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Single Member LLCs - Beware of the Disregarded Entity.
By Jim Crimmins, President Traders Accounting
Asset protection planning is only one of several very important issues that should be considered when choosing the appropriate business entity. However, if asset protection is one of the principal goals of the planning process, a single-member LLC should be avoided. In the recent bankruptcy case of In re Albright, 291 538 (Bankr. D. Colo. 2003), the debtor filed a Chapter 13 petition under the Bankruptcy Code, which was later converted to a Chapter 7 liquidation. One of the assets of the bankruptcy estate was a single-member LLC of which the debtor is the sole member and manager. The trustee filed a motion to allow the trustee to take whatever action was necessary to liquidate the single-member LLC and its assets. Specifically, the Chapter 7 bankruptcy trustee' argued that because the debtor was the sole member and manager of the LLC at the time she filed bankruptcy, the Chapter 7 trustee had effectively stepped into the shoes of the debtor. Hence, the Chapter 7 bankruptcy trustee had become the "substituted" sole member of the LLC and, as such could appoint new managers and/or vote to liquidate the LLC in its entirety. The debtor argued that the sole remedy of the trustee was to seek a charging order against distributions made on account of her LLC membership interest as set forth in section 703 of the Colorado Limited Liability Company Act, Col. Rev. Stat.§7-80-703.
The court agreed with the trustee's position and held that the debtor's bankruptcy filing effectively assigned her entire membership interest in the LLC to the bankruptcy estate pursuant to 11 U.S.C. §541 and that the trustee thereby obtained all of the debtor's rights including the right under Colorado law to control the LLC management. Since the trustee became the sole member of the LLC upon the debtor's bankruptcy filing then the trustee controlled all governance of the LLC including all decisions related to a liquidation of the LLC's assets.
Interestingly, notwithstanding it’s finding the court admitted that under Colo. Rev. Stat.§7-80-702 the result would have been different had there been other non-debtor members in the debtor LLC: "Where a single member files bankruptcy while the other members of a multi-member LLC do not, and where the non-debtor members do not consent to a substitute member status for a member interest transferee the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled". In re Albright, supra, at 540 n.7.
This decision underscores the importance of incorporating multiple members in an LLC if asset protection is an important goal in forming the entity. Moreover, as implied in Albright, the interest of the members should be more than de minimis.
From the standpoint of using a single member LLC (SMLLC) as a trading business we must first examine the reason you would want to trade as a business and in an entity. I caution you to remember that there is no cookie cutter approach to Tax Efficient Tradingă. You should visit with a Traders Accounting professional to ascertain which entity if any will give you the most benefit.
Traders Status (The IRS calls this Trader in Securities) is a position that a qualifying active trader can use when filing their taxes to indicate to the IRS that they are in the business of trading. There are several qualifications to consider prior to filing as a Trader in Securities. These can be found in IRS Pub 550 around page 70. When you file a return as a Trader in Securities you are filing as a sole proprietor, your expenses will go on Schedule C and your trades or income on a separate form (depending upon what type of trading you are doing. This business designation gives you the right to deduct all of your business expenses and the privilege of using the business designation to fund such things as retirement accounts. Unfortunately what a trader must do to qualify, as a “Trader in Securities” is a constant moving target, depending upon recent Tax Court cases, and believe it or not the personal position of any IRS auditor you might draw if you are audited. It is also believed by most tax professionals that self employed people are held to a much higher standard when the IRS reviews their tax return and are therefore audited at a higher rate than businesses set up as a formal entity. Remember as a Trader in Securities you are considered a sole proprietor! As a sole proprietor you also have zero asset protection. If you or one of your family were to have an accident of which your insurance company was only willing to cover part of the claims, judgment could be rendered upon you to pay the remaining liens. In order to do this you very well might have to forfeit your trading account. Not a good thought, however as you know we live in a litigious society and you never know when or why you might be the target of a law suit.
Traders who wish to deduct their business expenses, and obtain asset protection will generally look to the establishment of a formal entity to place their brokerage account and trading activities into. By doing so the trader creates a foundation in law about whether or not the business is a legitimate business to be recognized by the IRS, as well as the judicial system. The trader will also file a tax return that is appropriate for the entity they are using, and not a Schedule C for expenses as a Trader in Securities does. This formal entity might be an LLC, or a C corporation. Most traders would not consider a Sub S corporation because of the self-employment tax implications.
Let us examine an LLC. One of the attributes of the LLC is that the members can decide to be taxed as a corporation, a partnership, or a disregarded entity. In order to be taxed as a partnership it must have at least two tax payers as members to become the partners. In a tax court case two years ago it was established that generally a husband and wife even though they may file a joint return are considered as two taxpayers when it comes to setting up an entity and therefore can qualify as a partnership for tax purposes.
If the trader on the other hand wants to be a single member in the LLC, the fall back position of the IRS is that the LLC, for tax purposes, is considered to be a disregarded entity or a sole proprietor. This gets the trader right back to the position of a trader in securities, or sole proprietor with all of the audit dangers, all of the ever-changing rules of what constitute a trader in securities, and all of the litmus tests necessary to qualify as a trader in securities.
At Traders Accounting we do not generally believe that a single member LLC benefits many traders, if you feel that it offers benefits to you; think about remaining as a trader in securities, or sole proprietor. This will save you the time and expense of setting up an entity. We would like to offer a free service to you; go here and download our free confidential Tax Action Plan questionnaire. After filling it out and sending it to us we will prepare absolutely free a 40-page report for you that will make recommendations as to what would be the most Tax Efficient Tradingă method you could use. You will also qualify for a free 30-minute consultation with one of our professionals to answer any questions you might have. Don’t hesitate download and fill out the questionnaire today.
