February 02, 2015
Monday AM

While the extra fees from the formation of all these limited liability companies definitely adds considerably to my bankroll, the older ethics of my profession, to which I still adhere, specifies that I, as a licensed practitioner, must do no harm to my client’s financial position; thus professional responsibility alone warrants the caution that the LLC in most instances, by which I mean in excess of 98% of them, will not limit at all personal liability if something bad happens in a business operation. In other words for most of you it is just a waste of money and time, and that money could be better directed to one of the two things that actually can limit your personal liability: Insurance.

Indeed, for many small business operations the difference in administrative costs between an LLC and a simpler organizational form will actually exceed the insurance costs, so the money in the first instance is more properly directed to paying for insurance. This, of course, is not true for construction, transport, logging, and certain manufacturing operations where the cost of workmen’s compensation alone is anywhere from 50 cents for every dollar of labor to, conceivably, more than a dollar for every hour of labor. But those insurance rates are based on experience in industries that have high injury rates and high payout rates, so avoiding paying that insurance, particularly when you are exposed to personal liability, is a form of financial suicide timed to someone else’s schedule.

Despite the term “limited liability company” there is no limit to personal liability in a closely held business operation merely by labeling yourself an LLC. That is barstool BS at its finest, and most meaningless. If you are a member of an LLC, say of ten or fewer members, and something really bad happens in that LLC, your personal assets are fully exposed in court. In point of fact it is rather foolish to think that just labeling yourself one thing or the other would change that.

A myriad of other factors are instead involved. The principle legal concept involved here is what is called “piercing the corporate veil,” which is to say punching through the administrative and organizational wall that has been created, i.e. the corporation, and grabbing you personally by the neck in the course of tipping you over to dump all your cash and other stuff on the floor, for a gaggle of other someone else’s to grab and run off with. In the United Kingdom it is virtually impossible to “pierce the corporate veil” in court; it just isn’t done; but in good old USA the courts take an entirely different view, and the “corporate veil” is on occasion pierced.

The problem with closely held LLCs is very simple. The easiest method to “pierce the corporate veil” in court is to establish that the business entity is under-capitalized, and the reality of life is virtually all small businesses are under-capitalized. Quick to prove, and all that money you have spent on a, for you, ineffective organizational form, has gone for nothing; and in the meantime if you are uninsured, it is all on you and your cohorts.

Again, duly note I do not sell insurance; I sell tax and accounting write-up and advice. So I actually lose money by telling you this, but I also protect myself from the likely future liability of having given you some really bad advice. There may be a fool or a rookie out there somewhere, but all the old-time licensed practitioners around here have sense enough not to promote the LLC as a means to avoid personal liability in a closely held business operation because it probably won’t; have sense enough not to promote the LLC as a means of avoiding insurance obligations because such advice is likely illegal; and certainly have sense enough not to promote the LLC as a means to avoid paying payroll taxes and putting employees on W2s because any such advice is definitely illegal.

The promotion of LLCs comes from somewhere else: barstool BS, lawyers out to make a buck, young bankers who think they know more than they know, state entities that think they know more than they know; and beyond that there is something of a mystery here. Some of the folks in the insurance industry have pointed out it is in some measure how the state administration handles things. There are others who can perhaps help us understand what is driving this fad, but fad it most assuredly is. And not a good one, either.

The fantasy, of course, is that the LLC somehow protects you from personal liability when in fact in almost all instances it will not.

A satisfied customer every time will protect you from personal liability.

Insurance will protect you from personal liability.

No organizational form, in and of itself, can or will protect you from personal liability.

What follows is a bullet list of when an LLC might be an appropriate organizational form. Comprehensive detail on this subject requires chapters at least, but a solid start can be made via Wikipedia if you take the time to understand the legal meaning of all words and terms used on the subject. That, regrettably, requires something of a specialized education by itself, but I have noticed my technically-minded brethren have a way of figuring these things out pretty quickly. Ask the right questions.

What is obvious is that a lot of this LLC nonsense centers around the misbegotten notion that somehow putting employees on W2s and paying the commensurate workmen’s compensation rates can be avoided, and personal liability by the business owners can also be avoided if you call yourself a limited liability company. That is total crap. Duly note that the specific intent in this scenario is for the business operation to be under-capitalized, i.e. to avoid paying requisite insurance costs (perceived as a fixed cost by more wisely run businesses), as well as intentionally avoiding payroll taxes, unemployment taxes, etc. The lack of payroll tax reserves will become immediately apparent the minute some former employee is denied unemployment benefits and the Alaska Department of Labor opens up another rather routine “failure to pay payroll taxes and unemployment taxes” case; which the IRS generally immediately also picks up.

Walk that under-capitalized mess into court, and watch the flaming kamikaze crash in the corner five minutes later. Gloss is gloss, and the courts get that real clearly.

Sole proprietorships—LLCs are a waste of time, money, and effort. So far as the IRS is concerned you still file on Schedule C as a “sole proprietor.” Where equipment or high risk labor are part of the operation the old textbook theory is to incorporate; indeed 20 taxicabs, 20 corporations, so if one gets into a wreck, the other 19 are not affected. But if you are the sole owner of that closely held mess, the corporate veil will get pierced pretty quickly. State corporate taxes were recently eliminated on all kinds of business operations, so incorporating becomes more viable as an option, but state corporate taxes could be re-instituted at any point in time. For a sole proprietorship the best option remains insurance, not organization.

Mom & Pop partnerships are easily handled and split for social security tax purposes by putting an ‘X’ in a box on Schedule C. Insurance, not organization.

Partnerships (unrelated parties) from three to say 20 individuals might declare themselves an LLC because both are treated the same for tax purposes, and there is some limited separation. But that separation is chimerical to the extent the operation is under-capitalized. At this juncture, however, the only reason to be a partnership in Alaska is to avoid state corporate taxes, and since there is no corporate tax on many types of corporations as the result of recent state law changes, the corporate form of organization probably makes better sense in the first instance. (If the law changes, collapse the corporation and form an LLC or partnership.) It still remains the case that insurance protects against personal liability, organizational form very likely won’t.

Corporations do not by definition aspire to be LLCs. And even with corporations insurance protects you from personal liability far better than organization form.

Whether promulgated by bankers, accountants, lawyers, or bureaucrats this notion that declaring oneself a limited liability company (LLC) protects one from personal liability in a closely held business operation is one giant and rather smelly pile of BS. This has morphed into the notion that by declaring yourselves an LLC you can avoid payroll taxes, insurance, etc. thereby putting yourself in a competitive bidding advantage on available jobs. Wait ‘til Bob falls off the roof, or Sue slips on a banana peel on your business property. Then you will learn.

David G Hanger, EA, MBA
Ketchikan, Alaska

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