A limited liability company (LLC) is a tax-efficient form of business entity that provides liability and asset protection benefits. LLCs were created to combine the liability protection traditionally associated with corporations with the flow-through taxation and charging order protection traditionally associated with partnerships. These features make LLCs the most popular form of business for owning and operating real estate.
Liability Protection Benefits of LLCs
A properly operated LLC provides strong protection against debts of the business. This means that an owner of the LLC is not responsible for business debts and liabilities. If a creditor obtains a judgment against an LLC, the creditor must look only to the assets of the LLC to satisfy that judgment. The creditor cannot seize the LLC owner’s assets.
Note: In many real estate deeds, a lender will require the owners to sign a personal guarantee. A personal guarantee is an unsecured written promise from the LLC owner to pay the debt if the LLC does not pay. This is almost always a practical necessity for getting a loan. When an owner signs a personal guarantee, the LLC will not protect that owner’s personal assets from liability for the LLC debt. The LLC will continue to provide protection from other creditors.
Asset Protection Benefits of LLCs
As discussed above, LLCs protect a business owner from the debts of the business. But LLCs can also protect the business assets from debts of the owner.
This protection comes through a mechanism known as a charging order. Under the law of many states, a creditor that obtains a judgment against an LLC owner can only obtain a charging order. The charging order entitles the creditor to any distributions made from the LLC, but it does not give the creditor the ability to reach the underlying assets of the LLC or otherwise participate in the management of the LLC.
The purpose of a charging order is to protect the other owners from business disruption caused by one owner’s personal liabilities. This rationale breaks down if there is only one business owner. Some states do not extend charging order protection to single-member LLCs, and there are Bankruptcy Court cases that hold that charging order protection does not apply in that context. Charging order protection is strongest when there are multiple members of the LLC.
Flow-Through Taxation of LLCs
LLCs provide flow-through taxation. This means that all of the income of the LLC is reported on the tax returns of the owners of the LLC. The LLC itself is not a taxpaying entity.
To best understand this benefit, it is helpful to contrast LLC taxation with the way that C corporations are taxes. A C corporation is a separate taxpayer. When a C corporation receives income, the corporation pays tax on that income. Then, when the C corporation distributes the income to the owners in the form of dividends, the owners pay tax on the same income. This means that all income is effectively taxed twice—the C corporation pays tax when the income is earned, and the same income is taxed again when it is distributed to the shareholders. LLCs avoid this double taxation by eliminating the entity-level tax. Instead, all of the income of the LLC is taxed directly to the owners when it is earned.
This discussion assumes that the LLC is classified as either a partnership or a disregarded entity. These are the default classifications for a multi-member LLC and single-member LLC, respectively. But one of the benefits of LLCs is the ability to change the tax classification. An LLC that chooses to do so can file an election to be treated as either a C corporation or S corporation. This makes it easy to switch between tax structures if another tax structure is more efficient.