Why a Colorado Single Member LLC Can be a Disaster

Many people form a single member LLC for their business or real estate holdings, assuming they are protected in this structure.  Generally speaking, a Colorado single member LLC owned by an individual as the sole member is not a good idea.

Tax Classification

First, a single member LLC is disregarded for federal income tax purposes by default.  This means an individual running an operating company would report his income and expenses on his personal return, Schedule C.  A Schedule C return is audited at a much higher rate, than say an S corporation return.  Further, your profits are subject to self-employment tax, which can be avoided to some extent with an S corporation.  Thus, most CPAs will advise an operating company to file an S corporation over a single member LLC.  If you already have a single member LLC, you can convert that entity for tax purposes to a corporation by filing IRS form 8832.

Liability

For liability purposes, a single-member LLC theoretically has the same protection as a single-owner corporation.  However, most people who file for an LLC using a cheap filing service neglect to operate their single member LLC as it should – by doing an operating agreement, keeping clean books & records, and following corporate formalities.  Thus, if you formed a single member LLC to get away from the formalities of a corporation, you probably didn’t follow the formalities of an LLC either.  If this is the case, and you get sued, the plaintiff’s attorney will ask the court to set aside the LLC veil (also know as “piercing the corporate veil”) to hold you personally liable.

Asset Protection

One of the great features of an LLC is that a judgment creditor of a member has a limited remedy against  the assets of the debtor held in an LLC.  State law in most states limits the judgment creditor to a “charging order” against the debtor’s LLC membership interest, which means the creditor only gets what the member was getting in distributions.  The creditor cannot vote out the debtor as manager and vote himself in to liquidate the assets of the LLC.

However, this “charging order protection” may not apply if the debtor is the sole member of the LLC.  Several courts have ruled this way, bringing into question the protection a single member LLC affords the member.  Thus, if you own valuable assets in your LLC (and it is not an operating company), make sure it has at least two members, in which case it would be a partnership for tax purposes and provide asset protection for the members.

If you already have a single member LLC and want to convert it to an S corporation or multi-member LLC, please contact our office for more information.