“Ask the Attorney”: Single-Member LLCs

by Scott Edward Walker on February 10th, 2010

Introduction

This post is part of a weekly series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain english (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question

I plan on forming a single-member limited liability company (LLC) in California as an umbrella for a number of my different internet-related projects.  One particular project will involve subscription revenue from businesses around the country.  I have heard that some states may not recognize single-member LLC’s.  Are these types of internet businesses suitable for a single-member LLC?  Any other thoughts on single-member LLC’s are appreciated.  Thanks!

Answer

My colleagues and I are asked about entity choices all the time.  As I discussed in my post “Ask the Attorney – Formation Issues (Part I),” if you’re launching a venture, the first thing I recommend is to form an entity that will protect against personal liability.  There are three good choices: a C corporation, an S corporation or an LLC, each of which has its advantages and disadvantages.  A single-member LLC (as opposed to a multiple-member LLC) is a relatively new animal and, until recently, was not recognized in all 50 states.  As discussed below, in theory it has two significant advantages; in reality, probably only one.

First, like all LLC’s (as mentioned above), a single-member LLC is designed to protect against personal liability.  Accordingly, it should arguably be treated as a separate “person” for legal purposes, and thus the sole member/equityholder should be shielded from any liabilities of the LLC, including debts and lawsuits.

Second, a single-member LLC will be treated as a “disregarded entity” for federal income tax purposes (unless it formally elects to be treated as a corporation), and thus its profit or loss will be reported on an individual member’s Schedule C as if it were a sole proprietorship.  This will save the member time and money in connection with the preparation of income tax returns because the separate LLC entity need not file returns.

The most significant disadvantage of a single-member LLC is the risk that, unlike multiple-member LLC’s, it will not protect against personal liability in the event of a lawsuit or other claim.  Indeed, certain courts have “pierced the veil” of a single-member LLC and have held that it is not a separate entity and thus may not be used to protect the assets of the LLC from the creditors of the member.

To avoid the “piercing of the veil” issue, I suggest that you do two things: (i) create sufficient legal documentation (including a single-member operating agreement and Manager resolutions, etc.) to reflect that the single-member LLC is indeed a separate entity and has been treated as such; and (ii) if there is significant liability exposure, issue a small equity interest (e.g., 2%) to a close relative – i.e., create a multiple-member LLC — in which case, it will not be a “disregarded entity” for tax purposes.

The other disadvantage to a single-member LLC, according to certain tax practitioners, is the increased audit risk as a result of the individual member utilizing Schedule C as if it were a sole proprietorship (as opposed to separate entity tax returns).

Looking at your particular situation, the good news is that internet-related projects do not likely have significant liability exposure (as opposed to a manufacturing project or the purchase of real estate).  On the other hand, as I previously noted on VentureBeat, if you will be seeking venture capital funding, an LLC (single-member or otherwise) may not be the best choice.

The bottom line is that you need to sit down with a reasonably-priced lawyer and accountant and discuss the foregoing issues and determine what works best for you, based on your business objectives and risk tolerance.

Conclusion

I hope the foregoing is helpful (and please note that I’m not a tax lawyer – and thus this post should not be construed as tax-related advice in any respect).  If you would like some additional tips regarding launching a venture, you can also check out my post “Launching a Venture: Ten Tips for Entrepreneurs.” 

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