Issues Related To Single Member Llcs
Issues Related To Single Member Llcs
By default, a single member LLC will be “disregarded” by the I.R.S., meaning all income and losses will be included in the single member’s personal tax return on a Schedule C (in community property states, the “community” of the two spouses counts as a single member, allowing an LLC owned by a married couple to also be “disregarded” for tax purposes), and any business conducted will be treated (tax-wise) as being conducted by a sole proprietor. However, the I.R.S. also lets a taxpayer elect how to be taxed, by “checking the box.” So, if a single member LLC wants, it can be taxed as a corporation or a subchapter-S corporation (commonly referred to as an “S-corp”), which is a topic for another memo. The point is that, regardless of how the LLC is treated by state and federal taxing agencies, it is important to always treat the LLC as a separate entity. Think of the LLC as a separate person, completely independent of its owner, and be sure to clearly identify the LLC as the source of the goods or services being provided. Make sure to keep finances separate, with money going from the LLC to the member as a distribution, and the member then using the funds to pay personal expenses. To the greatest extent possible, the funds of the LLC should not be used to directly pay any personal expenses of the member. This memo will address the use of LLCs primarily as an asset protection strategy, but most of the information also applies when a LLC, and especially a single member LLC, is used to conduct a business.
“Inside Creditors” vs. “Outside Creditors”
When talking about LLCs, and especially single member LLCs it is important to understand the difference between “inside creditors” and “outside creditors.” An “inside creditor” is one who is owed money by the LLC itself. Absent a successful attempt to “pierce the veil” of limited liability protection, the inside creditor will only be able to go after the assets of the LLC. Some of the common things that may lead to a successful “piercing of the veil” include, but are not limited to: absent or inaccurate records; commingling of LLC and personal funds or assets; having the LLC directly pay personal expenses of the member; failure to maintain arm’s length relationships with related entities; treatment by an individual of the assets of the entity as his or her own; the entity being used as an “alter ego” of a primary owner of the entity, constituting a “mere sham” that serves no legitimate business purpose; and undercapitalization of the entity.
For example, if one of your assets is a residential rental property, which is owned by an LLC, and your tenant is injured on the property because the hot water heater blew up, they’re going to sue the owner of the property – the LLC. As long as you or your property manager hired a qualified plumber to install the hot water heater, your LLC should protect you from being personally liable for the tenant’s damages. The tenant is an “inside creditor,” because the liability stems from the activity of the LLC, not you personally. Alternatively, if you installed the hot water heater yourself (or hired your unqualified brother-in-law to do it), the tenant will be able to come after you personally. You are always personally responsible for anything you do personally, including the failure to hire someone qualified to perform work on behalf of the LLC.
An “outside creditor” is one who is owed money by a member of the LLC (or partner of a partnership). An example of an outside creditor would be if you were in a car accident and the other driver sues and obtains a judgment against you personally. The other driver could then seek to collect from you by going after your personally-owned assets, including your ownership interest in the LLC.
The law in some states, such as Arizona, Delaware, Wyoming, and a few others, clearly provides that the only thing an outside creditor can do is obtain a “charging order” against the LLC member (the law regarding limited partnerships contains virtually the exact same language). What a charging order does is entitle the creditor to receive any distributions of cash or other assets that you, as a member, would normally receive. In other words, the outside creditor basically becomes your assignee. In a sense, the charging order constitutes a lien on the member’s ownership interest. However, this area of law is far from clear. For instance, it has not been definitively determined whether or not such an outside creditor would be liable for any taxes due for profits allocated to a member but not distributed; in other words, the creditor risks receiving K-1 distributions of “phantom income.” Another question is what other membership rights the outside creditor receives, such as the right to examine the books of the LLC. What is clear is that the outside creditor, as an assignee, cannot participate in the management of the LLC in any way. They cannot force the LLC to make a distribution, sell assets, or dissolve and liquidate. Because of the restricted power such an outside creditor would receive under a charging order, plus the unresolved question regarding taxes on allocated but undistributed profits, it is rare to see a creditor attempt to obtain a charging order.
