Single Member Limited Liability Companies
Individual small-business owners often choose not to use a sole proprietorship entity structure to operate their businesses, because a sole proprietor is personally liable to the business’s creditors. Doing business as a limited liability company (“LLC”), which generally offers the same protection against creditors as a corporation, allows sole proprietors to protect themselves from claims brought by business creditors, because judgements entered against an LLC are not enforceable against the owner’s personal assets. Single member LLC (“SMLLC”) owners must be careful, however, because this protection does not apply if they personally guarantee a debt.
Generally, a sole proprietor may adopt LLC status by applying to the state and paying a small fee. Even though an SMLLC has only one member, it should still adopt an operating agreement. First, adoption of an operating agreement supports the idea that the SMLLC has an “arm’s length” relationship with its single member. In addition, lenders often expect to review an operating agreement when they evaluate loan applications from SMLLCs. Finally, an operating agreement can efficiently facilitate the entrance of another member or provide a smooth transition to another owner upon the death of the single member.
For federal income tax purposes, SMLLC owners generally choose to treat the business as a Schedule C, although they are entitled to elect corporate status. Such an election is seldom made.
Tax advisors may recommend that their clients use a different SMLLC for each business they operate or each piece of rental real estate they own to reduce exposure to creditors, although this practice has become more costly in recent years due to the fact that some states impose an entity tax on each SMLLC a person owns.
Multiple Member Limited Liability Companies
A multiple member Limited Liability Company (“MMLLC) is treated as a partnership for federal tax purposes (unless it elects corporate status) and offers many of the tax advantages of both partnership and S corporation status, while avoiding the tax disadvantages of both entities. An MMLLC member’s liability to creditors is limited to his or her capital contributions, although in many cases creditors will insist that one or more members personally guarantee the business’s debt. MMLLC members should avoid making personal guarantees of entity debt if possible, because such guarantees defeat the asset protection purpose for which the entity was, in part, selected.
No limitations are placed upon the kind of entity that may be a member in an MMLLC. Although state regulations vary, generally a member’s interest in an LLC is not freely transferable, and unanimous written consent by all members is needed in order to make a transferee a full member,
With a general partnership, each partner participates in management decisions and is jointly and severally liable for the partnership’s debts.
A limited partnership (“LP”) has two types of partner and must have at least one of each type to qualify as an LP:
- A general partner, who is the partner with unlimited liability and Controls partnership decisions; and
- The limited partner(s), is/ are the partner(s) whose liability is limited to the amount he or she has invested in the business, and who has little or no control over day-to-day partnership decisions.
Business owners can make a corporation, rather than an individual, a general partner, allowing them to avoid joint and several liability for all individuals concerned.
For partnerships holding real estate or oil and gas interests, an LP is a viable entity choice. Notwithstanding, an MMLLC may offer the same advantages relative to creditor liability without the concern for a general partner’s unlimited liability, Business owners should be reminded that LPs are governed by state law, and the rules that govern then may vary from state to state. A tax attorney can assist clients in developing provisions in their partnership agreements that can substitute for state law default governance rules.
Family Limited Partnerships
A family limited partnership (“FLP”) is a limited partnership composed of family members, Such a partnership can be used to transfer interests in a family business or other types of property to a younger generation. From a state law perspective, an FLP is no different from any other limited partnership; an FLP is merely a limited partnership whose partners are all family members or entities controlled by and operated for the benefit of family members.
Usually an FLP is set up with the parents as the general partners and the children as limited partners. A common strategy is to transfer part or all of the family business to younger family members through annual exclusion gifts. Often the fair market value of these gifts is substantially discounted through the use of large discounts that serve to reduce the value of the gift.
An FLP cannot be used principally as a conduit to allocate income to younger family members for purposes of taking advantage of their lower marginal tax rates. Family members are recognized as legitimate partners only if one of the following two requirements is met:
- If capital is a material income-producing factor, the family members acquire their capital interest in a bona fide transaction, even if by gift or purchase from another family member; or
- If capital is not a mate rial income-producing factor, the family members have joined together in good faith to conduct a business, some capital or service has been (or is) provided by each partner and they have agreed that each partner’s contribution entitles him or her to a share in the profits.
Before considering an FLP, you should be aware the IRS tends to view FLPs as potential vehicles for tax law abuse. As a result using an FLP as a business structure can subject business owners to substantial risk of IRS audits. Also, you should be mindful that making gifts of partnership interests to children and grandchildren in order to transfer income to younger members of the family, FLPs cannot be used to siphon off earned income of one family member to lower marginal rate members of the same family. The IRS may attempt to unwind transfers of FLP interests to younger family members on various grounds. For example, they may claim that the transferor never parted with the use of or control over the property he or she allegedly transferred to the FLP, (i.e., he or she still owned it at the time of death, so it should be included in his or her estate).