Small Business Saturday: The LLC

Important disclaimer:
Sewing Mamas LLC is not able to provide legal advice and any legal decisions you make should be made after careful research and in consultation with your own attorney and tax adviser. Laws vary from state to state and the best course of action depends your specific circumstances. The information presented herein is provided for informational purposes only.

When you start thinking about going into business, you are likely to hear discussions of business types that include LLCs.

What the heck is an LLC, anyway?
An LLC is a “Limited Liability Company.” As a business structure, it is something of a hybrid. The LLC assigns liability for the organization’s debts and other obligations in a manner that resembles the responsibilities of a corporation’s shareholders and handles the income and loss as in a partnership or sole proprietorship.

Let’s look at the last part of that first.
We talked about sole proprietorships last week. In that post, I mentioned that the income (and expenses) from a sole proprietorship is reported on your personal income taxes, using a Schedule C form with the standard 1040 tax form. This is called a “pass-through” because the tax liability is passed through your personal taxes rather than requiring a completely separate filing for the business like you would have for a corporation.

The federal government does not view the LLC as a separate tax entity, so the business itself is not taxed. This does not mean you don’t pay taxes on your business income! It simply means that the federal income tax liability is passed through to the LLC’s member(s) and paid with their personal income tax filing. In this discussion, our LLC is a single member LLC like the sole proprietorship. However, if your business has two members – you and your friend are going into business together, for example – you would file a form 1065 partnership tax return with your federal taxes. It is still a pass-through, just a different form since you are not a single member organization.

This is just for federal taxes, states vary on how they handle LLCs, so check with your state’s income tax agency to find out how to file at the state level. If you do this before April, you will generally find the folks who work in these departments to be quite helpful because they have plenty of time to field just about any question you many have. And remember, they want you to do things correctly, so they really do want to help you! Here’s a link to help find the information you need for your state.

Now to the liability part.
Remember that a sole proprietor IS the business? They are indistinguishable. However, the limited liability company structure means that the LLC’s owner(s) is not personally responsible for the company’s debts and other liabilities. Sounds good, right? After all, you do not want to lose your personal assets (like your house!) if the business does not succeed. Like anything else, there are a few caveats. This protection is lost if any of the following occur:

1. Personal funds are comingled with business funds.

You must keep your business funds separate from your personal funds. Open a business checking account, if you use PayPal, open a separate PayPal account, get a business credit card. Keep your business books completely separate from your personal accounting.
And really, this makes sense regardless of your business type. Even if you are organizing your business as a sole proprietorship, you still want to know if you are making money, right? If you don’t know what was spent on groceries and what was spent on business supplies, how do you know if you are making a profit? If they are separate, you know this just by looking at your business accounts. Plus, you are more likely to be paying careful attention to how you are spending your business’ earnings.

2. An owner personally guarantees a debt.

If you take out a loan for your business and use your house as collateral, you have just taken personal responsibility for the company’s debts.

3. The LLC fails to pay taxes or otherwise breaks the law.

(That one is pretty straightforward, yes?)

4. The owner(s) does not act in good faith.

If you do something in the course of business to intentionally defraud your customers, the government, etc., you are personally liable for the resulting mess. This could be harm to people, property or even the LLC itself.

5. The company lacks sufficient capitalization or insurance.

In simplest terms, capitalization = money in. So, if your business has not maintained a reasonable cashflow to pay debts and liabilities, or if you do not carry sufficient insurance, you may be held personally responsible for the company’s debts. Make sure your business carries appropriate liability insurance as well as insurance for your business assets.

Advantages of an LLC

• Owners are not personally responsible for the company’s debts and liabilities (with the aforementioned caveats).
• Membership interests can be sold to raise capital.
• Ownership of the business can be transferred while the business continues to operate.

With a sole proprietorship, all assets, licenses and other permits must be sold and transferred individually. However, with an LLC, the company is the entity that owns all those things rather than the individual owners(members). When an LLC is sold, business simply carries on since all accounts are in the name of the business. It is really quite tidy.

• Federal income tax filing is handled as a pass through, similar to a sole proprietorship or partnership, depending on the number of members in the company.

Disadvantages of an LLC

• Cost.

There are set up fees for forming the business, filing documents with the state and sometimes annual fees depending on your state’s laws. As an example, in Minnesota, there is an initial fee to file the paperwork to form the LLC, but after that, there is not an annual renewal fee as long as the renewal is filed by the annual due date. Some states also have a minimum tax that LLCs must pay, even if the business does not make a profit. Be sure to check with your Secretary of State or State Department of Revenue to find out what the requirements will be for your business.

• Paperwork

While a sole proprietorship seems to create itself, the LLC is a more structured organization that does require papers to be filed with the government.

• Business accounts records must be kept completely separate from personal accounts.

This just seems like a good practice for any serious business person, so I do not think it is a real disadvantage.

Well, that is a lot of stuff. Our next Small Business Saturday post is going to dig in to getting the LLC set up. If you have questions about what is here or information to add, please leave a comment. Here’s a link to lawyers.com that will help you find a local law firm that can help you with business formation questions in your area.

Kelly