When is a business too small to form a limited liability company?

I love limited liability companies. The LLC option reduces the business owner's risks in any venture. And the LLC option allows the small business owner to select a tax accounting approach that saves money.

Some small one-owner businesses, however, are probably too small to form a limited liability company in order to receive these two benefits. Accordingly, if you operate a sole proprietorship, you'll want to consider two issues: how small-business-friendly your state is and whether an LLC will over-complicate your tax accounting. Let me explain what I mean...

Consider the business environment of your state

Let's talk first about the business environment. Confusingly, whether your business is too small to form an LLC partly depends on the state in which you operate. Some states, like Nebraska, charge a modest fee. (Nebraska charges about $100 to set up an LLC.) And with a modest fee like this, the LLC option seems worthwhile even for many really small businesses. I can imagine, for example, that even a part-time business that makes $6,000 or $8,000 a year might be justified in spending $100 to set up an LLC to get the extra liability protection.

Other states, however, charge pretty hefty fees for the LLC option. For example, a California limited liability company costs only about $70 to start. (This is the LLC fee you pay to the state of California to form the entity.) But California also charges limited liability companies an annual franchise tax. The minimum California annual franchise tax is $800. And franchise tax can be way more then $800 if the business gets big. Many tiny businesses, in my opinion at least, can't justify an LLC option that costs, say, $800 or more each year. (Probably, these small businesses should look at buying additional liability insurance and implementing similar, simple asset protection techniques.)

The bottomline? The price you pay for the liability protection you receive is something you need to consider. If you're operating in a small-business-unfriendly state (like California), you often can't justify the LLC option when your business is very small.

Consider the extra tax accounting

And now let me make one other comment about a sole proprietorship being too small to form a limited liability company...

As a generalization, a limited liability company that has only a single owner doesn't really have to have more complicated tax accounting. By default, a one owner (also known as a single member) limited liability company is disregarded (ignored) as a separate tax payer. This "disregarding" means, in the case of a one-owner limited liability company, that the business income and deductions get reported inside the owner's 1040 tax return on a Schedule C tax form.

Here's the important point in all this: This Schedule C reporting means that the LLC doesn't complicate the sole proprietorship's tax accounting. So you might setup an LLC for a small sole proprietorship for limited liability reasons and then accept the default tax accounting treatment. And that's be fine as long as you consider the costs the state charges you for the protection, as mentioned earlier.

However, if a sole proprietorship sets up a single-member LLC and then chooses to have the LLC treated as a regular corporation or as an S corporation for income tax accounting purposes, two payroll-related costs pop-up. First, because the corporation status turns the proprietor into an "employee," the LLC will need to do payroll checks and quarterly and annual payroll tax returns (even if the only employee is the owner). Second, the owner-employee will probably increase the small business's tax costs by $434 because of the federal unemployment tax (also known as FUTA).

Given this extra accounting and the new extra FUTA tax, treating an LLC as a corporation probably doesn't make economic sense in the case of a small sole proprietorship where the only employee is the owner.

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