It’s time to take the gloves
off. After my last article touting the significant advantages
of limited liability companies (LLCs) over corporations, my
e-mail box filled up fast. Misinformed small business owners,
accountants, and attorneys wrote to question some of my
contentions. One local attorney who likes to form corporations
even wrote a “rebuttal” for this publication. Such debate is
healthy and often useful, but it’s important that the
arguments are based on fact. In this case, they were not.
Myth #1: S Corporations
have favorable tax treatment over LLCs.
Fact: An LLC can have exactly the same tax treatment as an S
Corporation.
Whether to form a company as
an LLC or a corporation is NOT an either/or proposition.
A company can be both—in effect, enjoying the liability
protection offered by an LLC and the tax benefits of corporate
status. An LLC is not a tax structure. It is simply a form of
business entity which provides personal liability protection
for the manager and members of the company, asset protection
for the business itself, a simple management structure, and
minimal reporting requirements and fees.
Myth #2: Single-owner LLCs
must be taxed as sole proprietorships.
Fact: A single-owner LLC may elect S Corporation tax
treatment.
Whether one person or a group
of people owns a company, it can elect how it wants to be
taxed; i.e. as a sole proprietorship, partnership, subchapter
C corporation, or subchapter S corporation, depending on the
specific tax issues involved. For an LLC that receives exempt
income such as royalties, rental income, or investment income,
which is not subject to self-employment tax, it makes sense to
have the company taxed as a “sole proprietorship.” As such,
income would simply pass through to the individual owner, and
filing a separate tax return would not be necessary. On the
other hand, independent contractors such as landscapers,
plumbers, and realtors usually should not file as sole
proprietors. A real estate agent’s commission, for example, is
considered “earned income” and is subject to self-employment
tax. I advise realtors and others in service-related
industries to form an LLC and elect S-corporation tax status,
which may create a significant Social Security tax savings.
Myth #3: An LLC with two or
more members must file a partnership tax return.
Fact: An LLC with two or more members may file as either an
S-Corporation or a partnership.
In most cases, my clients who
are members of multi-member LLCs opt to file as S Corporations
rather than partnerships. They prefer the immediate
gratification of approximately 40 percent savings in
self-employment tax over the less-than-assured long-term
advantage of higher retirement benefits. In a partnership, all
of the income is subject to self-employment tax, which
ultimately increases members’ retirement benefits. An
important reminder: the tax election applies to the
company—not to individual members---so it’s critical that
members agree on the tax treatment before the company
is formed.
Myth #4: An LLC provides
no greater liability protection than a corporation.
Fact: Arizona’s LLC law is tougher than most and provides far
greater asset protection than a corporation.
Arizona’s limited liability
law, as amended in 1997, is one of the strongest LLC laws in
the country. In fact, our act provides that the only
remedy available to creditors of LLC members is a
“charging order” issued by a court. Under a charging order, a
creditor effectively becomes a member of an LLC and can
receive distributions, if any, but has no right to the
company’s assets. The problem is, the creditor has no voting
rights. If other members vote to make no distributions, the
creditor has no access to funds, either. To avoid the hassle,
creditors often settle the case for pennies on the dollar.
Furthermore, if a member of an
LLC is sued for a reason unrelated to the business of the LLC,
only his or her personal assets held outside the LLC are at
stake; whereas, a majority shareholder in a corporation is not
asset-protected. A creditor with a judgment against a
shareholder can attach those shares and force a liquidation of
the company’s assets.
Myth #5: The corporate veil is
hard to pierce.
FACT: Wrong. Because corporations often fail to follow the
rules, they’re easy prey.
If a company is set up
strictly as a corporation, without LLC entity protection, the
company must meet strict requirements, including holding
annual meetings, keeping minutes of meetings, and filing
annual reports. If a creditor can prove that the debtor
company did not adhere to these requirements and show that the
corporate structure is nothing more than the company’s “alter
ego,” a favorable judgment is likely. An LLC has none of these
requirements, and enjoys far more favorable legal protection.
It’s important to remember, however, that any business entity
is vulnerable to creditors if damages are caused by fraud.
Myth #6: Lack of Case Law
Makes LLCs Too Great a Gamble.
Fact: The LLC is a relatively new entity and there are very
few test cases. But LLCs are governed by asset protection law
which has stood the test of time.
Arizona’s LLC act was derived
from two main sources—general and limited partnership statutes
and corporate statutes. The LLC asset protection provisions
are based on existing case law as it applies to these business
entities. Minimally, case law as it supports the strength of
other asset protection vehicles provides precedence for LLC
cases. Consequently, if and when LLC cases are eventually
tested and Arizona statutes are upheld, case law will become
more favorable—not less.
Myth #7: It’s difficult to
convert a corporation to an LLC.
Fact: Converting to an LLC is relatively easy, inexpensive,
and common.
A corporation can convert to
LLC status in one of two ways: If you have already formed a
corporation and a limited liability company, you can merge the
corporation into the LLC. If you want to convert your
corporation to a new LLC and maintain the same name, you must
first dissolve the corporation, then form the limited
liability company with the same name with the “LLC”
designation replacing the “Inc.” Because this is considered a
reorganization under IRC 368-F, it is not a taxable event.
The LLC retains the corporation’s original tax ID number and
continues to file a corporate tax return.
Conclusion
I would never assert that
limited liability companies are bulletproof. But from both a
legal and tax perspective, they are the most effective
business entity available to small companies. LLCs provide
the best of both worlds—favorable tax status and the best
possible asset protection. If your attorney or CPA doesn’t
understand the advantages of an LLC, look elsewhere.
See Your Attorney
Although the forgoing applies
to most cases, this information should not be deemed a legal
opinion, because every client’s circumstances are different
and could dictate varying applications of legal advice. Please
consult an estate- planning attorney who specializes in asset
protection regarding your individual needs.
Bill Gibney is
an estate-planning attorney, practicing in Phoenix. His
specialty is asset protection. He can be reached at
602-953-0006 or at gibneylaw@cox.net..
