Category: Sole proprietorship taxation

HOLDING LLC MEMBERSHIPS THROUGH SINGLE-MEMBER LLCs—A TRAP FOR THE UNWARY?

By , January 11, 2011 8:50 am

In my LLC practice, I often run across LLCs whose ultimate owners hold their LLC memberships through single-member LLCs.  They do this because they think that they are obtaining two significant benefits—greater anonymity as LLC owners and an extra layer of statutory liability protection.

EXAMPLE.  Arthur Able and Bill Baker are equal members of AB, LLC.  AB, LLC, in turn, holds real estate with a fair market value of $1 million.  Arthur holds his AB membership directly in his own name.  Bill holds his through a single-member LLC named “Cosmic Holdings, LLC,” of which he is the sole member.

I think the above ownership structure creates a serious trap for Bill.  One of major benefits of holding property in an LLC is that all U.S. LLC acts except that of Pennsylvania provide LLCs and their members with statutory charging order protections.  (And I understand that Pennsylvania case law provides charging order protections for Pennsylvania LLCs and their members.) 

I will write about charging order protections at greater length in future posts.  However, in essence, LLC statutory charging order provisions provide that if a creditor holds an unsatisfied judgment against a member of a multi-member LLCs on the basis of a claim unrelated to the LLC’s business:

  • The creditor may obtain a lien (a “charging order”) against the LLC on the debtor-member’s right to receive distributions of LLC profits, requiring the LLC to distribute to the creditor any LLC profits it would otherwise distribute to the member to the extent of the judgment.
  • However, the creditor may not levy on the debtor-member’s voting rights or other management rights in satisfaction of the claim.

In my view, the fact that LLC statutes provide for charging order protections and that corporations do not is the single greatest business organization law advantage of LLCs over corporations.    

To explain:  In the above example, Bill, as noted, holds his ownership in AB through a single-member LLC.  What this means as a practical matter is that if Bill accidentally but negligently runs over and kills a brain surgeon on business unrelated to the LLC and the brain surgeon’s estate obtains a $20 million judgment against him, the estate can levy on his single-member LLC membership; it can obtain Bill’s voting rights; and, by exercising deadlock voting power, it can force the LLC to sell its assets and distribute Bill’s share of the proceeds to the estate.  This is because charging order protections only protect LLC members; they do not protect the members of single-member LLCs that are members of multi-member LLCs.

By contrast, assume that Arthur is the AB member accidentally killing the brain surgeon.  In this situation, charging order protections will enable the estate to obtain a charging order against AB, LLC; but, because Arthur holds his membership in AB directly, the estate cannot obtain Arthur’s voting rights and thus cannot force AB’s dissolution.

In short:  Think long and hard before advising your LLC formation clients to hold their memberships in multi-member LLCs through single-member LLCs.  First, your client will thereby lose charging order protections.  Second, as a practical matter, he won’t need a second liability shield; so why bother with a single-member LLC?  Third, in any law suit, the “anonymity” he thinks he will obtain through his single-member LLC will quickly turn out to be worthless.

TAX CHOICE-OF-ENTITY TABLES

By , April 29, 2010 4:48 pm

On April 27, 2010, I taught a 90-minute national teleconference CLE-credit seminar for National Business Institute on the basics of LLC taxation.  In my experience, for most single-member LLCs whose members are individuals, the two federal income tax regimens that are likely to be useful are sole proprietorship taxation and Subchapter S; and for almost all multi-member LLCs, the relevant federal income tax regimens are Subchapter K (partnership taxation) and Subchapter S.  My seminar was based in part on tables I’ve prepared comparing the above regimens.  If tax choice of entity is a topic that interests you, you can access the table comparing sole proprietorship taxation and Subchapter S, click here; and you can access the table comparing Subchapter K and Subchapter S by clicking here.