Over the past several years, I have noticed a trend that simply did not exist to this extent before the pandemic. Increasingly, individuals who come into my office for a bankruptcy consultation tell me they own an LLC. Sometimes they have several.

When I ask what the business does, I often receive a surprising answer:

“Well…it never really got started.”

Or,

“I was going to start a business, but life got in the way.”

Or perhaps,

“I thought having an LLC would help me save on taxes.”

The explosion in LLC formations is one of the more interesting economic changes to emerge from the post-pandemic economy. While many Americans have built successful businesses—and I applaud entrepreneurship—not every LLC represents an operating business. In many bankruptcy cases, the LLC exists only on paper.

The Pandemic Changed How People Viewed Work

The COVID-19 pandemic fundamentally changed the way Americans think about earning a living.

Millions watched friends and neighbors start online businesses, become consultants, sell products through social media, drive for delivery services, flip real estate, trade cryptocurrency, or launch YouTube channels. At the same time, countless articles and social media influencers promoted the idea that everyone should “start an LLC.”

For many people, forming an LLC seemed inexpensive and harmless. Filing online often takes only minutes and costs relatively little compared to starting a traditional corporation.

Some people genuinely intended to launch a business.

Others simply thought owning an LLC would automatically produce tax advantages.

Unfortunately, those are two very different things.

An LLC Is Not a Business

This is one of the biggest misconceptions I see.

Creating an LLC with your state does not mean you actually have a business.

A legitimate business generally has characteristics such as:

• A genuine profit motive.
• Customers or clients.
• Products or services actually offered.
• Business records.
• Bank accounts.
• Advertising or marketing.
• Receipts and invoices.
• Ordinary and necessary business expenses.

Many of the LLCs I encounter have none of these characteristics.

The owner may have purchased a domain name, printed business cards, or simply filed Articles of Organization. Then nothing happened.

Years later, the LLC still exists, but it never generated income or conducted meaningful business activity.

The Tax Problem

This is where things often become complicated.

Some individuals begin claiming business deductions on their federal income tax returns despite never operating a real business.

They deduct items such as:

• Vehicles
• Cell phone expenses
• Home office expenses
• Computers
• Internet service
• Travel
• Meals
• Equipment
• Mileage

The problem is not that these deductions are inherently improper.

The problem is proving they were ordinary and necessary expenses incurred in carrying on an actual trade or business.

If the business never really operated, those deductions may not be legitimate.

Even more concerning, many people cannot produce receipts, invoices, bank statements, mileage logs, or other documentation supporting the deductions.

That becomes a serious issue if the IRS ever examines the return.

Bankruptcy Trustees Look at More Than Just Debt

Many people are surprised to learn that filing bankruptcy often involves reviewing several years of tax returns.

If significant business losses appear on those returns, the trustee may naturally ask questions.

Questions such as:

• What business was operating?
• Did it ever generate revenue?
• Where are the accounting records?
• Can you document the expenses?
• Are there bank statements?
• Were payroll taxes filed?
• Are there customers?

These questions are not intended to punish someone for trying to start a business.

Rather, the bankruptcy process requires accurate financial disclosure.

If deductions cannot be substantiated, additional issues may arise beyond the bankruptcy case itself.

Why This Matters in Today’s Economy

In my recent blog discussing the K-shaped economy, I explained how America’s economic recovery has not benefited everyone equally.

The wealthiest Americans continue purchasing million-dollar luxury automobiles, expensive boats, and investment properties, while many middle-class and working-class families struggle to finance groceries through buy-now-pay-later services or carry increasing credit card balances.

That same economic divide helps explain the rise of “paper LLCs.”

Many people were searching for a way to generate additional income, escape traditional employment, or create financial opportunities. Social media often presented entrepreneurship as easy and tax savings as automatic.

Unfortunately, registering an LLC is easy.

Building a profitable business is not.

Some individuals invested time and money into businesses that never became operational. Others received questionable tax advice or relied on internet videos suggesting that simply owning an LLC would unlock deductions that were never legally available.

The result is that by the time financial hardship leads someone to consider bankruptcy, they may have years of tax returns reflecting business losses from an enterprise that never truly existed.

Honest Mistakes Can Usually Be Addressed

The good news is that not every failed business creates a legal problem.

Many legitimate businesses fail. That is part of entrepreneurship.

The important distinction is whether the business was real and whether the financial records accurately reflect what actually occurred.

If mistakes were made, they are generally easier to address before filing bankruptcy than after.

A knowledgeable bankruptcy attorney can review your tax returns, discuss any business activities, identify potential concerns, and coordinate with your tax professional if corrections are appropriate.

The Bottom Line

Starting a business is something I encourage. America has always depended on entrepreneurs willing to take calculated risks.

But there is an important difference between owning an LLC and operating a legitimate business.

If your LLC never became operational, be careful about claiming deductions that cannot be supported with records or that were never connected to an actual trade or business. Those issues may not surface immediately, but they often become important during a bankruptcy filing when trustees carefully review tax returns and financial records.

As I have written in my recent posts about today’s K-shaped economy, many Americans are doing everything they can to improve their financial situation. Unfortunately, shortcuts promoted on social media or by self-proclaimed “tax experts” can sometimes create bigger problems than they solve.

If you are considering bankruptcy and have questions about an LLC, business debt, or deductions taken on prior tax returns, it is far better to discuss those issues before filing than to be surprised after your case has begun.

A Personal Word from Walter Metzen

For more than three decades, I have represented thousands of individuals, families, and small business owners through difficult financial times. One thing I have learned is that most people are trying to do the right thing. They simply receive bad advice or believe that something they read online applies to everyone.

There is nothing wrong with pursuing the American dream by starting a business. But there is no substitute for honest records, good documentation, and sound legal and tax advice. If your financial situation has become overwhelming, let’s talk about it. Together, we can separate legitimate concerns from unnecessary fears and develop a strategy that gives you the fresh start the bankruptcy laws were designed to provide.