The Limited Liability Company…The Time is Now

The pros and cons of forming limited liability entities such as Limited Partnerships, Family Limited Partnerships and Limited Liability Companies is a much discussed topic these days. It is this latter device, the much misunderstood “LLC,” which is the newest, though less notorious, least used, and arguably the most straightforward and valuable of them all.

Limited Liability Company (LLC): A membership business entity that provides the protection of a corporation, but which is more like a partnership arrangement in many ways. LLC “members (versus ‘share-holders' or ‘partners')” participate in the day-to-day management of the company without incurring personal liability. All taxing agencies (state and federal) tend to “look through” the LLC to its member/s as the responsible parties in terms of accounting for, and payment of, income tax. Profits and losses relative to passive activities within the company flow to the members who remain free of individual self-employment tax. Since there is no plethora of case law concerning the LLC at this time, it is, of course, advisable to seek out good professional legal and accounting advice before considering its use.

Although it is only within the past few years that the Limited Liability Company has been accepted and recognized throughout the U.S., all fifty states have now adopted and recognize the LLC as an acceptable, viable and valuable business entity (since 1997). It should be noted, however, that some states (e.g., New York which imposes a $2,000 surcharge for the establishment of an LLC), by imposing large – if not onerous – tax penalties on LLC's, can make its use somewhat impractical relative to the cost savings of, say, a Subchapter S Corporation (also an income tax ‘pass-through' entity, see IRC 1361).

While on the surface the S-Corporation and the LLC may seem similar, there are some significant distinctions: 1) The S-Corporation is limited to 75 shareholders, whereas the LLC has no limit to the number of members it can have; 2) All the shareholders of an S-Corporation must be persons, who are U.S. citizens or permanent resident aliens, whereas LLC members can be business entities (corporations, partnerships, trusts, etc.) or individuals even non-resident aliens; 3) S-Corporations are permitted to issue only one class of stock, while an LLC can issue several different classes of stock in the form of membership certificates (capital, common, preferred, etc.) and priorities of ownership, and 4) Even though treated preferentially by the IRS, the S Corporation is treated for income tax purposes on a state level the same as would be any other Corporation.

Perhaps the simplest way to look at the Limited Liability Company structure might be to view it as basically a fusion or hybrid of the corporate structure and the partnership arrangement: but with all of the essential features, benefits and advantages of both though minus the disadvantages of each. For example: in terms of taxation, the corporate structure allows for double taxation of its owners (i.e., income tax is imposed on the Corporation as well as personally on any owner salaries or withdrawals): and in terms of asset protection, the General Partnership structure allows for a creditors charging orders against individual partners.

The LLC, on the other hand, effectively avoids both of these negatives. As well, like the corporation, the LLC also provides “lawsuit protection” for its members (analogous to stockholders in a corporation) who are not personally responsible for the liabilities or the indebtedness of the company. An LLC that holds real estate, for example, effectively protects its member-owners from personal lawsuits and creditor claims or judgments against the LLC. In addition, unless they were to have personally guaranteed the indebtedness, a foreclosure upon a Limited Liability Company does not create personal liability for its members.

Even today, in some quarters one might still find some negativity or misunderstanding by legal and accounting professionals regarding the viability and dependability of the LLC due to its newness. With its earliest advent in the U.S., many, if not most, financial planners remained long unconvinced (and some still do) as to how an LLC might fare under scrutiny by the IRS, or how it might hold up in court. Prior to 1997 the common use of the LLC as an asset shielding vehicle or business entity was uncommon, to say the least.

Recent IRS rulings are now clear in their treatment of the LLC as a “partnership” for income tax purposes so long as there are at least two members. A single-member LLC will however, be “disregarded (looked-through)” for income tax purposes: with the full tax liability falling to the member as if no business entity existed. This characterization of the single member LLC does not, however, mean that it would not be held completely valid relative to asset protection under state legislation (i.e., treated essentially as a sole proprietorship). The overall effect of the single member LLC is that asset protection (against liability claims) need not incur additional federal income tax reporting requirements, system documentation and record keeping or major set up expense.

