What is and what is not a limited liability company (LLC)? An LLC is a creature of state law. With an entity, no matter whether it’s created by a state or you’re creating it through an agreement, you still need to address how it relates to a state, third parties, and the federal government.
- LLC was created under state law; do not exist in federal government
- Definition: LLC is an entity created by state law that mirrors or marries various elements, including creating liability protection for an artificial person
- LLCs create isolation between you and your business; LLCs are similar to corporations
- State: Set up an LLC with the state and pay the state a fee for protection
- State gives you certain types of rights/protection, such as from liabilities of the enterprise
- States give you protection personally from business activities, but some states give you protection from personal activities going into the business
- Third Parties: When dealing with third parties, follow certain formalities – document and maintain books and records of expenses and income for courts and the IRS
- Rule of Thumb: The amount of respect you show your business or LLC, is the amount of respect a third party shows it
- Federal Government: IRS makes sure you pay your taxes and where you go to get an Employer Identification Number (EIN)
- LLC is a separate person, but it’s not recognized by IRS as a separate taxable entity, unless told otherwise
- Three Choices for an LLC: Sole proprietor, partnership, or corporation
Full Episode Transcript:
Toby: Welcome to the Anderson Business Advisors podcast. My name is Toby Mathis. We’re the founding partners at Anderson and we go after the mission: Preserve, Protect, and Prosper, and this podcast is no different.... Read Full Transcript
Today, we’re going to be talking about limited liability companies. In fact, what is a limited liability company, what it is not. I can start right off on that one. A limited liability company is a creature of state law. I’m going to start just by kind of breaking down three different buckets you have to pay attention to whenever you’re talking about an entity, no matter what kind of entity it is. Whether it’s created by a state or whether you’re creating it by just an agreement. But you want to make sure that you’re looking at these three buckets and they are: how it relates to a state, how it relates to third-parties, and how it relates to the Federal government. Because they’re all three different buckets. No matter what type of entity you have, it’s going to need to address each of those buckets.
First off, eliminate liability company was actually created under state law. They do not exist to the feds. In fact, if you go to the IRS and try to elect a tax treatment called limited liability company, you’re not going to find it because it doesn’t exist. A limited liability company is an entity created by state law that basically mirrors or marries a couple of elements together. One of those elements is this idea of an artificial person in which creates liability protection. A liability protection, for example, if you go into business and you have debts in that business, the question is whether it’s going to come into your personal realm if the business fails or if the business cannot pay it.
Limited liability companies can create an isolation between you and the business. Where, for example, if you start up a plumbing company and you flood somebody’s basement and they sue you for $1 million whether or not they can follow you around for the rest of your life or whether it’s going to be limited to the business itself. That’s what limited liability companies really were designed to do is they’re very similar to their cousins, the corporation. Just a word to the wise, don’t ever call the limited liability corporation, it’s not what it is. It’s a limited liability company. They have some of the attributes of a corporation and the one thing really being inside liability, protecting inside liability.
Let’s go back out to our three buckets. We have the state bucket where you’re setting it up with the state and you just pay it a fee. Generally speaking, you’re going to be paying that every year. Sometimes you file taxes, depends on the jurisdiction. Some jurisdictions, you pay one time and you’re good, sometimes it’s bi-annually. Every state is a little bit different. But what you’re getting for paying money to the state—I was a big Godfather fan, you got Luca. You’re basically paying somebody for protection.
I grew up in Philadelphia and somebody walked up and said, “Hey, you have really big windows in your shop. Do you want to make sure that they don’t get broken? It’ll be $10 a month…” or whatever it is, “…and your windows will never be broken. If you choose not to pay that $10, there’s good chance your window’s going to get broken.” This is old idea that you’re paying somebody for protection. If you pay that $10 then if your windows get broken and nothing happens, and you’re not getting any help, you’re going to quit paying the $10. You could say, “Why am I even paying you?”
Well, the state’s no different. They’re giving you certain types of protections and one of those is protection from the liabilities of the enterprise, that they’re not going to come out and affect you personally, and just imagine if they did, people would quit setting up limited liability companies. You actually have a big, strong stake on your side to protect you and that’s what you’re paying for when you’re setting up a limited liability company—all these certain rights.
