When you work in our profession, you see a lot of Limited Liability Companies (LLC) that were set up by others. Sometimes, “mistakes” are made in the formation process. What do we mean by mistakes Well, we mean that the LLC was set up or modified in a way that is actually going to cost the entity and owner unnecessary time, money or heartache.
Some of these mistakes are caused by entrepreneurs and investors trying to save money on accountants and attorney fees. Some – in fact, most of them – are made by attorneys and paralegal services… Professionals who should know better.
But enough whining. Without further fanfare, here are the top three mistakes that we see people make again, and again, and again.
Mistake #1: Forgetting about Foreign LLC Registration Rules
Read those tempting advertisements for Delaware or Nevada limited liability companies? The advertisements sound pretty good, but most small businesses shouldn’t use/create out-of-state LLCs or for that matter out-of-state corporations.
Here’s why: If you’re doing in business in, say, Illinois, you’re not going to be able to avoid state taxes by forming your LLC in, say, Nevada. The tax and corporation laws in your state will require you to register your out-of-state, or “foreign” LLC in the states where your business operates. Those same laws will require you to pay state income taxes in the states where you earn your income.
A couple more quick points: Large businesses do like Delaware for a variety of reasons – mostly having to do with how sophisticated the Delaware chancellery courts are. But this applies to really big businesses that will litigate in Delaware – not small businesses. And Nevada does offer corporations a no-income-tax haven – but you need to set up a real business presence there, with an office, employees, property – the whole schabang.
Mistake #2: Electing to be Treated as a C Corporation
An LLC is a chameleon for tax purposes, which is great. An LLC with a single owner can be treated as a sole proprietorship, a C corporation or an S corporation (assuming eligibility requirements are met.) An LLC with multiple owners can be treated as a partnership, a C corporation or an S corporation (again, assuming eligibility requirements are met.)
But just because you can do something doesn’t mean you should. And unless you’ve got expert tax advice from a CPA or attorney, you shouldn’t make the election to be treated as a C corporation.
The reason is that a C corporation is taxed on its profits. When those profits are distributed to shareholders (in the form of dividends), the profits are taxed again to the shareholders. By electing to be taxed as a C corporation, then, the LLC owners create an extra level of taxation. This is often what you hear people refer to as the “double taxation” penalty of setting up a company. Yet this mistake is easily avoided.
Mistake #3: Electing to be Treated as an S Corporation Too Early
LLCs can also elect to be treated as S corporations – as noted in the preceding paragraphs. And once a business generates profits well in excess of the amounts paid to owners for salaries, an S corporation election saves the owners big money – sometimes tens of thousands of dollars per owner per year.
But you don’t want to elect S corporation status too early – especially if the LLC is owned and operated by a single owner.
By electing S corporation status, the LLC needs to file an expensive corporate return, needs to begin doing payroll – even if the only employee is the owner, and may need to pay additional payroll taxes like the 6.2% federal unemployment tax. (This tax is levied on the first $7,000 of wages paid to each employee.)
Wait until your business is profitable to elect S status for your LLC. You patience will pay off in two ways: simpler accounting and less expensive tax returns.