From aspiring entrepreneurs and newly-minted investors to well-established business owners and those who have already accumulated significant wealth there is an overarching theme occupying the minds of all of us. That is, “How do I protect what I have (or hope to have) from those who might come to take it?” Regardless of whether “others,” to you, means the tax collector, creditors, plaintiff’s lawyers, or future ex-family members, there is some conventional wisdom, hazy as the details may be, which indicates that you should transfer your assets into an LLC.
So What Is An LLC?
Limited liability companies, or “LLCs” for short, are creatures of legislative initiative. Across the country, legislators have elected to provide their constituents with access to these creative legal entities which provide significant advantages to those who avail themselves of them. There are various ways in which to own assets—a few of which are through sole proprietorships, partnerships, corporations, and LLCs.
Sole proprietorships are simply you, yourself, owning everything that you have in your own name or under a “doing business as” name. This is how most people own their property, and that is unsurprising, as the only step required to own assets as a sole proprietor is to own the assets. What sole proprietorships offer in ease-of-use they forfeit in protection.
If a sole proprietor divorces, defaults on a debt, is sued, or fails to pay taxes in a timely manner, everything that he or she owns is up for grabs to those who come seeking it. Sole proprietorships are awful for risk-averse individuals. Partnerships are no different, and in some cases are worse, in that the same risks apply, but there is also another potential class of predator—the other partner and the partner’s creditors, tax collector, opposing litigant, and spouse.
Corporations, like LLCs, are the product of legislation. Corporations are, legally, entities separate from their owners. Owning assets through a corporation provides benefits in that it separates assets and liabilities owned through the corporation from those assets and liabilities owned individually. However, unlike LLCs, corporations bring with them a number of failure points due to the technicalities of their continued operation. For the average business, investor, or property owner, a corporation is an inferior entity to an LLC.
What The Advantages Of LLC’s?
So, with all of that in mind, where does the conventional wisdom surrounding the efficacy of the LLC come from? On the whole, LLCs are simple to form, simple to maintain, flexible in operation, and provide significant asset protection. LLCs are not without their own unique risks, and this article will touch on those in due turn, but suffice it to say that without any unique information about what an individual’s goals, portfolio, risk tolerance, or liabilities, one could almost always recommend an LLC and be correct in doing so.
In Texas, each of the aforementioned business organizational structures are available, but it is the LLC that is deserving of most attention here. The Lone Star State, on balance, is one of the best states in the Union in which to form an LLC. In making that determination, there are several measures to analyze, those being ease of formation and operation, tax treatment, flexibility in operation, and asset protection.
Considering, first, the ease of formation and operation, it is important to note that LLCs, nationwide, are generally very easy to form. In almost every state, all that formation requires is paying a registration fee to the State and filing simple documentation with the Secretary of State. For example, in Arizona, you pay a nominal $50.00 filing fee and register your LLC simply by filing Articles of Organization. Texas, on the other hand, charges one of the highest fees in the country at $300.00.
Nationwide, the formation paperwork is quite simple and contains, for the most part, the same information. It is the continued operation where a more significant disparity arises among the states. Some states, like Missouri and New Mexico require no ongoing filings with the Secretary of State after formation.
Most, however, require annual reports and annual renewal fees. Texas, as some sort of compensation for its high initial costs, has no ongoing reporting fees, but does require an annual franchise tax report and an annual Public Information Report. On the whole, these obligations are minimal and the formation costs are negligible compared to the benefits the LLC offers.
Beyond formation and operation, it is worthwhile to evaluate tax treatment when selecting a business organization. Tax professionals earn their keep in navigating the incredible complexity of the Internal Revenue Code and the various state and local tax structures, but what makes LLCs particularly helpful in this regard is that in many cases you can choose how you are taxed. LLCs can be taxed as if they are sole-proprietorships, partnerships, S-Corporations, or C-Corporations, depending on how they are structured.
Unlike those entities, LLCs provide the owner or owners with tremendous flexibility to ensure that they pay only what they rightfully owe and nothing more. LLC owners might, depending on the structure of their business or assets, find it prudent to be taxed as an S-Corp, but S-Corp owners are stuck being taxed as S-Corps. The details of all of the various consequences of an LLCs tax election are a conversation for another day with a CPA, but there is no entity that provides tax flexibility superior to the LLC.
