Two More Reasons to Use an LLC over a Corporation

When a client contacts me for information on the best entity to form, I’m going to tell them LLC, at least about 80% of the time.

The things I love about LLCs are:

  1. Their amazing flexibility for taxes; and
  2. Their superior asset protection.

LLCs are the Bendy Straws of the Corporate World

An LLC can do something special, that a corporation can’t do. That is, it can choose its own tax election. An LLC can be taxed as a C Corporation, S Corporation, partnership or even as a disregarded Schedule C or Schedule E company. It’s the ONLY structure that has that kind of flexibility.

Plus, you don’t even have to make that choice up front. IRS rules allow us to make a tax election for an LLC pretty much right up until the day you file its very first tax return. Depending on when you create your LLC, that gives you until mid-April of the following year, or even mid-September, if you file for an extension.

Let’s say you think you might make a ton of money in the first year, but you aren’t sure. You form a C Corporation, thinking you want all the benefits, and, because you’re going to earn so much money, you’ll be in the top tax bracket for sure (at which point a C Corporation can save you tax money). But things don’t go as planned, and you lose money. Too bad for you, the C Corporation election ties up those losses in the company. You can’t take them against your other income, on your personal return.

Lets try again, but this time you form an S Corporation. This time you make a ton of money – way more than you need to live on. You take a salary, but want to leave the rest in the company, for growth. Again, that’s too bad. You can’t leave it in the company. Well, you can, but the IRS won’t see it that way. S Corporations are deemed to have distributed all the profit each year – and that’s how they will be taxed. In this case, you’d be better off as a C Corporation, but because you already made an election on the Corporation (to make it an S Corporation), the IRS doesn’t want you to change again for 5 years. You’re thankful for the income, but sure wish you weren’t paying so much of it out in taxes.

In each case, setting up an LLC would have been a better option. You wouldn’t have made a premature tax election. You could have waited through the year to see which way the profit wind was blowing.

LLCs have Asset Protection that Corporations Don’t

My second reason for preferring LLCs over Corporations has to do with asset protection. All incorporated entities offer some protection to their owners. If you set up a C Corporation, for example, and it signs a long-term lease deal for office space, but then goes under, the debt is the Corporation’s to pay (or not pay). As the owner, you aren’t responsible for paying the Corporation’s debt, unless you signed something personally guaranteeing the debt. As a Corporation owner, you can lose everything you’ve put into the company, but again, unless you did something to obligate your personal assets, they remain yours. That is the same for Corporations, LLCs and even LPs (although with LPs it is a bit different – the General Partners do stay liable).

However, while you’re protected from your company, the same doesn’t go the other way. Let’s say you’ve got a 2-level rental property that you hold in your own name, with a rotten set of stairs. A customer goes through the stairs, all the way to the basement. She breaks her hip in 3 places, and sues you. Your property insurance would have covered it, except you forgot to pay the premiums. So, the lawsuit is coming against you, and the plaintiff’s lawyer is looking at your assets. The house is mostly owned by your bank, who have a prior claim, so the plaintiff can’t make you sell the rental to pay for her damages. So far, so good.

Then the attorney sees that you own a C Corporation that makes money every year selling fishnet stockings on the Internet. Uh-oh. The attorney claims the right to seize your shares in that C Corporation. You can’t afford to fight it, or you fight and lose. Now the plaintiff has control of your shares, and votes to shut down the company, sell it to the highest bidder, and take the money. You may have a rental property, but you don’t have your main source of income anymore.

If you’d held your fishnet stocking business in an LLC, things would have been different. In that case, the plaintiff’s attorney wouldn’t have been able to get your ownership in the LLC. Almost every state in the US has a law that specifically prevents assets in an LLC from being seized by a creditor, and also says that your ownership in an LLC isn’t something that can be seized, either. In this case, you have leverage to negotiate a settlement that gets the plaintiff out of your hair, while keeping your fishnet stocking business going.

There are many variables when you’re structuring a business. That’s why it’s hard to go through a quick-service website. Unless you talk to someone who’s got some knowledge and experience on both the tax and the legal side, it’s hard to know what you don’t know. And that can leave you vulnerable.

Got questions? Contact us! We’re here for you.

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