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March 2004 Taxation, liability protection for single-member LLCs SMLLCs have major advantages over the other single-owner options, with respect to both taxation and liability protection One of the more significant developments in the choice-of-entity arena in recent years has been the rise of single-member limited liability companies. The SMLLC option is available for one-owner businesses and investment activities in virtually all states. SMLLCs have major advantages over the other single-owner options (i.e., sole proprietorships and solely owned C and S corporations), with respect to both taxation and liability protection. Tax advantages. Single-member LLCs are disregarded for federal tax purposes; their income and losses are attributed to the LLC owners unless the owners opt out by election. Tax returns. For a single-member LLC, income and losses are generally taxable to the owner as if the LLC were a sole proprietorship, and the relevant federal income tax information is simply reported on Schedules C and SE of the owner’s Form 1040. (If the SMLLC is engaged in the rental of real estate, Schedule E would be used. If the SMLLC is owned by a corporation or partnership or another LLC, the SMLLC’s tax information is included in the owning entity’s return.) In contrast, a sole-shareholder corporation owned by an individual can only be taxed as a C or S corporation and cannot opt to be taxed as a sole proprietorship. That involves separate federal and state income tax returns filed by the corporation. Owner-entity transfers. Further, loans and other transactions between corporations and their shareholders are subject to documentation requirements that, if not properly observed, can be interpreted as compensation or dividends and thus create significant tax headaches for both parties. With an SMLLC, all such tax complications are moot, as the taxing authorities consider an SMLLC a disregarded entity. Since an SMLLC’s cash and other assets are already presumed to the property of the owner, transfers of those assets are of no consequence. The “disregarded entity” determination creates many opportunities for SMLLC owners, including IRS permission for like-kind replacement property received by an SMLLC to be used to complete a Section 1031 exchange, even though the relinquished property was owned directly by the SMLLC’s owner. The same permission applies to tax-free Section 1033 involuntary conversions. Liability protection. The SMLLC offers corporate-style liability protection to its owner, thus protecting the owner’s personal assets from liabilities pertaining to the SMLLC’s business or investment operations. However, no form of entity protects an owner from liabilities brought about by his professional malpractice or tortuous acts (e.g., personal injury) inflicted on someone else. The relative vulnerability of SMLLCs was recently revealed in a 2003 case (In re: Ashley Albright), where the U.S. Bankruptcy Court in Colorado allowed an SMLLC owner’s creditors to take over control of the SMLLC and its assets. While the SMLLC form of entity would have protected the owner from claims against the SMLLC, it did not protect the SMLLC from claims against the owner. If the entity had been a multi-member LLC or a limited partnership, the creditors could not have stepped into the shoes of the debtor as a full owner. That is because LLC statutes generally allow judgment creditors of LLC members to obtain only charging orders against the members. Under a charging order, if the LLC makes a distribution of profits, the debtor members’ allocable shares of the distribution must go to the creditor. Thus, the creditor is not actually a member in the LLC but merely receives the distributive share. If no distributions are made, the creditor receives nothing. Corporation advantages. As long as the corporate veil isn’t pierced, the limited liability of owners of a corporation is acknowledged in all U.S. jurisdictions. By contrast, in some jurisdictions, the limited liability of the member of a single-member LLC is less certain. Thus, the sole shareholder corporation might be preferable if you:
See your lawyer. As CPAs, we are qualified to discuss with you the tax implications of your selection of entities, and we will be happy to do that. Issues of liability protection, on the other hand, lie within the domain of experienced attorneys who can advise you based on the specifics of your situation and the nature of your business. Since it can be extremely valuable to coordinate your planning efforts, we suggest that you consult jointly with your CPA and attorney to avoid duplication of effort and prevent important issues from slipping through the cracks. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