LLCs also provide a number of advantages and flexibilities in how they are operated. As opposed to Corporations, which depending on the state of formation may be required to jump through a number of draconian hoops such as holding annual shareholder meetings, board of directors meetings, and maintaining written minutes of each (regardless of the number of shareholders involved), LLCs are permitted to simply exist so long as they meet their annual reporting requirements.
LLCs also, in some states, such as New Mexico, Delaware, Nevada, and Wyoming, permit their owners to maintain anonymity. This piece offers significant allure to people who want to maintain privacy around their wealth, or who want to conceal their financial interests in businesses that may offend the sensibilities of their peers.
The area that most people associate LLC advantages with, apart from those previously discussed, is in asset protection, and this is the area that deserves the most discussion. To properly broach this subject, it is necessary to first understand how assets are placed at risk. The most common area of loss exposure is through civil judgment execution. Statistically speaking, one out of every three people in the United States will be sued in their lifetime. For sake of explanation, let’s assume that you are a landlord and you own ten rental homes as a sole proprietor.
If an accident occurs in one of the homes and you are found liable after suit, it is possible that the plaintiff could attach and liquidate your entire real estate portfolio. Not only would this immediately devastate your net worth and income, if it were not sufficient to satisfy the judgment, it could prevent you from future investment and growth as your monies on deposit in your bank and investment accounts could be similarly seized.
This is a risk that is not unique to the particularly wealthy. That real estate portfolio could just as easily be a mechanics tools, a lawncare business’s equipment, or a rancher’s cattle. An LLC could significantly reduce your risk of loss. If, instead of owning ten rental homes in your own name, you formed John Doe Rentals LLC to own five of those homes and Jane Doe Rentals LLC to own the other five, the same plaintiff might only be able to take five of your homes and the rest of your properties and assets would remain untouched. The level of protection that an LLC provides, however, depends on the State in which it is formed and operates.
Risks of LLC’s
All of that being said, nothing under the sun is perfect, and LLCs bring with them some potential risks—all of which are manageable, but each of which requires attention and planning. Among them are the risk of the company’s “veil” being pierced and its asset protection failing, fallout among its owners or members, and possible problems when one of its owners passes away.
Of chief concern is the possibility that an LLC may not always offer the protection that it was formed to provide. Essentially and generally speaking, courts across the country recognize a doctrine referred to as “piercing the corporate veil” which permits a plaintiff to attach its judgment to the personal assets of a corporation or LLC’s owners.
Each state’s court has its own discrete manner of determining what circumstances warrant piercing the veil, but as a general rule each state permits veil-piercing when the LLC is not treated by its owners as an entity separate from them, often referred to as the “alter ego theory.”
For example, it would be most unwise to form an LLC and then use the company checking account to buy groceries for your home. That would not be a legitimate business expense and would indicate to the court that you are managing the LLC as if it is just an extension of yourself. It would likewise be unwise, and likely would result in veil-piercing, if you were to use your LLC to engage in some sort of fraud. Courts are not quick to afford protection to people who commit fraud or try to hide behind technicalities.
If you currently have an LLC, or are considering forming one, you certainly should consult with your attorney and CPA in order to determine how to properly conduct your LLCs business in order to have the highest chance of avoiding veil-piercing so that you can enjoy the benefits of the LLC without the risks.
The other risks associated with an LLC, namely resulting from a disagreement between owners or the death of a co-owner, are manageable but worthy of consideration and planning. An LLC should have an Operating Agreement—a document that describes and details the rules for its operation, and that Agreement should address how to resolve disputes among owners.
This may be as simple as requiring majority vote for major decisions or may give a tiebreaker vote to a particular person. It could also involve any number of methods to establish a buyout process in the event that a member decides to exit the LLC—that could involve a set buyout price, or could incorporate a method for determining that price such as an averaging of blind bids or requiring a formal business valuation. That Agreement should also address how shares of ownership pass upon the death of an owner—it could permit them to pass to the estate of the deceased, redistribute them among surviving owners, or any number of alternatives unique to the nature of the business and individuals involved.
As previously mentioned, conventional wisdom dictates that LLCs are good ideas, and the foregoing, as a high-level overview indicates the same.
Texas or Delaware: That Is The Question
Conventional wisdom regarding business organizations overall generally indicates that every business should be formed in Delaware, regardless of where it operates. You, as a Texan or potential owner of Texas assets, should understand how Texas compares to Delaware. This analysis, again on a high level, should mirror the overview provided hereinabove by comparing formation and operational simplicity, operational flexibility, tax implications, and asset protection levels between the two states.
