A limited liability company (“LLC”) mixes the tax benefits of a sole proprietorship or partnership with the asset protection of a corporation. It also has fewer formalities than a corporation, making it more cost-efficient and easier to meet filing obligations. Based on the many benefits of LLCs, it is easy to see why it is one of the most popular business structures in the United States today.
Although there are many advantages to using an LLC, there are some drawbacks and pitfalls that potential business owners should consider when deciding which corporate entity to use. In particular, single-member LLCs (“SMLLCs”) have some nuances that are important to know.
LLC Basics: Members and Formation
A limited liability company is similar to a corporation in that it is made up of shareholders or members. Each member owns a portion of the enterprise. Because LLCs are extremely flexible, the members can choose to have a single manager, or they can have each member act as a manager for the LLC. The organization structure is set out in the LLC’s Operating Agreement, and there are no formal legal requirements. This is unlike a corporation because the structure of that type of business entity requires that you have both shareholders and a board of directors and meet several formal filing and meeting requirements.
LLCs can have many members, or they can be formed with just one member. The formation process is the same regardless of how many members participate.
LLC Basics: Tax Treatment
LLC members can elect how they would like to be taxed. The entity can either be taxed as a corporation or as if it were a partnership or sole proprietorship. Many business owners appreciate the potential for pass-through taxation as it avoids the “double taxation” issues that corporations face.
The default for the IRS’s purposes is that a single-member LLC is taxed as sole operatorship, and an LLC with more than one member is treated as a partnership and must file a Form 1065. However, LLC members can elect to be taxed as a corporation or even an S corporation. The LLC can also switch tax classifications even after it has made this election.
LLC Asset Protection
In most situations, an LLC provides asset protection to all of the members. This protection extends to both business assets and personal assets. That is, if the company is issued, the individual members’ property is protected from creditors of the LLC. The creditors can only reach the assets of the company, not the individual members’ property. This protection is often referred to as “corporate veil protection.”
Asset protection applies in the other direction as well. If an individual member owes debts or gets sued, creditors cannot get the LLC assets to satisfy personal obligations. This type of protection is called “charging order protection.”
Charging Order Protection: What is it?
The rationale behind charging order protection is based on the concept of fairness to the other members of the LLC. If a member owes money or gets sued in their individual capacity, it would not be fair or equitable that the other individual owners of the LLC would have to forfeit property that they partly own to cover that member’s personal obligations.
The other option may be to place the creditor in the role of the partner within the LLC. Again, however, that would not be fair to the other partners who did not choose to do business with this creditor. Of course, the creditor likely has little interest in being a part of an ongoing business venture; it is likely far more interested in getting paid its debt quickly and moving on. This option really does not work well for any party involved. Instead, the creditor can only claim any distributions that the partner would take because of their involvement with the LLC.
Charging Order Protection and SMLLCs
Charging order protection is a benefit to the individual member against whom the creditor is asserting the debt, but it is also a significant advantage to other owners of the LLC. In single-member LLCs, however, there is no incentive to protect other members because there are none. Instead, the lone member of the LLC manages and owns everything, regardless of the fact that the assets involved are legally listed as belonging to the LLC. There are no innocent parties to protect when an SMLLC is involved.
As a result, the general rule is that single-member LLCs do not have charging order protection. In fact, only five states offer SMLLC charging order protection. Setting up your LLC in those states may help you avoid difficulties that arise when you do not have charging order protection.
The following states offer to charge order protection for single-member LLCs:
- South Dakota
In the other 45 states, SMLLCs have no charging order protection. This means that if you own your major assets in an SMLLC in 45 states, creditors or the Court can take away these assets, even if they are held in an LLC. The LLC structure is essentially disregarded entirely in those situations.
Avoiding Problems with SMLLCs
The easiest way to avoid problems with SMLLCs is to create a multimember LLC instead of having just one member. However, you can also use another business entity as the owner of an LLC to help with asset protection. For example, your multimember LLC or corporation may be the owner of a single-member LLC. Then, the SMLLC would have an extra layer of protection between your personal liabilities and the LLC.
You may be able to use other strategies to increase your asset protection as well. The resources at Protect Wealth Academy can help you determine which setup may work best for you. Our extensive video library has over 100 hours of material to help you deal with issues like these. Take advantage of this information, sign up for a free membership.