Forming A Limited Liability Company (Llc) For Your Business Protect Assets From Lawsuits And Creditors
The limited liability company or LLC, as it is commonly called, is a relative newcomer to the business arena, originating in the 1970’s in Wyoming and spreading throughout the United States in various guises during the 1990s. Frequently misidentified as a limited liability corporation, the LLC is a morphed creature that combines some of the features of sole proprietorship, partnerships and traditional corporations. As such, it came into creation with the intention of providing the most gracious features of prior business structures and making them available in one package.
As America becomes increasingly litigious (Fulbright), it has become frightening, if not downright unwise, to conduct many businesses as a sole proprietor or simple partnership. Ways of doing business that served society for decades if not centuries have fallen by the wayside. As tax, business, employment and general liability laws have become more and more complex, it has become apparent that almost anyone involved in the ownership of a business needs to protect his or her personal assets from lawsuits. As a sole proprietor, the owner IS essentially the business – should credit or legal problems arise, the owner’s home, personal vehicles, bank accounts and any other personal assets are on the table. Likewise, members of general partnerships are vulnerable, even if it is through no fault of their own. It became apparent to most that it is necessary to protect one’s personal and family assets from any threat from business liabilities. Without protection, one lawsuit can otherwise devastate the lifestyle of an entire family.
Prior to the emergence of the LLC, the only tried and true way to accomplish the necessary protection was to incorporate. This can be an expensive and cumbersome process, both to set aside and to maintain. It simply was not practical for many smaller enterprises and was entirely impossible for a single business operator to do alone. Traditional corporations are subject to complex regulations that vary from position to state. The setup process is not easy without an attorney to handle the moral documentation. Corporations must have more than one member, have a limit on the total number of members, appoint officers, deal with distribution of shares and a myriad of other issues that generally don’t apply to dinky operations. In addition, after inception, there must be copious record-keeping, annual meetings, minutes kept, and adherence to complex tax codes. Corporations must deal with quarterly tax reporting, just one residence that can be intimidating to anyone other than a tax professional. Along with just this one item can come interest and penalties from one mistake or economic downturn that leads to a missed payment – costs that can put a marginal operation or “Mom and Pop” out of business before it even becomes established.
Additionally, corporations are essentially subject to double taxation. The corporation itself, as a legal entity in its own right, is subject to corporate income tax. Profits distributed to shareholders are again taxed on those parties’ individual income returns. This is not generally a viable option for tightly held, smaller businesses where a limited number of members are simply attempting to make a living from their business. A solution had to be developed between the raw vulnerability of going it alone and the often complicated operation of a corporation – otherwise small enterprise would likely have become primitive.
Enter the limited liability company. It offers mighty of the personal asset protection of a traditional corporation, can have anywhere from a single member (a single member LLC or SMLLC in common parlance) to an unlimited number. These members can be individuals, may be corporations, other LLCs and can even include international members, a perk disallowed for faded corporations. Unlike a sole proprietorship, the personal assets of someone with a SMLLC are generally afforded decent protection, though less than those involving at least two members. Unlike a traditional partnership, an LLC not only protects assets but affords the members the moral to determine how any profits are distributed. Profits are not subject to the standard fifty-fifty split, nor are they attributed according to how much a party has invested in the company. Members determine among themselves the graceful division and the consume of profits. Thus, a member may have entered with a minimal monetary investment but may be compensated at a substantially higher level due to the services they provide. Since there are no shareholders or other outside controls, members are free to distribute as they agree and glimpse fit or even not to make any distributions at all but to reinvest any available moneys back into the business. This freedom can be very engaging, particularly to a small group that is generally in accord as to business methods and goals.
Creators of an LLC are not petite to any plot management structure or the selection of officers. Such a company can be managed by one or more of the members or can be manager managed, where someone is hired to handle day to day functions of business. The level of activity of the members is generally up to their discretion when they agree to execute the company. Some may choose to be essentially just investors while others may play a more active role. In general, profits are distributed as agreed upon and subject to taxation via a pass through process. Distributions are thus not taxed at the entity level as with a corporation but are instead taxed only once as self-employment income by the member or members receiving the income. (As such, it is distinguished to impress that this income is subject to self-employment tax, currently over 15% at the federal level. In addition, if a member is not active in the LLC, any passive losses from the LLC cannot be used on his or her federal tax return to offset other income.)
Again though, the LLC offers a benefit not available to the sole proprietor or partner. Self-employment tax may be reduced by making distributions in the form of a salary to a member or members. The IRS allows for this practice of conveying profits as long as such salaries are not inflated to a point where they appear to be tax avoidance. Salaries must agree with was the IRS deems to be a fair market salary for a given position. If it doesn’t match the industry standards, the IRS will shift the perceived excess in salary and tax it as self-employment income at the higher rate, likely generating a bill for the filer (IRS).
