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Should you form an LLC?

Should you form an LLC?

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  • If you are simply “testing the waters” on a new business idea to see if it is something you want to pursue more seriously, then you likely do not need to form an LLC. For example, a lawn care business where you are mowing a few of your neighbors’ yards to determine if it is something you can genuinely grow into a business. Or perhaps a hobby where you occasionally sell what you create to friends or acquaintances. In these instances, you do not need to form an LLC.
  • If you are currently a sole proprietor then I would seriously consider forming an LLC. Likewise, if you are an independent contractor as a trade, then I would seriously consider forming an LLC. If you are an independent contractor and you drive for Lyft, Uber, Grubhub, any of those things, you really do not need to form an LLC because those companies should have the proper insurances and protections in place to protect you and to protect their clients or customers.
  • If you have rental properties should you put them into an LLC? The recommendation would be that you do. How you do it depends on the amount of asset protection that you are looking for. If you have multiple rental properties, you can choose to bundle all those rentals under one LLC which provides less asset protection. The other option is to put each rental property in its own LLC. This provides maximum asset protection for each rental. That decision really depends on your level of risk tolerance.

 

Liability and asset protection

The primary reason for forming an LLC is for liability and asset protection. If you are a sole proprietor and your business gets sued, then without the protections of an LLC, the person suing you can sue for your business assets and your personal assets – your home, cars, etc.. Obviously, this is not something that you want to happen and that is why people form an LLC. Forming an LLC separates you personally from your business. If you are a sole proprietor and you form an LLC, you operate that LLC correctly, and somebody sues your business, they cannot come after your home or your personal assets. And that is exactly what we want.

It is a common misconception that simply spending $50 with the Secretary of State to file as an LLC will protect you personally if your business is sued. This could not be farther from the truth. There are many things that you must consider in order to have the protections offered by an LLC.

  • You must operate your LLC as a separate business.
  • You must have an operating agreement. An operating agreement is just a document that states how your LLC will be operated, what kind of business it is in, who the owners are, how money is contributed, etc. It defines the way that your LLC will operate and should be drafted by an attorney.

 

Flexibility

An additional reason for forming an LLC is for the flexibility it can offer. There are other types of business entities out there, such as corporations, S-corporations, and partnerships. Corporations have certain formalities that you must follow. You must have shareholder and board of director meetings at least once a year where you take minutes and keep formal record of that. What does that look like if you are a single owner? What does the shareholder meeting look like? Those are things that you are required by law to do. With an LLC, it is not explicitly required to do that. In an LLC you define how you operate your company for the most part. You define your formalities whereas corporations have formalities written for them that must be followed.

Forming an LLC also offers flexibility in taking distributions from your business. If you have multiple owners of the LLC, let’s say there are two owners, and it is a 50 – 50 ownership situation. But in this scenario one owner does most of the work and the other owner simply contributes the collateral for the business. It is likely that owner that does most of the work will take more of the profit distributions than the one that just contributes the collateral. So even though it is 50 – 50 ownership, the working owner can take an 80% distribution and the investing owner can take the remaining 20% distribution. If you were a corporation and it was 50 – 50 ownership, then the distributions must be taken as 50 – 50. There is no getting around that.

And the last point of flexibility is the way that you can choose to be taxed. By default, an LLC is taxed the same way as a sole proprietor. Or if there are two or more owners, it is taxed in the same way as a partnership. However, you can elect to have your LLC taxed as a corporation. It could be a C-corporation or an S-corporation. This gives you the legal benefits and protections of having an LLC and the benefits of having an S-corporation tax election. Simply forming an LLC has no tax effect, your business would still be taxed as either a sole proprietor or partnership. There are no changes there. To save on taxes, you must elect an S-corporation taxation. Electing S-corporation taxation is done by completing Form 2553. Although it is just one form, it is not that simple, and I would recommend you reach out to your CPA to complete the form for you. The S-election tells the IRS that you are an LLC, and you are electing to be taxed and to file taxes as a S-corporation. You will find that S-corporations pay significantly fewer taxes than sole proprietors, LLC’s, and partnerships. This is because profits from an S-corporation are not subject to self-employment tax. Self-employment tax is 15.3% of your earnings which is quite significant. There are a lot of other things to consider before you choose an S-corporation election. You have got to make sure it is right for you and your business. I highly recommend that you talk to a professional, an attorney or a CPA. Make sure it is right for your business.

We are here to help. If you need assistance in determining whether or not to set up an LLC for your business or if you are already an LLC and are wondering if you should be making an S-corporation election, we’d love to help. Reach out to us at www.nguyencpas.com or support@nguyencpas.com and schedule a complimentary consultation with one of our advisors.

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