Single Member LLCs - Beware of the Disregarded Entity.
By Jim Crimmins, President Traders Accounting
Asset protection planning is only one of several very important issues that should be considered when choosing the appropriate business entity. However, if asset protection is one of the principal goals of the planning process, a single-member LLC should be avoided. In the recent bankruptcy case of In re Albright, 291 538 (Bankr. D. Colo. 2003), the debtor filed a Chapter 13 petition under the Bankruptcy Code, which was later converted to a Chapter 7 liquidation. One of the assets of the bankruptcy estate was a single-member LLC of which the debtor is the sole member and manager. The trustee filed a motion to allow the trustee to take whatever action was necessary to liquidate the single-member LLC and its assets. Specifically, the Chapter 7 bankruptcy trustee' argued that because the debtor was the sole member and manager of the LLC at the time she filed bankruptcy, the Chapter 7 trustee had effectively stepped into the shoes of the debtor. Hence, the Chapter 7 bankruptcy trustee had become the "substituted" sole member of the LLC and, as such could appoint new managers and/or vote to liquidate the LLC in its entirety. The debtor argued that the sole remedy of the trustee was to seek a charging order against distributions made on account of her LLC membership interest as set forth in section 703 of the Colorado Limited Liability Company Act, Col. Rev. Stat.§7-80-703.
The court agreed with the trustee's position and held that the debtor's bankruptcy filing effectively assigned her entire membership interest in the LLC to the bankruptcy estate pursuant to 11 U.S.C. §541 and that the trustee thereby obtained all of the debtor's rights including the right under Colorado law to control the LLC management. Since the trustee became the sole member of the LLC upon the debtor's bankruptcy filing then the trustee controlled all governance of the LLC including all decisions related to a liquidation of the LLC's assets.
Interestingly, notwithstanding it’s finding the court admitted that under Colo. Rev. Stat.§7-80-702 the result would have been different had there been other non-debtor members in the debtor LLC: "Where a single member files bankruptcy while the other members of a multi-member LLC do not, and where the non-debtor members do not consent to a substitute member status for a member interest transferee the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled". In re Albright, supra, at 540 n.7.
This decision underscores the importance of incorporating multiple members in an LLC if asset protection is an important goal in forming the entity. Moreover, as implied in Albright, the interest of the members should be more than de minimis.
From the standpoint of using a single member LLC (SMLLC) as a trading business we must first examine the reason you would want to trade as a business and in an entity. I caution you to remember that there is no cookie cutter approach to Tax Efficient Tradingă. You should visit with a Traders Accounting professional to ascertain which entity if any will give you the most benefit.
Traders Status (The IRS calls this Trader in Securities) is a position that a qualifying active trader can use when filing their taxes to indicate to the IRS that they are in the business of trading. There are several qualifications to consider prior to filing as a Trader in Securities. These can be found in IRS Pub 550 around page 70. When you file a return as a Trader in Securities you are filing as a sole proprietor, your expenses will go on Schedule C and your trades or income on a separate form (depending upon what type of trading you are doing. This business designation gives you the right to deduct all of your business expenses and the privilege of using the business designation to fund such things as retirement accounts. Unfortunately what a trader must do to qualify, as a “Trader in Securities” is a constant moving target, depending upon recent Tax Court cases, and believe it or not the personal position of any IRS auditor you might draw if you are audited. It is also believed by most tax professionals that self employed people are held to a much higher standard when the IRS reviews their tax return and are therefore audited at a higher rate than businesses set up as a formal entity. Remember as a Trader in Securities you are considered a sole proprietor! As a sole proprietor you also have zero asset protection. If you or one of your family were to have an accident of which your insurance company was only willing to cover part of the claims, judgment could be rendered upon you to pay the remaining liens. In order to do this you very well might have to forfeit your trading account. Not a good thought, however as you know we live in a litigious society and you never know when or why you might be the target of a law suit.
Traders who wish to deduct their business expenses, and obtain asset protection will generally look to the establishment of a formal entity to place their brokerage account and trading activities into. By doing so the trader creates a foundation in law about whether or not the business is a legitimate business to be recognized by the IRS, as well as the judicial system. The trader will also file a tax return that is appropriate for the entity they are using, and not a Schedule C for expenses as a Trader in Securities does. This formal entity might be an LLC, or a C corporation. Most traders would not consider a Sub S corporation because of the self-employment tax implications.
Let us examine an LLC. One of the attributes of the LLC is that the members can decide to be taxed as a corporation, a partnership, or a disregarded entity. In order to be taxed as a partnership it must have at least two tax payers as members to become the partners. In a tax court case two years ago it was established that generally a husband and wife even though they may file a joint return are considered as two taxpayers when it comes to setting up an entity and therefore can qualify as a partnership for tax purposes.
If the trader on the other hand wants to be a single member in the LLC, the fall back position of the IRS is that the LLC, for tax purposes, is considered to be a disregarded entity or a sole proprietor. This gets the trader right back to the position of a trader in securities, or sole proprietor with all of the audit dangers, all of the ever-changing rules of what constitute a trader in securities, and all of the litmus tests necessary to qualify as a trader in securities.
At Traders Accounting we do not generally believe that a single member LLC benefits many traders, if you feel that it offers benefits to you; think about remaining as a trader in securities, or sole proprietor. This will save you the time and expense of setting up an entity. We would like to offer a free service to you; go here and download our free confidential Tax Action Plan questionnaire. After filling it out and sending it to us we will prepare absolutely free a 40-page report for you that will make recommendations as to what would be the most Tax Efficient Tradingă method you could use. You will also qualify for a free 30-minute consultation with one of our professionals to answer any questions you might have. Don’t hesitate download and fill out the questionnaire today.