The Arslanian Law Firm - Attorneys at Law

The Single Member LLC: Having Your Cake And Eating It Too.

Authored by Paul Arslanian, Attorney, C.P.A., Managing Partner, The Arslanian Law Firm PC

We work hard to accumulate an estate which will allow us to retire, and to provide security to our survivors. Liability exposure is a constant threat. For example, the physician who owns the property on which his medical clinic is located could be sued by a patient who slips and falls in the parking lot. The owner of a rental home could be liable to a renter, or to a renter's guest, who is injured on the premises. The owner of a recreational boat also faces liability from its use. A corporation which has more than one operating division, or owns real estate, subjects all of its assets to liability which might arise from any such holding.

Insurance should almost always be the first line of defense in this regard, but there remain the risks of liability in excess of insurance coverage or that the incident is not covered under the policy. To minimize this exposure, individuals and businesses are increasingly turning to a convenient and cost-effective method to shield themselves from potential liability: the single member limited liability company.

What is a Single Member Limited Liability Company?

In Michigan, the limited liability company ("LLC") has been a popular business alternative to the corporation and partnership since 1993. It combines the protection against personal liability for the owner, like a corporation, with the flexibility of management, distributions and avoidance of double taxation found in a partnership. An owner of an LLC is called a "member" and can be an individual or a "business entity" such as a corporation, partnership or another LLC.

When the LLC was first introduced in Michigan in 1993, the legislation required the LLC to have at least two members. This limitation prevented sole owners of business or investment property from availing themselves of the advantages of the LLC. The only alternative was to place the property in a corporation. In 1997, Michigan amended its LLC laws to allow a Single Member LLC. Since then, individuals and business entities in Michigan have taken advantage of this form of ownership to protect themselves from liability that may arise from property by transferring it to a Single Member LLC.

The Single Member LLC has a unique attribute that makes it more convenient and cost- efficient than the corporation. The Single Member LLC is considered by the Internal Revenue Service to be a "disregarded entity." This means that the owner is not required to file a separate income tax return for the Single Member LLC. The Single Member LLC is ignored for federal income tax purposes, and an individual or business entity treats the property owned by the Single Member LLC as if owned in the name of such individual or entity. Income, gains, losses, depreciation and related items are reported on the owner's federal income tax return. Thus, the Single Member LLC provides the liability protection of the corporation without the additional tax reporting and related expenses.

The Single Member LLC is appropriate for many different types of property owned by individuals or business entities. The Single Member LLC is a natural fit for rental and investment real estate. It may be appropriate for vacation property and recreational vehicles such as boats. An individual who runs a business as a sole proprietorship can place the business in a Single Member LLC, thereby adding the liability protection of the Single Member LLC without any change in tax reporting. Many corporations, partnerships and LLCs are now "dropping" operating divisions and real estate parcels each to a separate LLC in order to insulate the property in each from liabilities associated with the others. Such a business entity, and its owners, might thus avoid liability because the entity will own nothing except Single Member LLCs which each own an operating division or real estate parcel that would otherwise be owned by, and bring liability exposure to, the entity.

The Single Member LLC shields the owner's other assets from liability that arises from the property, or the business, held in the Single Member LLC. If, for instance, a person is injured on land owned by a Single Member LLC, the injured party is generally limited to suing the LLC and recovering a judgment against its assets only. If the Single Member LLC incurs ordinary debts (not personally guaranteed by the owner) in the operation of a business, the debts can only be collected against the property held by the LLC.

To keep the liability shield in place, the owner should respect certain formalities of maintaining the Single Member LLC, such as adopting an Operating Agreement (similar to Bylaws of a corporation), documenting annual minutes of the company, and making the required annual filing with the State of Michigan. A person who operates a Single Member LLC should consult with an attorney familiar with such entities to put in place a cost- effective routine to comply with these requirements.

What are the Limitations on Liability Protection?

There are certain limitations to the liability protection afforded by the Single Member LLC. Even though a creditor of the Single Member LLC cannot recover against the owner's assets, the creditor of the owner can recover against the Single Member LLC's assets. If the individual or business entity owner of the Single Member LLC wishes to shelter the Single Member LLC's assets from creditors of such individual or entity, the owner would have to form the LLC with one or more additional members. Assuming the Operating Agreement for the LLC is properly drafted, the presence of two or more members may limit the creditor of one member to obtaining a "charging order" against the LLC, which makes recovery against the LLC assets extremely difficult. The downside to this alternative is that an LLC with two or more members is considered a "partnership" for tax purposes, and the LLC might be required to file an income tax return. The benefit of the additional liability protection may justify the additional expense.

Certain professionals, such as physicians and attorneys, who operate a professional practice as an LLC are not shielded from liability that arises from their own malpractice. Such is the case with all "professional" business associations under Michigan law. The professional is still protected from "ordinary" liabilities, such as a slip and fall injury, or debts incurred in the ordinary course of business.

The Single Member LLC, like other business entities, does not protect its owner from certain liabilities imposed by law, such as unpaid employment tax and environmental contamination. It also does not protect the owner from liability for such owner's misconduct.

How Is the Single Member LLC Created?

The Single Member LLC is created by filing a document, the Articles of Organization, with the State of Michigan's Department of Consumer and Industry Services. The owner should verify that the name chosen for the Single Member LLC is not currently used by another business entity before submitting the Articles of Organization, in order to avoid multiple attempted filings.

Also, the owner should adopt an Operating Agreement, which provides the rules that govern the operation of the LLC. The Operating Agreement is important to demonstrate that the owner fulfilled this aspect of observing the formalities of the Single Member LLC. The Operating Agreement is also crucial if the owner later decides to add one or more members (other owners) to the company, such as a spouse, child, business or joint venture partner. If there are, or may later be, two or more members of the LLC, a properly drafted Operating Agreement is essential to define the operation of the company, the rights of its members with respect to each other and the company, and the limitations on member interests.

The ongoing maintenance of a Single Member LLC is simple. Every year, the owner files a brief Annual Statement with the State of Michigan and pays a $15 fee. The owner should also prepare annual minutes of the company, which affirm certain acts of the LLC from the prior year.

The Single Member LLC And Estate Planning

The LLC has the added benefit of making the process of estate planning easier. For instance, when an individual owns real estate inside an LLC, it is more convenient and less expensive to give a minority interest in the company to a spouse or child than it is to transfer directly a fraction of real estate. There is no need to prepare a deed or a property transfer affidavit, and the owner does not incur the expense, or the hassle, of filing such documents with the county register of deeds or the local tax assessor. A transfer of an LLC interest is accomplished with a simple assignment of a member's interest. This assignment is a private document and is not filed with the county or local officials. If an individual is making gifts of fractional interests on an annual basis to take advantage of the annual exclusion from the gift tax (currently $11,000 per person, per year), this technique is particularly useful. Also, the LLC may be designed to restrict the transferability of a member's share. This feature, along with the minority status of the transferred interest, can result in a valuation discount for the transferred interest, which means the owner can transfer a greater portion of the LLC while taking advantage of the annual exclusion from the gift tax.

Conclusion

The Single Member LLC is a useful and cost-efficient tool for individuals and business entities to take advantage of the liability protection of a corporation and the flexibility of a partnership. In most instances, this is truly a case of "having your cake and eating it too." As with any such undertaking, it is important to understand the legal, tax and practical aspects of making the transition from outright ownership of investment, business or recreational property to ownership by an LLC. A knowledgeable advisor can address these concerns as they relate to specific property. Weighing the potential benefits against the known burdens, individuals and business entities increasingly choose this underutilized tool to help shield themselves from the threat of liability.