As is commonly known, a regular corporation (e.g., a “C” corporation) is taxed first at the corporate level, then the stockholders (owners) are taxed again on the owner withdrawals. The LLC, on the other hand, by providing “pass-through” tax treatment, as would, say, a general partnership, averts such “double taxation.” In other words, the LLC as an operating entity is not taxed on its own profits; but instead on the income taken from it by its members (i.e., income accounting responsibility and income taxation is “passed-through” to the individual member/s).

Regarding creditor claims, do note that even though a judgment creditor's claim may be imposed upon an LLC, such claim may not be imposed individual upon its member/s (i.e., even with regard to single member LLC see U.S. Uniform Partnership Act  28 relative to restrictions concerning charging orders per se). What this then means is that the personal assets of an LLC's member/s would not be reachable by a judgment creditor without a valid claim against, and the dissolution of, the entity: which dissolution would, of course, not be allowed unless somehow all the members were to have conspired and acted in concert to create the cause for the claim.

Before the advent of the Limited Liability Company, the “Family” Limited Partnership was considered a superlative instrument for estate planning and protection. However, the chief reason for forming an “FLP” versus a General Partnership was to avoid creditor claims against assets held in the partnership, by avoiding charging orders against the limited partners. That is to say that under a Family Limited Partnership, a judgment creditor could not attach a limited partner's interest, and the general partner's exposure would thereby be limited only to its percentage of the total value of the assets so held. The problem with the FLP for holding real estate, however, was (is) that the general partner still has personal liability to the extent of his percentage of ownership. An answer, of course would be to name a corporation as the “general partner.” Interestingly enough, though, the LLC actually affords its members the same creditor protection as would such a limited partnership, but wholly without personal liability of any of its members: and without the added legal work, time and expense of creating, administering and maintaining the corporation and all of its reporting requirements.

Note that even though the IRS does not consider the single member LLC to exist the structure none-the-less continues to afford maximum protection against creditor claims and lawsuits: even though the owner member continues to report its income and expenses as an individual (e.g., a Form 1040, with a Schedule C for the business and Schedule “E” for rental income).

While on the surface the LLC seems to be a fairly uncomplicated and innocuous device for doing business and for holding assets, it still has many other relatively unexplored facets. One of which is that of holding real estate assets and protecting them from judgment creditors, bankruptcy actions and actions in marital dispute. For example, all of one's real estate holdings can be placed into an individual LLC; or each separate property or parcel can be held by a separate LLC, with a different investor or beneficiary “partner” in each one. In using the LLC for holding real estate in this manner, separate tax returns for each entity need not be filed and of even greater interest, a tenant's injury on the premises will not create a personal liability for the member/members. Only the LLC can be sued. Therefore, by holding properties in this manner, other properties remain apart from involvement in the claims of creditors arising out of a lawsuit against a particular LLC.

The LLC also provides a truly serviceable vehicle for shielding or passing wealth to family members without having to re-title the real estate. Once real estate is transferred into an LLC, the members' interest is converted to, and its ownership characterized thereafter as, Personalty (i.e., personal property) Vs. Realty (real estate), which “shares of ownership” can then be transferred, all or in part, as tax-free gifts (in blocks up to $10,000 per-year to each recipient). Again, note that the procedure for transferring LLC shares is far less complicated (quite simple in-fact) as compared, say, to altering, preparing and filing new transfer documentation (e.g., Grant Deed, Warranty Deed, Bargain and Sale Deed, etc.) and the requisite Preliminary Change of Ownership documentation. Moreover, when the gift is to a child, the LLC allows the parent to easily retain full control of the asset throughout its lifetime by continuing to act as “Managing Member” for the LLC.

In short the benefits afforded by the Limited Liability Company are long overdue, but apparently here to stay, with confidence within the financial community growing stronger everyday. And a major welcome benefit of the LLC is that one can be set up for as little as $199.00 (go to www.mycorporation.com).