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Cost-Benefit Analysis in Forming a Limited Liability Company

I’ve written a few posts now about Limited Liability Companies (LLC) in California. In prior posts, for example, I’ve discussed whether an LLC can be used to form a law firm in California. I’ve also described the minimization approach law schools in the US typically use when teaching about business entities, like an LLC. I’m going to talk about LLCs in this post, but the basic logic I’m describing will apply to other types of entities also.

In this post, I am going to expand on this idea of minimizing tax and legal liability. Most law schools start there and, unfortunately, also end there which means there is a bias towards always forming an LLC because, essentially, why would wanting to minimize tax and legal liability ever be a bad thing? In my view, it’s not a bad thing, but it might not be as good a thing as you initially think.

The reason is because of Cost-Benefit Analysis. In other words, forming an LLC will result in several benefits, advantages, or positives. If you just stop there, then you should clearly always form an LLC. Realistically, of course, forming an LLC will also involve certain costs, drawbacks, or negatives. This should not be a groundbreaking concept to anyone because the same is true for all decisions you make in life.

What ultimately matters when deciding to form an LLC is — like it is in other arenas in life — what the net result is. Do the benefits of having an LLC outweigh the costs of having an LLC? One relevant consideration here would, for instance, be whether the same benefit you’re seeking (e.g. minimizing legal liability) can be achieved via other means that do not involve an LLC at all.

Minimizing tax liability and legal liability are, of course, benefits that can come from having an LLC. Here are some of the major costs that come to mind, in no particular order:

Paperwork Burden

Having something like an LLC is going to involve dealing with a lot of forms and paperwork. There’s the paperwork to create the LLC originally such as the Articles of Organization. There’s also the paperwork to run and maintain the LLC, such as the Operating Agreement and the Statement of Information. When dealing with paperwork, it’s not just filling out the forms. You also have to keep copies of the forms, organize the forms, make sure you file the right forms at the right time to avoid penalties, etc.

Many people, of course, have no problem with paperwork at all. If you’re one of those people, then this paperwork burden might not matter much to you. However, if you’re the type of person who struggles with paperwork (for instance, you can’t fill out a form at all much less maintain organized files), then this paperwork burden is going to be a really big deal for you. If you can hire someone to manage that burden for you, that might be the way to go.

Segregation Burden

One big source of the paperwork burden I just mentioned has to do with segregation. Fundamentally, an LLC is legally separate and distinct from you. To make it easier, imagine that your LLC is a person. For ego reasons, let’s call this person “ANDY”. Thus, if your LLC owns property, such as a car, that’s not your car. That’s ANDY’s car. This is the case even if you own 100% of the LLC yourself. If your LLC makes money because customers are making purchases, that’s not your money. That’s ANDY’s money. This, again, is still the case even if you own 100% of the LLC yourself.

If it helps, you can perhaps imagine it in terms of children. An item such as a bicycle or jacket belongs to your teenage child even though ultimately you are the one in charge of your child. If your employer has ever given you a company credit card to use as part of your job, the idea is the same as here: namely, you can use the company credit card and spend your employer’s money, but you have to follow certain rules, such as not using the company credit card for personal expenses.

In my experience, at least, recognizing that there is a difference between what you own and what the LLC you own owns is the biggest problem people encounter, especially when they have never worked with an LLC before and are doing so for the first time after forming one online for $99.

One way to segregate your money from your LLC’s money is for your LLC to have its own bank accounts. Unless your situation is very unusual, I would consider it a de facto requirement that your LLC has to have its own bank accounts. Having separate bank accounts, of course, also means dealing with forms, which adds to the paperwork burden I mentioned earlier.

Financial Costs

Lastly, having any kind of LLC is going to involve financial costs that have to be paid. I’m not going to discuss taxes here as that opens up a whole big can of worms, but I will say that if you are using your LLC to make money, you should hopefully be able to deduct a lot these financial costs as business expenses.

These financial costs run the gamut, but here are two major examples:

  • Filing fees and taxes to the State of California: If your LLC was formed in another state and you’ve registered it in California, you may have to pay fees and taxes to that other state also. California has an annual tax for LLCs of $800 regardless of whether you conduct business or make money, but it is waived for the first year for 2021 to 2024. If you’re interested in finding out more about that annual tax, when it is due, and what forms to use, see this page on the website for the California Franchise Tax Board.
  • Professional Service Costs: I’m primarily referring to two costs here: (1) the cost of an accountant to deal with tax issues. LLCs are meant for making money so you’re inevitably going to have to worry about doing your taxes properly, and (2) the cost of an attorney. Again, because LLCs are about making money, you’re inevitably going to have legal problems that need to be dealt with, such as writing up contracts, dealing with lawsuits that arise from customers, suppliers, etc. Obviously, many of these Professional Service Costs will be incurred regardless of whether you have an LLC or not. However, the magnitude might just be more if you have an LLC.

As an aside, I’ll also make a shameless self-plug for a June 2020 blog post I wrote about how an entity like an LLC must be represented by an attorney in legal proceedings. Many people who form single-member LLCs often try to represent the LLC in legal proceedings and find out that they have to shoulder the unexpected expense of hiring an attorney.

These are by no means all of the costs and burdens associated with having an LLC, but I think I’ve hit on a lot of the major ones. In considering the Cost-Benefit Analysis then, the relevant question to ask if you’re considering forming an LLC for your business is:

“Whether the benefits of minimizing tax liability and legal liability are worth it given the Paperwork Burden, Segregation Burden, and Financial Costs of having an LLC or if similar benefits can be obtained via other means, such as minimizing legal liability by purchasing insurance?”

As you might imagine, there is no one-size-fits-all answer here. Everyone will gauge what is “worth it” or not differently.

I hope this post was helpful. Again, this post was specifically about California, but realistically, you’ll probably find that a lot of what I mentioned above (e.g. the Cost-Benefit Analysis) will apply in other states too.

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Andy Chen

Andy I. Chen is a lawyer licensed to practice law in California and New York. Andy maintains offices in Los Altos, California and Modesto, California. Under the New York Court of Appeals' 2015 decision in Schoenefeld v. State of New York, Andy does not accept cases from those in New York state. He does, however, know many lawyers in New York state and would be happy to make a referral.

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