Now, next bucket is dealing with their parties including judges and other things. That’s a whole other ball of wax when you’re talking about these limited liability companies. You still have to follow a certain level of formalities. Meaning you have to document things and you’re always going to hear practitioners say, “Oh, limited liability companies are so much easier than corporations.” Now they’re just saying, “No, they’re not.” You have this middle bucket doesn’t care whether an LLC—that’s what we call a limited liability for sure. There’s professional limited liability companies also called professional limited liability companies for doctors and lawyers in certain states, but you have this LLC and it still has to maintain books and records for the courts and for the IRS.
Like we have the one element of just the state, and you may not have a lot to do to get the protection from the state, but you still have to meet certain requirements. Those requirements are generally books, and records. For example, at the IRS, no matter what type of business you have, you really have to keep books and records. Books and records, this means records of money that’s coming, money that’s being spent, expenses and income to be more specific. Also, records meaning that if we took you out of the mix and you’re no longer able to testify about what this LLC has been doing, would we be able to piece it all together from the records? Would there be writings that said, “Hey, we decided to buy these vehicles and put them into a rental pool.” Would there be documentation to back up what those agreements were and all those fun stuffs?
That gets you squarely into the second bucket which is when you’re dealing with third-parties. Now here’s a really important element to think about with that limited liability companies. The states give you protection personally from the activities of the business, but some states give you protection from your personal activities from going into the business. For example, if me and Paul go into business, again, let’s just say we’re plumbers and Paul goes through a divorce, do I end up having to deal with his ex-spouse as my partner or is it Paul? Is there any protections I have? Or let’s say that Paul has a crazy teenage kid that gets into a really bad accident. They’re coming after Paul for everything he’s got, and they want his piece of the company. Do I have to then take on the insurance company or the person they harmed as my new partner in this business?
The LLCs can give you protection so that they can’t just come in and take over that interest, but it is certain jurisdictions. For example, at our firm we tend to really focus in on Wyoming and Nevada. You’ve probably heard of other jurisdictions as well including Delaware but, in our opinion, really there’s a couple that we focus our attention on because of all the benefits you get, and really is night and day when you compare them. That’s not the subject matter of this podcast.
Let’s go back into the second bucket of when we’re dealing with third-parties. Now that we know that we have certain types of protection then we want to make sure that third parties honor it. The rule of thumb is the amount of respect you show your business, or you show your LLC is the amount of respect a third party will show it. If you don’t have a bank account for your LLC for example, do you think that that’s showing much respect if you don’t have an operating agreement for your LLC, for example? Do you think that’s showing a lot of respect? No. They’re going to ignore the LLC and go right to you personally.
For example, if I go into a bank and I want to get a loan, I better make sure that I know what the bank wants to see. I better make sure that I have adequate paper work to make sure that I’m covering everything that they want to see. If I do that, they’ll probably give me a lot of respect. If I walk in there and say, “Yeah, I have an LLC.” And you show them a certificate of formation with the state and that is it, they are looking squarely at you and they’re going to hold you personally responsible. They’re probably not even going to go through the formalities of dealing with a loan to an LLC, that just goes straight to you because that LLC is deficient. It doesn’t look like an LLC. It’s not an LLC as far as they’re concerned. They have a person sitting in front of them.
Now if I come into the bank and I have my P&Ls (Profits and Loss), I have my balance sheet, I have a separate bank account, the company has separate assets, the LLC has an operating agreement and all the members of the LLC have signed-off on it, and I walk in and I say, “Here’s our track record—” Anytime you’re dealing with loans by the way, it’s going to be cash collateral or credibility. You got to make sure that you have all three or at least one of them to get a loan without having a personal guarantee. You go into the bank and they’re going to look at that far differently. In fact, you’ll be able to get a lot of trade lines, credit cards, and things like that in the business just by having it separated from you. Now, it’s just like a teenager; now it’s going to develop its own credit profile but that is the second bucket.
The other way I always look at this is if you’re in front of a judge. You got to be able to look him and say, “This is not me. This is a separate entity that I created. Here’s its body. Here’s its records. I have met all the conditions by the state. I get protections and you need to give me those protections.” That’s where that works out. That’s the second bucket is dealing with third-parties like banks and judges. Other parties as well if you’re entering into contracts and things like that. They just have to know that it’s not you. There needs be enough there to where they feel comfortable dealing with this artificial person called a limited liability company.
