Single-Member LLC Risk
Single-Member LLC Risk
With every state having adopted the LLC as a limited liability business entity over the past couple of decades, the LLC has become the entity of choice not only for operating a business but also for ownership of real estate. However, although once considered a nearly bullet proof shield against lawsuit judgments reaching personal assets of business and real property owners, LLCs, particularly single-member LLCs, are coming under attack in courts around the country.
The primary advantage of an LLC is that owners are not personally liable for claims against the LLC, whereas, for sole proprietorships and partnerships all personal assets of a proprietor or general partners are at risk when a claim is made against the business. For a rental property owned by individuals or by a partnership (either general or limited types), a substantial judgment obtained by a tenant of one property can potentially result in loss of that particular property, all other real property, and all other assets of individual owners or general partners.
However, when each property is owned by a separate LLC, a judgment in favor of a tenant of one property may result in loss of that property but the tenant cannot attack the personal assets such as homes, bank and brokerage accounts, or other rental properties or businesses held by other LLCs.
Of further benefit is the fact that the statutes of most states do not allow a judgment creditor to obtain any ownership or operational control over a LLC. The creditor only obtains a “charging order” against the interests of the member. A charging order is a court order granting the creditor the right to garnish distribution from the LLC to the member. Accordingly, a member who does not depend on cash flow from the LLC can indefinitely delay distributions. This can force the creditor to agree to a settlement acceptable to the member.
Charging orders were carried over to LLCs from partnership law where they originated for the purpose of preventing the interest of other partners being jeopardized by a judgment against one partner. However, in recent years some courts in the country have taken the position that for a single-member LLC there are no partners to protect and single-member LLCs have lost some protection.
Example 1 (Littriello v. United States) – Frank Littriello was the sole owner of several Kentucky limited LLCs that did not make elections on Forms 8832 to be treated as corporations, and therefore were treated as disregarded entities by the IRS, pursuant to the default classifications under Treasury Regulations. The IRS assessed employment taxes on the LLCs, which flowed up to Littriello as the sole owner of the disregarded entities. The IRS won this one when the Sixth Circuit Court in 2007 affirmed the WD Kentucky District Court’s 2005 holding.
Example 2 (Olmstead v. Federal Trade Commission) – More recently (June 2010), the Florida Supreme Court issued a ruling for a $10 million judgment against Shawn and Judy Olmstead, allowing their creditors access to all their assets held in single-member LLCs.
Note that this case might have been decided differently in a different state. Some states allow foreclosure of an LLC interest, others provide that a charging order is the exclusive remedy of a creditor, and yet others are silent on the issue. The court reasoned that because the Florida LLC charging order statute does not expressly provide that a charging order is the exclusive remedy (general and limited partnership statutes do provide so), the LLC charging order is not the exclusive remedy and, thus, a creditor may levy on the LLC interest.
There are some ways to protect single-member LLC assets.
- Don’t commit negligence, fraud, or illegal acts – this will avoid liabilities whether or not the assets are protected.
- Follow the first advice item as well as possible, maintain high ethical standards, show respect and kindness to all, avoid careless decision making, and don’t be greedy.
- Understand the LLC statutes of your specific state.
- Form and operate your LLCs legally and in accordance with the operating agreements.
- Add another member to any single-member LLCs.
- Obtain business liability insurance and an umbrella policy having limits as high as possible.
An LLC is the only business structure that can choose how it wants to be taxed. However, the LLC must make a choice by filing the appropriate election with the IRS (Form 8831) unless the default entity is the entity of choice. Otherwise, the IRS will automatically assign a default tax status, based on the number of owners – a partnership if two or more owners or “single-member disregarded” status if only one owner (member). The latter can mean that the LLC is no different from a sole proprietorship as far as the IRS is concerned.
While, for an operating business the problem can be avoided by operating as either an S Corporation or C Corporation, with one of these actually often being tax-wise advantageous for an “active” business, an LLC taxed as a partnership is usually tax-wise preferable for the “passive” business of owning rental properties.
In order to maximize the protection provided by LLCs, there are other things that must be kept in mind no matter how many members. It is very important that individual LLCs be operated as separate independent entities, separate from one another and separate from the owner. Important issues include the following:
- Follow the operating agreement regarding any required meetings and other formalities and be sure to generate related documentation.
- Maintain separate LLC checking and other bank accounts rather than use your personal accounts for the property, preferably separate accounts for each LLC.
- Avoid commingling of personal assets with LLC assets and commingling of one LLC’s assets with another LLC’s. Do not write checks between LLCs unless as formal documented loans. Never pay for personal expenses from a LLC checking account.
- Maintain adequate reserve funds within each LLC to minimize the risk of commingling.
- Maintain utility, vendor, and other accounts in the name of the individual LLCs.
- File a fictitious name statement if you want to do business under a name other than that of the LLC.
- Always properly document any changes in ownership or management of the LLC.
- Use LLC-specific letterheads, envelopes, tenant notices, etc.
- File LLC tax returns.
- Execute documents on behalf of the LLC rather than as an individual.
LLCs still provide the best asset protection for most real estate investors. However, you should stay alert for future changes in LLC law and tax law, including law arising from statutes, regulations, and court decisions.
Additional Information
For additional discussions regarding LLCs in considerably more detail than is provided by this series see our “Buying Income Property” and “Managing Income Property eCourses.