asset protectionbusiness planning

The Smallbiz Entity Trap

By February 3, 2020No Comments

When researching what type of business entity to select, entrepreneurs often seek the most popular option – a Limited Liability Company (LLC). LLCs are popular because they don’t require the administration that S-Corporations (S-Corps) require – filing quarterly tax returns, holding annual meetings, paying employee wages. Additionally, LLC participants, aka “members,” don’t own the LLC property, which provides members with some liability protection. (Hence, Limited Liability Company.)

LLCs can have one or more members, single-member LLCs (SMLLCs) or multiple-member LLCs, respectively. Furthermore, unless an LLC selects to be treated as an S-Corp, LLCs are treated as partnerships, where the loss or gain of profits flow through to the members.

However, when approached about entity selection, while administration and tax issues are important, for start-ups, it’s critical that liability protection is thoroughly considered. If a judgment is placed against an LLC, the judgment creditors can generally only place liens on the distributions or the LLC property. So, if an LLC member of a multiple-member LLC is sued, the judgment is placed solely against that member’s distribution, whereby the other members can receive their distributions. But, if the LLC is an SMLLC, treated as a partnership, and a judgment is entered against the distribution, then that member won’t be able to receive their distribution (share of the profit) until they settle the judgmentd.

What’s a partnership of one? A sole proprietorship.

Who gets sued in sole proprietorships? The proprietor. Whose assets are subject to judgments in sole proprietorships? The proprietor’s. Ergo, depending on the jurisdiction, S-Corps are sometimes more suitable; they provide an extra layer of liability protection.

Because an S-Corp owner/employee would be treated as an employee for the S-Corp, if the S-Corp was sued, the S-Corp owner/employee, unlike an LLC manager/employee, would still be able to receive wages and, thus receive part of the profits.  (Ownership shares of an S-Corp are not wages.)

As mentioned above, an LLC can seek to be treated as an S-Corp, whereby the owner is also paid as an employee. But, that means that the administrative burdens that accompany S-Corp status are now also a part of the LLC. And that defeats the simplicity purpose of establishing an LLC.  

THE TAKEAWAY…Potential smallbiz owners should consider liability as an important factor when selecting a legal structure: Choosing the wrong entity can mean the difference between a great launch or great flop .

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