create an LLC?
Banks and insurance companies may not form as LLCs, and there are special rules for foreign LLCs. Foreign LLCs do business in states outside of the state in which they were formed.
By default, the IRS views an LLC similarly to a sole proprietorship or partnership for tax purposes. Therefore, the members must pay taxes on the LLC's profits as personal income. In a single-member LLC, the member can pay taxes by reporting all business and personal income on a single Form Schedule C.
LLCs as a Disregarded Entity
The federal government taxes single-member LLCs similarly to a sole proprietorship. The federal government considers the single-member LLC a disregarded entity, which is an entity that is not recognized as separate from its owner. Under this method, similar to partnerships, only profits from the business are taxed as personal income.
Taxation differs for a corporation because the IRS taxes the corporation directly on any profits it earns and then taxes its members on any income earned from the corporation's dividend payouts. This treatment results in double taxation.
Why Choose an LLC? Why is having an LLC important?
To understand why you should choose an LLC, you must first understand the difference between an LLC versus a partnership and an LLC versus a corporation.
LLC vs. Partnership
A partnership is a relationship between two or more individuals to operate a business. Each partner contributes money, property, labor, and skills to the company and shares in the profits of that business. The partnership itself is not an independent, taxable entity, and all business expenses, business income, and business property are the responsibilities and assets of the individuals that make up the partnership.
Because all business income and expenses pass through to the partners and most business operating costs are tax deductible, the IRS taxes partnerships on only profits—the IRS taxes partnerships LLCs.
LLC vs. Corporation
In contrast, a corporation is a group of members authorized to act as a single entity in the eyes of the law. The corporation, a newly formed entity, is distinct from its members and can conduct business as a “legal person.” Similar to any person, a corporation can:
- file lawsuits or be independently named as a party in a lawsuit
- make its own contracts and purchases
- incur its own debts
- pay its own taxes, and
- conduct its own financial transactions—like making investments or lending money
Members are not liable for the corporation's liabilities or obligations because it is an independent entity. As previously discussed, the corporation is a taxable entity, and both the corporation and the member are taxed separately.
Tax Advantages of an LLC
Having an LLC allows you to enjoy the tax advantages of a partnership while simultaneously enjoying the asset protections of a corporation. When an LLC has more than one member, the IRS views it as a partnership instead of a corporation by default.
In default status, LLC members avoid double taxation. And as a separate entity, LLC members still reap the legal protection benefits of escaping personal liability for most of the LLC's financial obligations. With nearly 90% of U.S. corporations involved in some form of litigation and 45% of those lawsuits involving small businesses, personal asset protection should be a priority for any business owner.
The average liability suit costs at least $54,000. Without personal asset protection, a $54,000 judgment could be financially devastating and lead to the dissolution of a small business or personal bankruptcy.
What personal assets are protected by LLC formation? Does an LLC protect you from the IRS?
LLC formation protects any member's personal assets like personal bank accounts, personal property, or real property from seizure to satisfy the LLC's legal liabilities or other obligations. An LLC offers members personal asset protection from any creditor lawsuits that result in LLC liability.
Although an LLC usually shields its members from most business tax liabilities, there is an exception. It does not protect members from unpaid payroll taxes. Payroll taxes are taxes that employees are required to pay on wages, salaries, and tips of its employees. These taxes include state, local, federal, and FICA—Social Security and Medicare.
The cost of the state, local, and federal taxes will vary based on the elections noted on an employee's Form W-4, but FICA taxes are universal and must be paid to the IRS for any employees working for your LLC. If your LLC has employees, you must ensure FICA taxes are paid to avoid personal asset seizure or obligation.
What does it mean to elect Corporate Status for your LLC?
As mentioned above, if your LLC has more than one member, the IRS will consider it a partnership for tax purposes by default. However, you can elect corporate status for your LLC by filing Form 8832 and making the election. If you choose to elect corporate status, your LLC will be treated as a corporation for tax and legal purposes—incurring double taxation and additional formalities corresponding with those required for corporations.
How to protect your assets using an LLC (i.e., steps to take)
To protect your assets using an LLC, you should:
(1) Contact a lawyer or registration agent (in some jurisdictions) for guidance and assistance in properly forming an LLC.
(2) Purchase LLC insurance
(3) establish a separate bank account in the LLC's name
(4) Maintain the LLC as an independent entity
(5) Establish LLC credit, and
(6) Consider placing your personal assets in a trust.