The third bucket is the federal government and specifically the Treasury which means we’re dealing with the IRS. The IRS is its policing arm to make sure that you’re paying all of your taxes and stuff. Well it’s also the place where we go to get what’s called and EIN or Employer Identification Number. An LLC is a separate person. It is a legal fiction created to operate businesses, but it is not recognized by the IRS as a separate taxable entity unless you tell it what type of entity you want the IRS to treat it as.
If that made you confused, here’s the easiest way to look at it. An LLC can be disregarded meaning, ignore it for tax purposes, look at its owner, and its owner will report all of the incoming expenses on the owner’s return. If that owner is you, you are being taxed as a sole proprietor. If you have more than one owner, then you will either be a partnership which means you’re both reporting basically your share of the profits or losses on your personal return or it could elect to be treated as a corporation—actually, it’s a single owner.
LLC can be treated as a corporation as well but basically, you have three choices: you’re either going to be disregarded meaning taxes as sole proprietor is you, a partnership, or as a corporation. If it’s a corporation then the IRS just looks at it and doesn’t think LCC, it thinks corporation. It’s looking for an 11-20 or 11-20S return. It’s either going to be a C- or an S-Corp. you do this on the inception date of that LLC where you’re creating and obtaining its EIN or it’s Employer Identification Number which is just a social security number for a business. When you obtain that, you’re saying to the IRS, “Here’s how I want you to treat it. Treat it as ignore it, treat it as a partnership, or treat it as a corporation.” You could even make a S selection. At the end of the day, that LLC—depending on which three buckets you’re dealing with—is extremely flexible which is why, by far and away, they’re the most popular entity right now.
Basically, I hope this answered your question of, “What is an LLC?” I hope you could see what it is. It’s a separate legal entity and it has a high degree of flexibility. If you’re going to buy real estate, perfect entity. It’s probably where 9 out of 10 practitioners go when they’re buying real estate because we could treat it as a flow through entity. It’s giving you protection so that if you have an accident on that property, they can’t take all of your other personal assets and vice versa. If you have a bunch of partners in this thing and one of them goes out in either gets divorced, or has a massive lawsuit, or passes away or is disabled, whatever there is going on in their life, it doesn’t come in and they don’t grab all the assets inside that LLC. It’s a very effective tool for that. If you’re running a regular business, you can have an LLC taxed as a corporation and ran as a corporation.
Now, I will say this, depending on your jurisdiction, that may be more attractive than others which is why you always use a professional to make sure that they’re looking at your particular situation. But a lot of times, if you’re dealing with banks, etc., if you’re a corporation that kind of want to see as a corporation because they may not be up on these LLCs, they have been around since 1978 and they’ve been universally accepted really. In fact, the pass-through attributes to the LLCs, they issue wasn’t completely decided for certain states specifically if you’re a tax person, community property states, they treat a husband and wife as one person. That was like 2003, so it’s not that long ago that these things have really been around.
A lot of these institutions, they have to recognize it that they’ve been around for 100 years so they’re looking at it going, “What’s this new kid?” Well, now they’re pretty much universally accepted more and more and more but sometimes, I like to straight line from A to B which is certain activities, you’re going to want to just use a regular corporation otherwise you can certainly set-up that LLC and have it taxed as a corporation.
There’s almost no difference. There’s only one little difference that I could think of which is, the small business stock, the 1244 Stock Loss which requires tax certificates not membership interests. There’s a small little nuance to difference between them but for the most part, it really won’t make much of a difference.
But again, give us a call if you want to ask that question, see whether truly you’re going to have an impact on you because sometimes it does, sometimes it doesn’t. But chances are it’s going to be really tough for you to tell unless you’re dealing with somebody who deals with it, day in and day out. They’re an awesome tool, they’re probably the most popular entity to date, right now there’s probably more LLCs being set-up in this country than all the corporations and all the other jurisdictions combined. It’s just one of those entities that everybody’s going to because they’re so flexible.
To understand that flexibility, I like to break it into the three buckets. Hopefully that will help you determine whether or not it’s an appropriate entity for you. At a minimum, now you should have a good idea of what is an LLC, a limited liability company. Please don’t ever call it a limited liability corporation or we’ll make fun of you. Anyway, this is Tony Mathis. I hope you enjoyed this podcast.