You gotta love influencers. They post advice on social media channels about topics that they aren’t true experts in. My latest favorite is all the supposed “gurus” spreading myths about why founders should have an LLC.
My Guru says I need an LLC…
In the past few weeks, I’ve seen ridiculous posts on Instagram encouraging people to incorporate their business into an LLC for the wrong reasons. Here are just a few of the post titles that I have seen:
- A few lenders that loan money to LLCs
- How to layer multiple LLCs to avoid liability
- How to instantly get a $50k-$100k loan when you form an LLC
When you see this nonsense, you should run away. Quickly. For experienced professionals, those titles are immediate red flags. Here is why.
Lenders don’t give a damn which legal structure you used
Lenders could care less whether you form an LLC, a C-corp, or operate as a sole proprietorship. In most instances anyways. Why?
Whether or not to give a business a loan is based on “the ability to repay.” That means that the business can demonstrate, through its financial documents, that it is making enough money to pay back a loan. This is called the primary source of repayment and is based on net profit, not gross profit. Extra credit if any “gurus” are reading this and can explain why that distinction matters.
I’m feeling spicy today. I’ll give an hour of free consulting to anyone that has read or watched my content long enough that can tell me what the typical debt-service-coverage-ration (DSCR) is that most lenders look for. Here is a hint - it starts with a 1.XX. Fill in the Xs and post a comment below.
Back to my point. Legal structure doesn’t matter for a loan. Proving the ability to repay does.
In one video, another guru presented a complex legal structure whereby they had upwards of eight LLCs. All for one type of business. The entire purpose of that structure was to “eliminate any and all liability.” That is another terrible idea. Why?
First off, there are ongoing, annual expenses that come with having any sort of legal entity. Unless you are qualified, you will likely have to pay someone to file your legal entity’s tax returns each year. Then there are state fees. For example, where I live, there are franchise & excise, and business license fees that have to be paid every year.
Yes, I know that those can be expenses to the entity and may be a tax deduction. Here’s something else to understand. Not all tax deductions are created equal. Most tax deductions aren’t 100% write-offs. What!? Yep, it is true. In most instances, a write-off only reduces your tax liability by the percentage of the effective tax rate your entity will fall in. So, if you spend $100, you aren’t always saving $100 in taxes. You are saving a few hundred bucks, depending on your tax bracket. It is like saying you saved money going shopping and getting discounts. No, you didn’t. If you got 20% off a $100 bill, you still spent $80.
Second, layering LLCs may not be the most effective way to reduce tax liability. Paying the maintenance costs on eight different LLCs is more likely to be more expensive than buying a high-limit general liability policy.
Your LLC comes with a business loan, hurray!
Yeah, wrong again. If you still believe this, you didn’t read the first section. Go straight to jail, do not pass Go.
Legal entities can develop their own credit scores. However, that does not occur through the formation. It occurs when the business borrows money and pays it back. Just like how consumers built their own credit.
What most of the gurus (I know, I’m picking on them) aren’t telling people is that when your new LLC borrows money for the first time, it will more than likely be in the form of a corporate credit card where the approval was based on…they founder’s personal credit score.
An LLC does have benefits
Are there benefits to an LLC? Or any legal entity, for that matter? Yep, there are. They can limit liability, thus their name, they can even help to legitimize your business, and you might even reap some tax benefits from an LLC.
I do like to educate people. If you are considering taking out a business loan, educate yourself about the process and how lenders truly evaluate borrowers for approval.