Contact an Attorney or Registration Agent
Prevention is key when thinking of protection. Attorneys can advise on the proper procedures and formalities required to start and maintain an LLC. They can also assist you with creating your official documents (i.e., operating agreements, bylaws, and meeting minute books) and answer specific questions about how to protect your assets. In some jurisdictions, a registered agent may also offer guidance on LLC formation. Failure to follow formal procedures can lead to penalties, including loss of personal asset protection.
LLC insurance is an insurance policy or set of guidelines that specifically helps to protect businesses from various liability claims like bodily injury or property damage caused by your business, your employees or vendors, or your products. This added protection could be beneficial if your business is found legally liable for damages by utilizing the policy to pay out claims without dipping into the LLC's business funds. Several insurers offer LLC Insurance, and an online search should render several options.
Have a Separate Bank Account Just for the LLC
Commingling money can cause a loss of asset protection. Commingling refers to using business funds for personal expenses and vice versa. One way to ensure that courts are clear about what monies were spent on business and personal expenses is to open a bank account in your LLC's name. Establishing a bank account in your LLC's name gives the LLC the ability to pay its own expenses and invoices, purchase its own supplies, and ultimately cover its costs. There are a variety of business bank accounts available. You should contact a financial advisor or your current bank to learn more about business account offerings that match your needs and goals.
Maintain the LLC as a separate entity.
Forming an LLC automatically creates a separate legal entity, right? Well, yes and no. LLC formation creates a separate legal entity. Still, additional steps should be taken to ensure that there is no uncertainty regarding the LLC's and its member's actions. As noted above, you should have a separate bank account for your LLC. Once established, it is important that you do not use the bank account for personal expenses or personal cash withdrawals. It is ok to pay yourself a salary from this account, but it is important to remember that the LLC's bank account should not act as your personal ATM; this account is used by the LLC and for the LLC to maintain viable business operations. Any business purchases should be tracked along with a description of why the purchase was made. Keep a record of the tracked expenses in case you need to explain them to a judge or the IRS.
Establish LLC Credit
Because your LLC is an independent entity, it can take on its own debt and establish credit. Doing so offers an additional layer of evidence that the LLC is its own entity. In addition, establishing credit provides other capital access for the business and further illustrates that LLC finances are kept separate from personal finances.
Consider Placing Your Personal Assets in a Trust
LLCs and trusts are both considered independent legal entities. Therefore, when an individual moves their personal assets into a trust, they transfer ownership from their control to the trust's. While relinquishing control of your personal assets may be frightening, it could protect the asset from being subject to creditors. You should consult an attorney or financial advisor for guidance and to learn if this option fits your goals and needs.
Is limited liability absolute?
Unfortunately, limited liability is truly limited and not absolute. Sometimes a court will “pie
ce the veil” and hold members accountable for the LLC's obligations and debts. Piercing the veil could occur if any of the following circumstances exist: (1) if a member acts as guarantor for any of the LLC's obligations, (2) if members commingle money, (3) if a member uses the LLC to commit fraud or other wrongdoing, or (4) if regarding the member and the LLC as separate would lead to injustice.
The LLC should manage all business expenses and debts with its own financial resources and instruments because it is an independent entity. Also, understandably, courts will not protect any business that is engaged in fraudulent activity or assist any company in harming the public.
Are there any disadvantages to choosing an LLC?
Protecting personal assets benefits any business owner, but LLCs also have disadvantages. Most people consider the disadvantages minor compared to the benefit of asset protection, but they should be noted.
First, an LLC is more costly to start and maintain than a sole proprietorship or a traditional partnership because of the required formalities that affect formation. To create an LLC and remain compliant, an LLC must pay annual reporting fees and sometimes a franchise tax fee (depending on the jurisdiction). Franchise tax fees are required in the following states:
- New York
- North Carolina
- New Hampshire
- District of Columbia.
If your LLC operates in any of these jurisdictions, franchise tax fees may apply. These fees are not required with a sole proprietorship or traditional partnership. Also, ownership transfers are slightly more complicated for an LLC than an S-Corporation or C-Corporation. Registering your LLC as an S-Corporation or C-Corporation avoids this minor inconvenience.
If you have any questions about creating your LLC, contact our attorneys here at Newburn Law, PC for a free consultation.