The laws of many states do not provide that a charging order is the exclusive remedy, which means it may be possible for an outside creditor to foreclose on the charging order in order to obtain a member’s ownership interest. This means that they are not just an assignee; instead, they obtain all of a member’s ownership rights. Some states’ laws go so far at to explicitly allow a creditor to foreclose on a debtor’s ownership interest in an LLC (or partnership). The difference between a creditor holding a charging order and a creditor foreclosing on the charging order is the permanence of the creditor’s interest. A charging order is a temporary remedy that has the effect of assigning income to the creditor until the judgment is paid. After the assignment of income (or garnishment, if you want to look at it that way) terminates, the debtor regains the right to distributions. By contrast, foreclosure of the interest makes the assignment (or garnishment) permanent, which means that the creditor becomes the owner of the distributional interest. The creditor may then attempt to sell the interest to an interested buyer.
Another way to get around a state’s law stating that a charging order is the exclusive remedy is to attempt a “reverse piercing of the veil.” Basically, this is an attempt to use the same factors that might be used to hold an owner personally liable for an LLC’s debt in order to reach the assets of the LLC for the debt of an owner (i.e., comingling of funds, alter ego, etc.). For instance, a state supreme court recently approved the use of “reverse piercing” to allow two creditors of an individual to use the assets of a limited partnership controlled by that individual to satisfy his personal debts. The businessman owned or controlled various business entities. The creditors showed that revenue from the largest of these, a limited partnership, was transferred to a corporation owned by the same individual. Then the funds were used to pay for the businessman’s lavish lifestyle, including such items as a second home, a country club membership, a luxury vehicle, credit card bills, and college tuition for the businessman’s son. Under these circumstances, the court held that the legal distinction between the partnership and the person controlling it had become a fiction to be ignored in the interests of justice.
Most of the law dealing with charging orders developed before LLCs were invented in 1977, and originally dealt primarily with partnerships. Obviously it takes at least two people to form a partnership; however, it is now possible, in all 50 states, to have a single member LLC (“SMLLC”). After years of speculation and the lack of any solid case law, the issue of whether SMLLCs are afforded the protections of the charging order was finally addressed by a U.S. bankruptcy court, In re Albright, (2003). The judge in Albright held that charging order protection does not exist for a SMLLC because there are no non-debtor members to protect. The court granted full economic and non-economic rights to the trustee, allowing the bankruptcy trustee to manage the debtor’s LLC. The trustee subsequently sold the LLC’s property and distributed the net proceeds to the bankruptcy estate for satisfaction of creditors’ claims. Thus, until Albright is overturned or rejected by other courts, the safe presumption will be that SMLLCs probably do not provide charging order protection.
How to Solve Single Member LLC Dilemma
So, if you are the only member of a SMLLC and you want to maximize asset protection from outside creditors, your have a couple options:
Never file for bankruptcy. This is the best solution. However, if you have a serious issue with creditors, one or more of them may be able to put you into an involuntary bankruptcy.
Add a second member. This may work, but, for the following reasons, is not fail-safe:
There has not yet been a court case that has clarified the minimum amount of an LLC the second member must own. You could go with 1-2%, but a court might say that’s a “peppercorn” interest and therefore disregarded the second member because they do not own a large enough interest.
The second member must pay fair market value for the interest. The Albright court warned about adding a “peppercorn” co-member in light of bankruptcy avoidance provisions and fraudulent transfer law. So, if 2% of your company is worth $20,000 and you give a 2% ownership interest to your child for $2,000, the court could find that you made a fraudulent transfer.
The second member has to be a “real” member, with full membership rights, including, but not limited to, the right to: receive financial statements; review the LLC’s books and records; vote on certain LLC matters; and receive a share of the profits pro rata based on the membership percentage owned. If the second member is a “sham” member, the court may disregard the second member’s interest and find that you have a SMLLC.
The court may also look at the relationship between the members. If you add a trust set up for your child/children as a second member, for example, the court might look to see who is trustee of the trust. The more “incestuous” the relationship between the members, the higher the odds that a court will disregard the second member and determine that “function” overrides “form,” meaning that you have a SMLLC.