Common Misunderstandings of Becoming a Limited Liability Corporation (LLC)

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I frequently receive emails and questions from freelancers who want to take their business to the next level.

Should my business become an LLC? How will the taxes affect my business?

While the ins-and-outs of a limited liability company can be difficult to navigate — especially for first-time business owners — the question remains; should you convert your solopreneur business to an LLC?

Here are the most common misunderstandings about the LLC designation so you can make the best choice for your business.

The paperwork is easy to DIY

One of the most damaging myths about becoming an LLC is that it’s easy, and can be accomplished on your own. However, despite all of the self-help resources available online, many potential pitfalls exist when trying to DIY.

And falling into any one of them can result in the rejection of an LLC application.

Additionally, failing to complete even one requirement, could mean your company is monetarily penalized or even have its rights and privileges suspended.

At the worst, neglecting any step in the LLC process can mean the complete termination of your business.

Lastly, if you don’t know exactly what you’re doing, your company could be formed incorrectly, which results in lots of future problems.

Other common mistakes made by business owners who choose to DIY include, failure to prepare agreements between shareholders, the omission of minutes for the organization, not authorizing enough shares or too many, and failing to file stock issuance notices.

Some states will allow income tax avoidance

Many business owners think that since other companies don’t have to pay any income tax in a certain state that their business won’t either. But this couldn’t be further from the truth.

In fact, a company not only has to conduct its business in the state where it was formed, but a limited liability company must also have some sort of business presence in that state.

An LLC can be used as a tax entity

Another common misunderstanding is that an LLC is a seperate tax entity, but this is not the case. As far as the IRS is concerned, an LLC is dependent upon its number of members.

For example, if you are running a business of one (you’re the only member) you’ll have to follow the same taxation rules a sole-proprietor would. Yes, you can still be a sole-proprietor and run a limited liability corporation.

But if you have more than one member within the LLC business, it means you’ll be taxed as a partnership.

LLCs are not as safe as corporations

Some business owners fear that forming an LLC will make them more vulnerable to liability than if they were to form a corporation. But looking at the differences between the two types of companies, it’s clear this is not the case.

A limited liability company does just that — it limits the liability of all the owners of the company. A corporation’s liability exists separately from the liability of the owners.

Only businesses can form LLCs

As previously mentioned, limited liability company’s can be formed by businesses both large and small. There are no restrictions with regard to what size a company must be in order to obtain the LLC designation.

Filing an LLC will protect personal assets

Another common, yet incorrect assumption is that personal assets will be protected simply because you are named a member in their LLC.

But in reality any members of an LLC can be thought of as shareholders, and as such, they are not responsible for any debt the LLC may incur, nor are their personal assets covered.

Basically, the protection of personal assets and the debts an LLC may incur are two separate things.

An LLC can help avoid self-employment tax

While it is true that companies under the S-Corp designation aren’t required to pay the self-employment tax on dividends they pay to company owners, S-corporation owners are required to pay themselves what the IRS calls a reasonable salary.

Naturally, self-employment tax does apply to this salary, which means filing under the S-Corp designation will not exemplify you from paying SE tax.

However, an LLC may be able to reduce the amount of self-employment tax you have to pay, if its profits surpass the amount the IRS deems to be a reasonable salary.

You can’t open a second LLC

Business owners of a company can have more than one LLC at the same location. However, if you’re planning to do this you must keep the liability for each company separate — basically, each company must be regarded as separate from any other.

This means that a bank account must be opened for each, as well as fees charged whenever equipment owned by one company is used for another.

Additionally, any financial transactions must be separated and any deposits to a particular LLC must be made to the account designated for that company.

LLCs can have numerous benefits, and it’s important that you understand all the ins-and-outs before forming one for your small business.

Ensure that all potential pitfalls and requirements have been reviewed and completed so you can make the best decision for your future.

Got a question or comment about forming an LLC? Sound off.

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