When the limited liability company first came into existence it was quickly adopted in the legal and financial world. This business entity offered several advantages over the other entities that were available at the time: C corporations, S Corporations, sole proprietorships, general partnerships and limited partnerships. An LLC offered the limited liability protection of a corporation coupled with the passthrough tax attributes of a general partnership. A lower capital gains rate on the sale of assets was available to investors, a tax advantage not applicable to corporations. Items of profit and loss could be specially allocated to members separate from their capital interests. With the advent of the singlemember LLC, many possibilities became available to businesses and investors that were not available to a sole-proprietor. The single-member LLC is a legal entity owned by only one member, or in a community property state, a husband and wife provided only one spouse activity participates in the business. The single-member LLC provides the limited liability protection that a corporate structure offers but without the formalities required of a corporation.
For tax purposes, a single-member LLC is referred to as a “disregarded entity”. In simple terms, this means that the profit or loss of the LLC passes through directly to the underlying member as if the LLC did not exist. There is no separate tax return required for the single-member LLC. For example, if an individual establishes a business as a single-member LLC, the profit or loss from that business is reported on Schedule C of the individual’s income tax return. If an individual holds a piece of rental property in a single-member LLC, the profit or loss from that rental activity is reported on Schedule E of the individual’s income tax return.
Because the single-member LLC is referred to as a “disregarded entity” some people have tended to treat these entities as if no regulations exist regarding their operation. This could not be further from the truth. LLC’s must be properly operated in order to secure the limited liability protection that is desired. Since protecting the personal assets of the owner of the LLC is typically the primary reason for establishing an LLC, it is important that owners understand how to properly operate this entity. The focus of this article will be on single-member LLC’s. However, all requirements delineated here also apply to LLC’s with more than one member. However, with multi-member LLCs there is the additional requirement to file a separate tax return for the entity, either a partnership or corporate tax return, depending upon the tax treatment elected for the particular LLC.
The following guidelines will assist in proper maintenance of the LLC:
- Articles of Organization must be prepared and filed with the Arizona Corporation Commission.
- Although not specifically required, it is recommended that an Operating Agreement be prepared, especially for LLCs with more than one member. Among other things, the Operating Agreement details the authority of the members and the allocation of profit and losses.
- Although not specifically required, it is recommended that minutes of the annual meeting of the members be prepared. This is similar to the annual meeting of shareholders for a corporation.
- The LLC must have an employer identification number. This number is obtained from the IRS and should be used when opening bank accounts for the LLC.
- Property that is to be owned by the LLC must be titled in the LLC name, not the owner’s name. If an LLC is formed after property is purchased, title to the property must be transferred to the LLC.
- Loans for the underlying business or property should be in the name of the LLC. The lending institution will usually require the LLC member to personally guarantee the loan or mortgage, but the loan itself should be in LLC name.
- The insurance for the real property in an LLC should be purchased by the LLC in the LLC name.
- The LLC must have a separate bank account. All revenue from the business or property must be deposited to this bank account and all associated expenses must be paid from this account. If more than one LLC is owned, each must have its own bank account and segregate its revenues and expenses. If one LLC needs cash and other has a surplus of cash, a distribution should be made to the member and then the member should contribute the funds to the LLC with the cash requirement. Alternatively, one LLC could loan funds to the other LLC provided it is clearly delineated in the books and records that a loan has occurred. In no case should one LLC pay the expenses of another LLC, even if commonly owned.
- Generally, it is recommended investment property or businesses be owned in separate LLCs. For example, if an individual owns five separate pieces of rental property, five separate LLCs should be established each owning one rental property. The rationale here is to minimize exposure to creditors. In the event an accident occurs on a piece of property and a lawsuit ensues, only the assets in that particular LLC are available to settle creditor claims. Therefore, if only one piece of property exists in the LLC then only that piece of property is subject to loss, provided the LLC has been properly maintained and assets appropriately segregated. Of course logic must prevail and you must determine what risk you have to exposure. As you work at maintaining your LLC, constantly think in terms of building a protective wall around the asset. Keep assets isolated, keep transactions separate and distinct.