So here's a question that I've been puzzling over for some time and can't find any good information on. Hopefully someone here, perhaps JoeJester, has some experience that has provided at least part of an answer.
My question has to do with asset protection associated with an LLC. Note that, specifically, I am not talking about taxation issues, but with liability exposure. Also note that I am talking about U.S. liability concerns -- though hearing about the situation in other countries would be interesting.
In general, an LLC affords a similar level protection to its members as a C- or S-corporation from liabilities. Thus, if the LLC gets sued the exposure is generally limited to the LLC's assets.
But that is where the question comes in. How do you determine what is and what is not an asset of the LLC, particularly when it comes to profits? In a corporation -- as I understand it -- retained earnings remain an asset of the corporation and are exposed to the liabilities of the corporation. But once earnings are paid out in dividends, they are no longer an asset of the corporation and are now an asset of the shareholder that received them. Thus, they no longer stand good for the corporation's liabilities.
But LLC's are pass-through entities. In a corporation, shareholder doesn't pay any taxes until they receive the dividends. The shareholder has no claim on any of the retained earnings and the corporation paid any taxes that were due on them -- they are an outright asset of the corporation and thus stand good for its liabilities. In an LLC, however, the members are taxed fully on the profits in the year they are made whether the member receives a dime or not. To the extent that they did not receive the profits on which they were taxed, they have a direct claim on those funds.
So the question is whether or not the retained earnings (more accurately described as undistributed profits) held in an LLC's accounts exposed to liabilities resulting from a bankrupty or lawsuit?
If so, then what are the options to protect them? For instance, consider the following example.
A company, Widgets, LLC, has annual profits of around $1 million and has 10 members, all with an equal ownership interest. Normally the members receive $50,000 in distributions and the LLC retains the other $50,000 for operating capital and to fund equipment purchases for expansion. Of course, the members are paying taxes on $100,000 each year out of the $50,000 that they received. Say that this has been the case for ten years, so the company has retained a total of $5 million. Of that, it has spent $4 million of it on equipment and has the other $1 million sitting in its accounts. In addition, the company has $2 million in assets that were purchased with revenues and expensed with funds that were not included in the profits on which the members paid taxes. So the company has control of a total of $7 million.
The company now gets involved in a lawsuit and, if they lose, may well see a $10 million judgement. What fraction of that $7 million can be assigned in the judgement? Just the $2 million in assets that were purchased with pre-profit dollars? Or the full $7 million that it controls? If it's the full $7 million, then what happens if the company distributes the $5 million that it controls but that the members paid taxes on and have a direct claim on? Would that be something that the court can and would reverse?
The thing that would make the most sense -- and also be the easiest to keep track of -- is that at any given time Widgets, LLC has control of so much capital, be it equipment, supplies, money, investments, accounts receivables, whatever. It also has, at any given time, a liability to its members amounting to the total undistributed profits that have accumulated over time. In a very real sense, those undistributed profits are funds that the company does not own, but is merely managing. Thus, at any given time, the assets of the LLC should be the difference between what the company controls and value of what it is managing for its members, namely the undistributed profits.
But somehow I don't think that the laws (which vary from state to state since LLC law is a state issue) are that common sense.
My question has to do with asset protection associated with an LLC. Note that, specifically, I am not talking about taxation issues, but with liability exposure. Also note that I am talking about U.S. liability concerns -- though hearing about the situation in other countries would be interesting.
In general, an LLC affords a similar level protection to its members as a C- or S-corporation from liabilities. Thus, if the LLC gets sued the exposure is generally limited to the LLC's assets.
But that is where the question comes in. How do you determine what is and what is not an asset of the LLC, particularly when it comes to profits? In a corporation -- as I understand it -- retained earnings remain an asset of the corporation and are exposed to the liabilities of the corporation. But once earnings are paid out in dividends, they are no longer an asset of the corporation and are now an asset of the shareholder that received them. Thus, they no longer stand good for the corporation's liabilities.
But LLC's are pass-through entities. In a corporation, shareholder doesn't pay any taxes until they receive the dividends. The shareholder has no claim on any of the retained earnings and the corporation paid any taxes that were due on them -- they are an outright asset of the corporation and thus stand good for its liabilities. In an LLC, however, the members are taxed fully on the profits in the year they are made whether the member receives a dime or not. To the extent that they did not receive the profits on which they were taxed, they have a direct claim on those funds.
So the question is whether or not the retained earnings (more accurately described as undistributed profits) held in an LLC's accounts exposed to liabilities resulting from a bankrupty or lawsuit?
If so, then what are the options to protect them? For instance, consider the following example.
A company, Widgets, LLC, has annual profits of around $1 million and has 10 members, all with an equal ownership interest. Normally the members receive $50,000 in distributions and the LLC retains the other $50,000 for operating capital and to fund equipment purchases for expansion. Of course, the members are paying taxes on $100,000 each year out of the $50,000 that they received. Say that this has been the case for ten years, so the company has retained a total of $5 million. Of that, it has spent $4 million of it on equipment and has the other $1 million sitting in its accounts. In addition, the company has $2 million in assets that were purchased with revenues and expensed with funds that were not included in the profits on which the members paid taxes. So the company has control of a total of $7 million.
The company now gets involved in a lawsuit and, if they lose, may well see a $10 million judgement. What fraction of that $7 million can be assigned in the judgement? Just the $2 million in assets that were purchased with pre-profit dollars? Or the full $7 million that it controls? If it's the full $7 million, then what happens if the company distributes the $5 million that it controls but that the members paid taxes on and have a direct claim on? Would that be something that the court can and would reverse?
The thing that would make the most sense -- and also be the easiest to keep track of -- is that at any given time Widgets, LLC has control of so much capital, be it equipment, supplies, money, investments, accounts receivables, whatever. It also has, at any given time, a liability to its members amounting to the total undistributed profits that have accumulated over time. In a very real sense, those undistributed profits are funds that the company does not own, but is merely managing. Thus, at any given time, the assets of the LLC should be the difference between what the company controls and value of what it is managing for its members, namely the undistributed profits.
But somehow I don't think that the laws (which vary from state to state since LLC law is a state issue) are that common sense.