Limited Liability Companies, or LLCs, can be simple or complicated, depending on the use of them. Let me start by saying, I am not a lawyer. None of this should be construed as legal advice.
I’m going to talk about the overall basics of LLCs, and then more specifically some tax information / misinformation I've recently heard. One major takeaway I want to give is that an LLC is a legal structure; not a tax structure.
Many see LLCs as a tax strategy - which isn’t true. You can create the opportunity for a new tax structure through an LLC, but the creation of LLC itself does not change your tax status. One of the major reasons to utilize an LLC is for its LIMITED LIABILITY properties - aka the LL in LLC.
By the way - did I mention I’m not a lawyer and this is not legal advice?
The idea behind an LLC is that it separates business from personal. Even if you are the only person in the LLC, you’re now two separate entities - and creditors of one entity do not have access to the other entity.
I’ll just use myself as an example - I own Pocket Project LLC. I’m the only member and only employee. So why didn’t I just operate as Logan Murray?
A few reasons:
It adds legitimacy to my business. I took the steps to set up a company and operate the business separately from myself.
Organization. With an LLC, this is a separate entity that doesn’t intermingle with my personal finances. It has its own long-term goals and reports separately from me.
I separated my legal liability. If one of my clients tried to sue me, they would have to sue Pocket Project, not Logan Murray. If they sued PP for $100k, they can take all the assets in PP, but if that didn't settle the full lawsuit, they can’t get the remainder from me personally, because I am a separate entity.
Issues with LLCs
I feel a little weird making that last point, so I want to comment on it. This doesn’t mean I’m acting recklessly because I’m personally untouchable… obviously if PP was sued and lost everything, that would be a huge issue for me and my current clients.
Additionally, and this is a comment due to my lack of legal knowledge, I’m not 100% convinced that it would operate that way. Would I really be totally relieved of any liability, even though I’m so clearly the only one taking action in Pocket Project? I think it adds some added layer of protection from me personally, but I’m not sure how strong that protection is.
A qualified attorney should be used to determine your specific situation.
The way I see my LLC is that it is one layer to an asset protection plan. The main layers to this plan include:
Operating ethically and competently to ensure no issues arise;
Getting insurance coverage;
Creating an LLC for the business.
My opinion is that an LLC is a “nice-to-have”, but there are far better ways to protect yourself. The best way; don’t mess up and don’t get sued! The next best is utilizing insurance.
If you are running a business, I think insurance is more important than an LLC; a couple common policies include Errors and Omissions Insurance, or Malpractice Insurance.
If you have a rental real estate property, more importantly than an LLC you should have a homeowner’s policy with a landlord rider, as well as a strong umbrella policy for further liability protection.
An LLC isn’t a catch all, and is less important in my opinion than adequate insurance coverage.
Finally, a few other issues that may arise from creating an LLC:
It may be expensive to keep an LLC relative to the benefit of the LLC (looking at you, California)
If you’re moving the ownership of a rental property into an LLC, you need to make sure the mortgager is okay with that, and you don’t create a sale of the home to the LLC.
There must be total separation of personal and business, or you could risk “piercing the corporate veil” and rendering the LLC useless.
All of this should be considered and reviewed with an attorney because remember… I’m not one of those. And none of this is legal advice.
Now let's get to the fun stuff: taxes. I hate to be the bearer of bad news, but LLCs don’t bring any special tax loopholes on their own :/
The default taxation of an LLC is that it is a ‘disregarded entity’ - which is pretty self explanatory. The IRS ignores the LLC altogether.
If you create an LLC as the sole owner, you’re taxed as a sole proprietorship - which is the same taxation as if you did not create an LLC.
If there is more than one person creating the LLC, then they are taxed as a partnership - same as if they did not create the LLC.
These are the defaults - you also have the option to make an election for the tax classification on your LLC to be different - for example taxing it as an S-Corp or C-Corp.
But, that is an advanced tax move that has a lot of considerations and implications - in this simplified blog, I’m talking about those who do not elect to change their tax classification.
But now that your LLC is a real business, you can deduct new expenses, right? No… again, nothing changes. The IRS disregards the LLC and taxes you the same as if the LLC doesn’t exist.
To summarize, not all LLCs are taxed the same. This is because an LLC is a legal structure; not a tax structure. Due to an LLC being a disregarded entity, your taxation will not change solely due to creating the LLC. It opens doors to new tax classifications, but that goes beyond the initial decision of LLC vs. no LLC.
To make sure I cover all my bases, I am talking about federal tax here. There are 50 individual states that have their own tax rules. I cannot confidently say if states disregard LLCs for tax purposes similar to the IRS. Make sure you understand the rules in your resident state.
A Couple Misconceptions
This entire post is inspired by a recent podcast I listened to. The podcast interviewed an experienced real estate investor that gave a couple of his tax tips (he is a DIY tax preparer).
It all stemmed from one comment, which I paraphrase here: “I created an LLC with my wife, which allows me to deduct charitable expenses on Schedule E through the business, that I am otherwise not entitled to outside of the business”.
Two issues with this person’s statement:
LLC with your spouse: if you create an LLC with your spouse, you just created a business (which this person acknowledged). But a business with two people in it, even if it is your wife, is considered a partnership.
This means that they should be reporting their rental property on a partnership tax return - this is different than a standard individual tax return. Eventually this will report to their personal tax return, but they are skipping that step, which could result in some administrative headaches and penalties.
Going forward, they should be filing a partnership return to the IRS, which creates an added tax filing burden and potential extra filing costs.
This person created an LLC for non-tax purposes, but ultimately created some tax issues that they seem unaware of. Be careful of all the ramifications of creating an LLC.
Charitable business expenses: as I mentioned earlier, creating an LLC doesn’t automatically entitle you to new deductions now that you’re a business. Charitable contributions certainly cannot be deducted as an expense for your rental property…
Same with a business. If I deduct charitable contributions made by Pocket Project, then I get to avoid self-employment taxes as well as Federal and state income taxes. Where if I gave it personally, I wouldn't get any tax benefit.
The IRS is very aware of this, which is why they do not allow it. Giving to charity is not a legitimate expense that helps to bring in revenue or rental income, and therefore it is not deductible as a business or rental expense.
How is this person able to do it? You can do whatever you want on your tax return, but if this person gets caught, then that may bring a heavy administrative burden to correct prior returns, on top of interest and penalties.
LLCs are pretty easy to set up - it usually takes a one- or two-page form filed with the state, a fee that is typically manageable, and then a couple weeks to get approved. These are some pretty low barriers, financially and administratively, that make an LLC appealing.
But make sure you understand why you are choosing to create an LLC, and all the ramifications of doing so. LLCs are notoriously posed as creating huge tax advantages; which for the average person just isn’t true.