Single Member LLCs - Tax Status vs Legal Status

We’ve been talking about single member LLCs (SMLLCs) for the past couple of days on the TaxLoopholes Forum. Because an SMLLC means one thing legally and something else from a tax perspective, it’s really easy for people to confuse the two.

A SMLLC means different things to the IRS and the legal system. To the legal system, it means simply an LLC that has one owner. To the IRS, it’s a tax classification that determines how it will be taxed, and what tax return it will file. Under the IRS definition, a SMLLC can be owned by one person, or by a married couple, as long as they file a joint tax return.

Having a SMLLC doesn’t mean you have fewer legal protections. In many cases an LLC is actually MORE secure. That’s because the charging order protected granted to LLCs by the states don’t allow creditors to reach through the LLC to its assets to satisfy a debt of the owners.

Say I run you down with my car (sorry). You sue me, my insurance doesn’t cover the accident, and I can’t pay the judgment … what next? Well, if I had my business operating through an LLC, you can’t take it away from me. If I had a half-dozen real estate properties in an LLC, you can’t take those away from me either. The best you can do is file a charging order against my LLC’s profits. A charging order is like a garnishing order - profits are diverted from me to you until my debt is repaid. You generally don’t have the right to force me to sell assets within my LLC to repay my debt.

But if I have my business in a C or an S Corporation, things change. My shares are not protected the same way that an LLC’s ownership interests are. You could apply to a court to take away my shares in the C or S Corporation to satisfy my debt. At that point, any assets owned by my C or S Corporation effectively become yours too. Because you have control of my shares, you can vote to liquidate the company or whatever you need to do to satisfy the judgment.

So actually, an LLC is a preferable entity to me because you can elect the right tax status for the job AND give yourself extra legal protection.

There was a legal development that shook up the idea of single member LLCs. It was a bankruptcy case in Colorado. In that case, a guy going bankrupt tried to protect all of the assets in his LLC from his bankruptcy trustee. The court said no, in the circumstances it was unreasonable to try and protect the assets from his own actions.

Where things got off track was due to a comment the court made. They said if the defendant had a partner in the LLC, the legal protection would have held up, because their decision to bust through the corporate veil and into the LLC’s assets would impact more than just the defendant. That’s what got everyone freaked out about SM LLCs and asset protection.

But I believe that this is a really specific case. Remember the guy declared bankruptcy. In the eyes of the court, allowing the defendant to escape responsibility for his own actions by hiding all his stuff in an LLC was a slippery slope. That’s what the court wanted to discourage. It makes sense - if you knew you could declare bankruptcy, lose your debts and keep your stuff …

The asset protection rule still stands: if you own a SMLLC and are sued personally by a third party, generally speaking your LLC assets won’t be at risk.