Single Member LLC – Charging Order – Creditor Claims, Pass-Through

Recently I’ve run across some significant issues with the single member LLC’s with courts handing down noteworthy judgment decisions in favor of creditors using the theory of “fraudulent transfers” and “civil conspiracy.” I ran across two such individuals that have made me more caution on client advice regarding single member LLC’s.

SINGLE MEMBER LLC – LIMITED LIABILITY COMPANY PASS-THROUGH LEGAL ENTITY

The LLC is a TAX HYBRID “pass-through” legal entity similar to a partnership but with the limited liability of a corporation. The LLC is tax-driven and was classified legally by the IRS on January 1, 1997 when the IRS threw out its old, and unnecessarily complicated, business entity tax classification regulations and agreed that LLCs should be taxed as partnerships (or sole proprietorships if they have one owner) without jumping through a number of technical hoops. Moreover, the IRS now lets an LLC elect to pay taxes as a sole proprietorship, as a partnership, or as a corporation by filing IRS Form 8832.

For “Income Tax purposes” income and expenses of the LLC “pass-through” directly to your income tax return proportionate to your percentage of ownership, or if there is more than one member, whatever percentage you decide, for example, 50/50 or 75/25. Irrespective of your equity ownership percentage, this is a significant advantage over other forms of business entities, and the LLC also has another significant advantage; members decide how they want to be taxed or, in other words, as sole proprietor, partnership, or corporation. The LLC will obtain it’s own Federal Identification Number (similar to a social security number), operate as a business, and maintain it’s own bank account.

SINGLE MEMBER LLC MAY NOT BE PROTECTED FROM CREDITORS

Ninety percent of financial advisors give the wrong advice regarding single member LLC formations. Single member LLC are mistakenly assumed to protect the member from the creditor. Most financial LLC advisors state that a Limited Liability Company (LLC) protects the owner (i.e. single member LLC) against present, past, and future creditors because the creditor may not step into the shoes of the LLC and has to look at the LLC member for collection.

The advisors point to an IRS Revenue Ruling (77-137), where the creditor holding the “Charging Order” will receive the “K-1.” They further explain, the creditor must pay the taxes on the income generated by the LLC, even though the creditor never receives any actual cash from the business. The creditor saddled by the charging order is treated as a “substituted limited partner for tax purposes” and will suffer the tax consequences without capacity to force payment, dissolution, or distribution of the LLC.

CHARGING ORDER DEFINES CREDITOR AS SUBSTITUTED LIMITED PARTNER FOR TAX PURPOSES TO PROTECT SINGLE MEMBER LLC

The area of the laws surrounding the issues of the charging order to protect the single member LLC is dynamic and evolving. There’s no legal reasoning for a charging order protection for single member, even though most state statutes call for such protection. The charging order protection cannot create a “personal legal liability” out of a legal business entity for “the acts” of the LLC.

There are several litigation issues unique to the LLC that are beginning to emerge in trial forums. State LLC laws, when written, were primarily tax driven, and accordingly, they defined key terms and concepts in accounting and tax terms, and not with thought of contract tort law issues. When the LLC is in financial distress, litigation will usually focus on:

A. Dissolution issues,

B. Capitalization issues,

C. Failure to comply with state statutory and regulatory requirements, and

D. Violation of one or more provisions of the entity’s documents.

FRAUDULENT CONVEYANCE, CIVIL CONSPIRACY WITH SINGLE MEMBER LLC

The central issue to single member LLCs (one owner) is “FRAUDULENT CONVEYANCE” which, if not handled properly may become part of a “civil conspiracy” to fraudulently act against creditor claims. In some cases the financial planner, lawyer, or accountant becomes part of the conspiracy and in some cases such advisors have been reprimanded.

Single shareholder corporation, single shareholder of Sub “S”, and single member LLCs can provide the owner with protection against liabilities arising from “the conduct of the LLC” but not the owner of the LLC membership shares. In other words, “if” the LLC does something wrong, the owner is not necessarily responsible. To reach the owner’s personal assets, a plaintiff would have to “pierce the veil” of the entity showing that:

A. The LLC, the corporation, or the Sub “S” was under capitalized for it’s intended business purpose,

B. Formalities were not followed,

C. The owner used the LLC, Corporation or Sub “S” mostly for personal purposes,

D. It did not serve a “bona fide” commercial purpose,

E. It lacked in economic substance and was merely an alter ego of the owner whose sole intention is to frustrate the creditor(s), etc.

A single member LLC (one owner), Corporation, or Sub “S” will not protect the owner, because the charging order protection that is much touted, is based on protecting the “innocent” non-debtor.

Under the Uniform Fraudulent Transfer Act you would be committing a crime, see Section 19.40.041:

“…(a) a transfer made or obligation incurred by a debtor is fraudulent as to a creditor whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation: (1) with actual intent to hinder, delay, or defraud any creditor of the debtor…”