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Does a limited liability company offer a less protection than a regular corporation?

By Stephen Nelson

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Published: 17Aug2009
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Not long ago, supposedly-knowledgeable professionals regularly suggested an LLC didn't offer legal protection as good as that offered by a regular corporation. This bit of legal or accounting advice was often paired with the statement, "Well, the fact is, this LLC thing just has not been tested as often in the courts..."

I'm not an attorney. But I have taught graduate-level tax classes about limited liability companies to certified public accountants and attorneys, and I have worked on LLC formations with dozens of attorneys hundreds of times. And I think the statement that a limited liability company offers less protection than a corporation is pure poppycock. In fact, I would be suspicious of anybody who reflexively suggests this.

But let me explain my rationale with a little detail. The people who say that a limited liability company offers less legal protection fail to note two critically important features of the LLC option:

The First Reason an LLC May Offer Better Protection: Less Room for Mistakes

By legislative design, a limited liability company is less complex to operate than a corporation. A limited liability company only requires that its owner or owners follow state law and a simple operating agreement.

In comparison, a corporation requires its shareholders to have regular (probably annual) meetings. The corporation has by-laws which also require a board of directors be set up to govern. This board of directors should meet regularly--perhaps monthly or quarterly. The board of directors also needs to elect and monitor the officers (president, vice presidents, treasurer and so on) who run the day-to-day operations of the corporation.

A corporation was designed originally to allow passive, silent investors to put their money into business ventures operated by professional managers. The corporate legal structure was not set up for the small owner operator. And what that means is that you've got more corporate red-tape and more stuff you can get wrong.

Arguably, you may get better legal protection with an LLC simply because you're less likely to "break" the LLC.

The Second Reason an LLC May Offer Better Protection: Charging Orders

Another feature often missed when people talk about the legal protection afforded by a limited liability company concerns "charging orders:"

In any state, your creditors may be able to gain ownership of the shares you own in a corporation. These shares could include shares in a small business corporation that you use to support yourself and your family. Obviously, that's not good. If a creditor gains ownership of a majority of the shares in a small business corporation, they control the corporation. That may mean a creditor controls your job.

However, in many states (particularly Western states), creditors cannot gain ownership of your interest in a limited liability company. In these states, the very best option a personal creditor has is a "charging order." A charging order, which a judge issues, says that if the limited liability company distributes money to a particular member, that money should instead go to the member's creditors.

That also sounds pretty bad. But think about what the charging order leaves you with. A member creditor can't get money from the LLC unless the LLC decides to make a distribution. (Maybe the LLC will decide not to distribute funds, which means creditors won't be able to get anything out of the LLC.) And the LLC still gets to operate in the way that makes most sense for the business conducted inside the LLC. As compared to a small business corporation, the LLC may be able to offer the individual LLC member and the LLC itself extra legal protection.

(Note: The "charging order" benefit may not work for single-member limited liability companies.)

Summing up, the limited liability company probably does offer at least equal and quite possibly better legal protection than a regular corporation. You are less likely to screw up a limited liability company's legal protection. And in some cases, your ownership interest in a legal liability company is better protected than shares you might own in a small business corporation.

Seattle accountant Stephen L. Nelson has been CPA for twenty-plus years. He holds an MBA in Finance from the University of Washington and an MS in Taxation from Golden Gate University. He's also taught LLC and S corporation taxation to accountants and attorneys from around the United States in the graduate tax school at Golden Gate University, the nation's largest tax school. For more information on LLCs, visit his website LLCs Explained.

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