LLCs offer some additional flexibility in taxation as they are not recognized as a specific tax classification. The option is sometimes available to forgo the pass-through system where the LLC is treated like a partnership and opt for taxation as an S corporation. In the case of SMLLCs, there are also variances from the norm for tax purposes. Unless the appropriate create is filed, the IRS will treat income as it would that of a sole proprietorship. Per the IRS:
“An LLC that is not automatically classified as a corporation can file Form 8832 to elect their business entity classification. A business with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.” Form 8832 is also filed to change the LLC’s classification.”
Additionally, the SMLLC may have less to offer in terms of asset protection than a multi-member LLC. As there are no other members to suffer wound, the SMLLC is more vulnerable to adverse action by creditors. Particularly, if the single member defaults on personal debts and is successfully sued or attempts to declare personal bankruptcy, the courts may quite likely conclude that the SMLLC really more of a sole proprietorship. The owner-member may then find himself forced to liquidate the assets of his SMLLC to pay personal debts. This is normally done via a charging order giving the creditor interest in these assets or an extreme case can cause a complete foreclosure. Worse perhaps, a person with impending adverse judgments or bankruptcy procedings who inexplicably transfers personal assets into a SMLLC may catch himself facing charges of fraudulent conversion, have his transactions reversed and be prosecuted.
With a multi-member LLC, a charging order can be rendered virtually worthless fairly easily in many cases, discouraging a member’s personal creditors from even attempting to acquire one. Unlike shares in a corporation that can be treated as personal assets and seized, giving the creditor a voting interest and perhaps even control of a corporation, a carefully structured LLC can make a member’s interest an exact liability to a creditor. As the organization allows members to decide how, if and when profits are distributed, a creditor may find that no distributions are made. The effected member may continue to receive income via a salary or wages that are not subject to the charging order or he may be granted loans from the company. Thus, a charging order may give a creditor an interest in one member’s section, but grants no means to perforate the company structure and gain influence on distribution. If a distribution is not made to the member so attached, the creditor can secure himself in the inverse position of owing taxes on money he never receives. This can obviously act as a strong deterrent to creditors. Additionally, a carefully constructed operating agreement can contain provisions for the removal of an individual member subject to credit issues, thereby closing the hole and keeping the LLC entirely untouchable.
The establishment of an LLC, be it for asset protection or for the cache’ of appearing to the public as a well established and reputable business, is relatively simple. Aside from choosing members, selecting a name that is dissimilar from any other registered business and generally containing letters (LLC or LC) that publically identify it as an LLC, the requirements generally boil down to filing notice with the proper state agency and paying a fee. States vary in whether the names of all members are disclosed or whether only a designated agent for legal service is required. Some allow a representative company to act as an agent. It is generally necessary to station a time frame for the existence of the LLC and indicate what the business type may be. There are periodic fees and renewals that vary by state. Beyond that, the real meat and potatoes of an LLC is contained in the operating agreement.
The operating agreement, while not necessarily filed with the state, is absolutely vital. It is crucial to ward off any future problems in many areas. For starters, it is indispensable should any documentation ever need to be produced to parties outside of the company to validate that the LLC is a legitimate, honest business that exists separately from its individual members. It also needs to be carefully crafted to deal any internal difficulties. It needs to spell out at the very least the methods for decision making among members and what happens if a member dies or leaves the company (without these clauses, an LLC will dissolve in one of these events). It should identify the members and their initial investment and percent interest. All should sign and receive copies.
Once this documentation is in place, there are additional steps that should be followed. Foremost among these is likely to be the establishment of a business bank record or accounts, as it imperative to keep business transactions separate from personal ones to reduce liability. For the same reason, it is not desirable for any member to personally guarantee any accounts, lines of credit or loans. A federal employer identification number should be secured (IRS) and used instead of individual social security numbers. While the LLC may not be required by the state to enjoy annual meetings, preserve minutes, etc., it is still significant that good business records be kept. Aside from any potential issues with the IRS, accurate record-keeping can only serve to maximize the protection of assets afforded by the formation of the LLC in the first location. In the event of any legal challenge, the LLC must be above reproach.
As a relatively new business entity, the rights and parameters of LLCs are still evolving. There is not yet an aged, established body of legal precedents and judicial interpretation to guide attorneys and the courts. As the government will no doubt try to close loopholes for its own economic attend, as lawsuits proliferate in America, and as creditors continue to aggressively pursue debtors in a down-turned economy, both attorneys and the LLC members whom they advise must keep abreast of changes in the wind and be prepared to turn sails accordingly. Just as the corporate cover has been and can be pierced, LLCs will no doubt prove to be no less bulletproof as case law continues to develop.
(This article is for information and entertainment purposes only and does not constitute legal advice. Please direct legal questions to your attorney.)
Sources:
“Forming a Limited Liability Company (LLC) – www.irs.gov
“Understanding Your EIN” – www.irs.gov
LLC Basics” – www.nolo.com/legal-encyclopedia
“Fulbright’s 6th Annual Litigation Trends Survey Report” – www.fulbright.com
“Overview of How an LLC Protects your Personal Assets” – www.assetprotectionattorneys.com
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Filed under Sole Proprietorship Bankruptcy by on Oct 16th, 2010. 
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