For decades, large businesses operated as corporations thereby, for the most part, shielding their stockholders, directors on the Board, and executive officers of any personal liability if the business has unsettled claims against it. Why should large businesses have all the protection? Back in the 60s and 70s, small businesses began to routinely incorporate to get those same protections. Along came something called a limited liability company (aka “LLC”). It first got formed in Wyoming in 1977 to solve a particular problem they had and it was so successful that it swept the country and now every state has its own LLC provisions. Wisconsin enacted its LLC law in 1994. The bottom line is, for legal protection, an LLC provides the same kind of protection that a corporation provides.
But what protection are we talking about? Is it perfect and all-inclusive? No. Here’s the simple analysis. For any kind of business, there are three general types of claims that can be made against it.
The first type of claim is a situation where an LLC (or a corporation) borrows a large sum of money to fund the business. Then goes belly-up. Can’t repay the loan. Are the members of the LLC or stockholders of the corporation liable? Generally speaking: no. but, there’s a fly in the ointment. Most lenders know this and won’t risk having a bad loan with a small business so they require the owners to guarantee the loans with their personal funds and/or secured property. In this case, being an LLC or a corporation provides very little protection, if any.
A second type would be what is generally called “garden variety payable” owed to suppliers who have sold goods or services to the business. Generally, when businesses sell to other businesses they often do so “on credit” – pay in 30 days or so. In some cases, credit is offered to customers only after they have established a good payment history with the supplier. A personal guaranty is often not required of the owners after credit terms are extended to the business. If these payables go unpaid, the owners are generally held harmless by the courts in which case the presence of an LLC or a corporation proved to be worthwhile. Nonpayment will affect the company’s credit rating and make it more difficult to get credit terms from other suppliers. Please note. No one is advocating that this is morally right or wrong. The purpose here is to solely mention that it exists as a potential benefit.
The third type of claim is clearly more insidious and more common. It’s not about loans or debts. It’s about something the business did or failed to do that caused injury (either physical or monetary) to a customer, person of interest or another business. There are many valid reasons to want the business to compensate the individual or business. Businesses, however, must protect themselves against the risk this will occur in the life of the business.
We have, in these United States of America, a very litigious way of solving problems. Every day, when people are injured, they are prompted to sue whoever or whatever cause their injury – asbestos, polluted water, cookies made with peanuts, coffee that was too hot, etc., etc. If you think, for one moment, that your business is too benign or too harmless to be sued. Think again. You own a residential duplex you rent out to tenants. You tell them they are responsible for safety on the sidewalks. Ice causes a visitor to fall, hit his head, and dies. He was a neurosurgeon. His family looks to sue somebody. Do they sue the tenant? Probably but the tenant is penniless, for all practical purposes. So, they sue the owners of the property. Absent malice of some unusual legal gyration, the only remedy the family might have is to take possession of the property not the contents of the owners’ stock portfolio. Once again, a reason to have an LLC or corporation.
So, you might ask, if the legal protection of the two types is almost the same, which is better? Most of the time, the simple answer is this – an LLC is better. It’s simpler to form and it allows for the most favorable tax elections.
A corporation must report its income and expenses on a corporate tax return, be it an 1120 or a 1120S (for an S corporation election). An LLC allows an owner to elect to either bypass that corporate filing requirement or enter the revenues and expenses of the business on his/her own personal tax return thereby saving accounting fees usually necessary for preparing a corporate tax return. Simply put, the LLC provides for that flexibility. Other than that, it’s usually a coin toss but the election is valuable enough to drive the decision.
So, bottom line. If you go into business, any business, form an LLC, get a federal identification number, and conquer the business world.
Written by Bill Ferguson, Certified SCORE Mentor, CPA, and Attorney