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Limited Liability Company Myths

By Stephen Nelson

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Published: 02Mar2009
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Business owners and entrepreneurs sometimes struggle with whether or not they should form a limited liability company for a new venture or investment. And, in a way, that makes sense. Deciding to form a limited liability company requires careful analysis.

Unfortunately, people often complicate the analysis of LLC incorporation because they believe several "urban myths" about the limited liability company. The good news in all this--at least from your perspective--is that you'll make your own entrepreneurial decision-making easier and more profitable by recognizing and then ignoring these myths. But let me explain...

Limited Liability Company Protection Weaker than a Regular Corporation

Commonly, you hear knowledge-able business people--sometimes even attorneys and accountants--suggest that a limited liability company provides its owners with weaker protection than a corporation. Often the person unhelpfully offering this bit of mythology pairs the advice with the statement, "Well, you know, the thing is, LLCs just haven't been as tested in litigation."

This myth is dead wrong--and for two big reasons. First, if you talk with attorneys knowledgeable in LLC law, you'll learn that a limited liability company offers better protection than a regular corporation because by design an LLC requires less legal maintenance in the form of meetings, minutes, boards and officers. Less required maintenance means in layman's terms that the LLC owner is less likely to "break" the legal protection.

The weaker legal protection myth misleads business people in a second way, too. In many states, an LLC provides protection that regular corporations do not. How? In many states, your personal creditors may in a worst-case scenario be able to gain ownership of your stock in a corporation but not of your interest in an LLC.

In other words, many times, the LLC doesn't just provide you, the owner, from bad stuff that happens inside the LLC. The LLC also protects itself from bad stuff that happens outside the LLC to its owners.

Limited Liability Company an Alternative to S Corporation

Another limited liability company myth concerns the "LLC versus S corporation" question.

People often assume (incorrectly) that one option you need to consider as an alternative to a limited liability company is the S corporation. After all, sure, LLCs may be great. But S corporations (so the rumors say) offer small businesses the opportunity to minimize payroll taxes that the owners pay.

But here's where this myth loses touch with solid ground reality. An S corporation is not a real corporation. An S corporation is a tax accounting classification that the Internal Revenue Service and almost all state revenue agencies allow corporations and LLCs to make.

In other words, a business owner never has to choose between an LLC and an S corporation. A business owner can choose to have his or her LLC treated for tax accounting purposes as an S corporation.

Note: If an LLC doesn't make an election to be treated as an S corporation, the IRS uses default rules to determine how the LLC is taxed. Typically, the one-owner business operating as an LLC gets taxed as a sole proprietorship. And the multiple-owner business operating as an LLC gets taxed as a partnership.

Limited Liability Company the 'Fly-by-night' Option

One last, almost laughable, LLC myth needs busting: the notion that the LLC option is the one that 'fly-by-night' operators use.

One can guess where this notion comes from: All the big, old business entities like General Electric, 3M, and IBM operate as regular corporations. And so it sort of seems like new small businesses should, too.

But here's the problem: The corporation is not state-of-the-art legal technology. The corporation is, really, an old technology. You should think about a corporation as being like a railroad or a steel cable suspension bridge.

The limited liability company option, in comparison, is like a personal computer or the Internet. In a sense, the LLC amounts to a new legal technology with big benefits as compared to the old technology of the traditional corporation. Which is probably why newer big companies like Microsoft, Amazon.com and many of the cellular phone companies make extensive use of the LLC.

Note: Big benefit number one is the fact that the LLC requires less legal maintenance. Big benefit number two is the fact that LLCs may choose how they want to be treated for tax accounting purposes.

About the author: Stephen L. Nelson, CPA practices tax accounting in Seattle, Washington and is an adjunct tax professor at Golden Gate University's graduate tax school. Nelson is also the author of numerous do-it-yourself llc formation guides including Setting up a California Limited Liability Company and Setting up a Texas Limited Liability Company.

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