THE LIMITED LIABILITY COMPANY STRUCTURE: IS IT HEAVEN OR HELL?
The limited liability company, or “LLC”, was first introduced in the State of Illinois in 1994 and is now well known and accepted in the market place and amongst professionals. Created to be a combination of a partnership and a corporation, the LLC grants its investors/equity holders, (known as “members”), limited personal liability for the obligations of the LLC company.
Lawyers and accountants have long touted the LLC as the perfect vehicle for asset protection. The LLC has become the vehicle of choice for estate planning, protection of family assets, and the preferred structure for incorporating businesses. However, recent court decisions, Internal Revenue decisions, and new creditor attacks/theories have limited the effectiveness of LLCs and may be making the corporate structure obsolete for some intended purposes.
How Does an LLC Work?
LLCs are different from corporations and one should not assume that both have the same attributes. For income tax purposes the LLC is treated in a manner consistent with that of a partnership where the individual partners report the earnings and losses of the LLC on their own personal tax return. Unlike the general partnership, where the individual partners have unlimited personal liability for the obligations of the partnership, the members in an LLC have, as the name implies, limited personal liability.
In an LLC and partnership, the partners/members do not receive W-2 earnings; rather the partner/member receives distributions of earnings and guaranteed payments. The distribution of earnings may not be equal to the profits of the LLC. Many LLCs have provisions in their operating agreements that provide the members of an LLC a minimum paid annual cash distribution to cover the income tax liability to be realized by the individual member for their prorated share of the LLC’s profits. These required distributions are known as ‘tax distributions’. When a member provides services for the LLC and is paid remunerations for services, these regular stipends for said labors are known as ‘guaranteed payments’.
The Changing World…
In our litigious society and in our uncertain times we attempt to limit our risks and protect our assets whenever possible. The law changes and we must be vigilant in protecting our interests. There is a need to review our business and personal planning regularly.
In a recent case in the United States Bankruptcy Court in the Northern District, the Court ruled that the income tax distributions paid to the members of an insolvent LLC were recoverable by the bankruptcy estate. The theory was that the member’s tax distributions were a violation of the Illinois Fraudulent Transfer Act. The fraudulent Transfer Act states that a violation occurs when, property is transferred to;
1. Hinder or delay in collection by a creditor, and/or
2. Transferred for less than fair value when the debtor was insolvent (constructive fraud).
The Court concluded that the discounted fair value of the assets was less than the company’s liabilities and therefore the LLC was insolvent. The working capital of the LLC when formed had less working capital than other companies in that same industry, therefore the Court gave credence that it was too thinly capitalized when formed. Finally, the Court found that the tax distribution payments to the members provided no value or benefit to the LLC.
For example; let’s say I formed a company, purchased assets and after one year, took the LLC’s earnings and reinvested the majority of it back into the company and only took out a tax distribution to cover my income tax obligation. Then the LLC gets sued. The fraudulent Transfer Act empowers creditors to recover property transfers for a four year look back period. So I could become personally liable to repay to creditors of the LLC the tax distributions or profit distributions that I received if the assets are less than the obligations of the LLC. Given that the fair market value of the assets I purchased is likely to have significantly decreased after the first year, it is highly probable that the LLC would be by definition insolvent, regardless if it had profits and was paying its obligations at the time the tax distribution was paid to the member.
Other Factors to Consider…
Under 805 ILCS 180/30-20(e), it is believed that a creditor of an individual who is a LLC member would be limited to a charging against the LLC to collect the obligation of the individual. The creditor of the member would be able to receive whatever distributions from the LLC that the member would be entitled to receive. Since many LLCs are composed of family members and friends it has been common for the LLC to play games so that the member’s distributions are reduced or eliminated thereby defeating and frustrating the collection efforts of the creditor. Many times the judgment creditor was forced into an unfavorable compromise of their unpaid obligation to collect a fraction of what was owed.
Creditors have interpreted the Illinois compiled statutes so as to permit the creditor who has a judgment lien to foreclose on the debtor’s LLC membership interest thus forcing the winding down of the LLC and sale of its assets to satisfy the debtor member’s obligations to the extent of his/her interests.
The Internal revenue Service has ruled that in a single member LLC, the single member is personally liable for all payroll tax obligations of the LLC, including non trust fund obligations, penalties, and interest. The IRS says that it ignores the LLC protections and holds the individual personally liable.
It is unsettled with the Internal Revenue Service if an inactive member in a LLC which operates a trade or business has earned income subject to self employment taxes. The distinction can result in an additional tax equal to the LLC’s profits times 15.65%.
LLCs are still useful planning tools but the usage of an LLC may need to be reviewed to determine if it has the intended value for your company. Sometimes establishing entities in other States whose law may differ is an alternative that one should investigate.