Texas vs. Delaware LLC Formation and Operation Simplicity
Forming an LLC in Texas is a simple endeavor. Each relevant form is available for preparation and filing online twenty-four hours per day, seven days per week. The same can be said for Delaware.
On this front, the two states are in a dead heat. However, Texas is slightly more expensive on its face. It should be noted that if you intend to form your LLC in Delaware but operate it in Texas, you will need to employ a registered agent in Delaware and then register your now-foreign LLC in Texas, which dictates additional costs and record-keeping requirements.
Once the LLC is established, Texas and Delaware each require annual reporting, and Delaware requires an annual franchise tax of $300.00, while Texas’s annual tax depends on the nature of the business. Beyond that, the ongoing operation of the LLCs between the two states are functionally the same.
Texas vs. Delaware LLC Operational Flexibility
Neither Texas nor Delaware impose significant operational burdens on LLCs beyond the annual reporting requirements. However, Delaware offers one significant advantage over Texas—it permits anonymous ownership. Texas, conversely, requires public disclosure of each LLC’s officer’s, incorporators, and managers. This could be a deal-breaker if anonymity is a crucial factor, so in this regard Delaware tops Texas.
Texas vs. Delaware LLC Tax Implications
Setting aside the differences and implications between the various entity tax-elections that you could employ for your LLC, each of which is available whether formed in Texas or Delaware, there is a corporate income tax in Delaware that could be a factor depending on the classification of your LLC formed there. Texas has no corporate income tax and its Gross Receipts Tax is quite affordable. Details on that tax are available on the official website. On this front, Texas beats Delaware.
Texas vs. Delaware Asset Protection
At the heart of the Texas vs. Delaware LLC formation decision is the degree of asset protection that each state offers. Unlike the foregoing, which are essentially dollars-and-cents calculations that you and your CPA should be able to resolve fairly easily, this area is more nebulous. Texas is better than many states in that it has added an “actual fraud” element to its alter ego doctrine. As a quick refresher, the company’s veil of protection could be pierced if a court determines that the LLC is no more than an “alter ego” of its owner(s).
Normally, the elements the court will consider, in a standard alter ego determination, are whether the company was properly formed, whether it was properly capitalized, whether its assets were employed for personal use, and whether its funds were commingled with personal funds.
Texas, however, ads an “actual fraud” element, which requires that a plaintiff demonstrate, at least in contractual disputes, that owner or members “used the LLC to perpetrate actual fraud for the [owner or member’s] direct personal benefit.” Shook v. Walden, 368 S.W.3d 604, 607 (Tex.App.-Austin 2012, pet. denied).
Texas also, in BOC Section 101.113, prohibits naming an LLC and a member as defendants in the same suit, which is a significant barrier for would-be plaintiffs, as “piercing the veil” proceedings are not actionable claims, but merely means to establish personal liability, so these suits cannot proceed the way that they do in most states.
In this regard, Texas provides significant levels of asset protection. The “actual fraud” element, because it requires proof of both an intent or purpose to commit fraud, and that an actual fraud occur, is a very high bar to chin, and sets Texas apart from many states.
Delaware, on the other hand, offers its own strengths. Claims against LLCs in Delaware must be brought in specialty courts where the facts are determined by judges rather than juries. This is an attractive prospect for potential defendants, as plaintiff lawyers love to try to appeal to the emotions of juries in order to obtain monumental judgments.
Judges, generally speaking, are less likely to let their emotions pervade, as they are exposed to far more tragedies than the average person and are trained to dispassionately apply the law to the facts, even when the law results in outcomes that they may personally disagree with.
In this regard, and with those differences in mind, it is difficult to plainly determine which state offers superior asset protection, but each are excellent choices and you and your attorney should discuss these differences as you determine where you should form your LLC.
If you are interested in forming an LLC in Texas, there is a great deal of helpful information, along with a registration portal and a series of helpful documents available here.
Information in this article is provided free of charge and purely for informational and educational purposes only and is not offered as legal advice. No attorney-client relationship is created by the offering of this article. [WEBSITE NAME] is not a law firm, does not represent clients, and is not representing you or anyone else. Although every effort is made to keep information up-to-date, laws may change. Retaining legal counsel for your individual case and circumstance is advisable before taking any action that has legal consequences. Consult a tax advisor or financial consultant as well, as this is not offered for any tax or financial service or advice.
Tyler Ginn is an attorney who specializes in banking law, business organizations, and tax-exempt associations. He serves on multiple nonprofit boards supporting public education, public legal assistance, religious institutions, and regional arts programs.