Taxation of the LLC - Choosing your entity taxation:
A Single Member LLC may choose to be a corporation (C or S) or a disregarded entity (all business tax entries pass-through client’s Schedule C / 1040 returns.
A Multi Member LLC may choose to be taxed as a partnership, C Corp, or S Corp. Must make a timely, affirmative election as a corporation, or will be assigned the default position by IRS, to be taxed as a partnership, and all gains and loss pass directly to partners at tax time. Unlike a corporation, an LLC allows gains and losses to be allocated differently than each partner’s share of ownership.
Self-employment tax: Currently IRS has pending regulations that restrict the current ability to allow all non-wage income from the LLC to pass through to the Member. We will discuss this.
Transfer of assets to Member’s LLC as capitalization should not trigger gain recognition on those assets. An existing tax basis carries over to the new entity.
New case law indicates that it is important to structure new LLC’s as Multi-Member LLCs, to avoid tax authorities or bankruptcy courts treating Single Member LLCs as being alter-egos of the owner.
Liability Protection of an LLC
General rule: LLC gives protection to members against claims against the entity (business).
Four fact patterns emerge:
The LLC, as a business, incurs a claim against activities performed by the entity, through its officers or employees. The creditor who obtains a judgment will be limited to the assets of the business.
The Member of the LLC incurs a claim against himself personally. Car crash, etc. If Member is one of two or more Members, the creditor should be limited to a charging order against that member’s cash receipts. The LLC may alter expenditures and activities to limit the ability of Creditors to collect. The Creditor may incur “phantom income” or constructive receipt of income created by the LLC, but not distributed to debtor member (and therefore unreachable by the creditor).
The Member of a Single Member LLC may find, depending on the nature of the claim (eg. Bankruptcy) that the court will set aside the LLC as Member’s alter ego, and attach the claim to all of Member’s available assets.
The Member(s) may have done such a poor job of performing the basic corporate formalities that a court will determine that the “corporate veil” can be pierced, and reach the Members personally. Such formalities would include any annual reports to the state, filing tax returns, using business funds for personal use or for another business, not keeping records and accounting documents, etc.
Hence, the safest route for asset protection is the multi-member LLC, where all partners “materially participate” in the business, and where all partners have contributed capitalization of fair market value in relation to the percentage of ownership received. Income can be reallocated for good business reasons to disproportionate percentages.