I help my clients form lots of business entities. While many of them are corporations, LLCs (Limited Liability Company) are, without a doubt, the most popular. It seems everyone these days wants to start their own LLC, and that’s not necessarily a bad thing—but there are drawbacks to having what is known as a single-member LLC.
Before we get into the reasons why a single-member LLC is not necessarily a good thing, we need to go over some of the background on LLCs in general. Time for a history lesson. The LLC was developed as an alternative form of corporate entity from the classic C-Corp, or corporation. Structured based on partnership rules, the LLC is technically just that, a fancy partnership recognized by state law and given added liability protection than what was provided by the typical general partner/limited partner model used by partnerships. If you have an understanding of the difference between partnerships and sole proprietorships, you may see where I’m going with this.
Partnerships all require more than one member. That’s why they’re partnerships, right? You can’t be a partner to yourself. If an LLC is considered to be highly similar to a partnership, then if you’re operating a single-member LLC, it’s like you’re operating a partnership with only one partner—and that’s a no-no. Traditionally, a partnership with only one partner, then, was a sole proprietorship, a type of business entity with undoubtedly the least amount of liability protection you could have. Therefore, if you’re operating an LLC as a single-member LLC, which makes you more like a sole proprietor than a partnership, that means you have less liability protection than if you have an LLC with multiple members. Which, of course, is why I, as a business attorney, always recommend including a second member when forming an LLC. People don’t always listen, but at least we can say we warned them.
OK, so back to the problems with the single-member LLC. Considering the above, we know these types of LLCs have less liability protection than if there were multiple members—but did you know that in some places they’re completely disregarded? Take the IRS, for example. When you register for an EIN (Employment Identification Number), they tell you your LLC will be taxed as a disregarded entity—just like a sole proprietorship. Not like a partnership. Not like a corporation. You have to affirmatively select one of those options. Even more amazingly, some states don’t even allow you to form a single-member LLC. California isn’t one of them, in case you were wondering. Though California will definitely disregard your single-member LLC (and hold you personally liable for damages) if your LLC is ever sued and doesn’t have enough capital to cover the damages if the other party wins.
To recap, the single-member LLC is problematic because it can be so easily disregarded. This means less liability protection, possibly less tax benefits, and the risk of personal liability if your LLC is undercapitalized.
So How Do I Solve This Problem? I Thought My LLC Was Supposed To Protect Me From Liability
The solution is easy: add another member to your LLC. We always recommend a family member, such as your spouse, partner, parent, or child. You don’t have to give them a 50% stake in the company, just a couple percent will do. You still get to make all of the important company decisions while they are just entitled to a very small share of the profits (and losses).
But I Don’t Want To Share!
There’s always those people who feel the’ve built their company by themselves, with their own hard work and capital, and they don’t want to share the membership interest in their LLC with anyone else. A completely valid point that I can definitely accept. If you’re one of those people, just keep in mind that you’re never going to insulate yourself from liability as well as you could by adding another member, but here are a few tips that may help you protect yourself slightly more.
Elect corporate tax treatment with the IRS instead of “disregarded entity” tax treatment that is default with a single-member LLC.
Keep unbelievably perfect records of all meetings and resolutions for your company. Even though you’re only one member, vote on everything. Document all major events. The more records your company keeps, the better.
Never personally sign for any LLC-related purchases or contracts. Always sign your name on behalf of your company.
Never mix money in your personal bank account with your company’s bank account. Keep them totally separate and keep excellent records regarding your LLC’s assets and liabilities.
Use your LLC’s EIN on all tax filings.
So there you have it, some reasons why a single-member LLC is not necessarily the best idea for forming your business entity, and some tips on how to get around the problems it presents.
Photo courtesy: Bob Jagendorf
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