Avoiding Liability Risks of Single-Member LLCs

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Businesses have traditionally limited exposure to liabilities by forming a group of corporations or subsidiaries to insulate assets. Although effective, these structures are complicated and burdensome, often requiring separate boards of directors and annual meetings. Single-member LLCs (SMLLCs), which require few formalities, can also be utilized to insulate liabilities of various divisions of a business, or even the assets of a single taxpayer, such as an individual or corporation.

For federal income tax purposes, SMLLCs are particularly attractive, since they are entirely ignored. SMLLC income is reported on the member’s individual (or corporate) income tax return. The question arises, however, whether the SMLLC will be respected as a separate legal entity for liability purposes.

The doctrine of “veil piercing” has been developed by courts to find corporate owners personally liable for debts of corporate entities where the corporate form was utilized to defraud creditors. SMLLCs seem at particular risk for veil piercing since they are entirely ignored for federal (and NYS) income tax purposes.

Some states’ LLC statutes incorporate by reference the veil piercing doctrine which has developed in the corporate area. Although New York does not have a “piercing statute,” there is no reason to believe that in an appropriate case a New York court would not employ a piercing analysis to deprive the single member of the protections of LLC limited liability.

That a SMLLC is ignored for income tax purposes should not alone assist a creditor’s efforts to pierce the veil of a SMLLC. A 1999 IRS Chief Counsel Advisory considering whether it could “levy on the assets of a [SMLLC] . . . to satisfy the tax liability of the taxpayer” concluded that “the mere fact that the LLC entity is disregarded for federal tax purposes does not entitle the Service to disregard the entity for purposes of collection.”

However, the tax blessing accorded to SMLLCs may also be a curse if the member assumes that since the SMLLC is ignored for income tax purposes and also dispenses with formalities, financial matters of the LLC may be similarly fused with those of its single member. To defend against a claim that the SMLLC was merely the “alter ego” of the member, the SMLLC should avoid consolidating the SMLLC’s financial statements with its own. If consolidated financial statements must be used,  loans and other transactions between the member and the SMLLC should be documented.

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