LLC -- Liability on distributions

Discussion in 'Off-Topic' started by WBahn, Oct 3, 2013.

  1. WBahn

    Thread Starter Moderator

    Mar 31, 2012
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    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.
     
  2. JoeJester

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    Apr 26, 2005
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    from http://www.nolo.com/legal-encyclopedia/llc-basics-30163.html

    Limited personal liability does not extend to everything ....

    I hope this helps WBahn.

    For Colorado specific info see http://www.nolo.com/legal-encyclopedia/lc-protection-members-personal-debt-colorado.html

    As far as your specific question, only the assets owned by the company, paid for by the members, is subject to whatever lawsuits. That would be equipment, furniture, bank accounts ... et al. I believe Oklahoma had a $50 per member liability as well. I'd have to confirm that, but that is what I remember when I was a member of an LLC in the panhandle of OK.

    That $7 Million would be gone to pay for that 10 million lawsuit. The slate will be clean. Early distribution of the 5 million might be reversed by the courts if it's determined it was distributed because of the lawsuit.
     
    Last edited: Oct 3, 2013
  3. WBahn

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    Thanks, Joe. I'll follow those links you included a bit later.

    Yes and no. I was aware that, like corporate liability protection, that there are exceptions to the protections offered by an LLC. I almost used the term "contract liabilities" but decided not to. For this discussion, let's assume that there is no issue of personal liability and we are only talking about a liability that is the LLC's alone.

    So, if I understand things correctly, if I am a member of an LLC and I own 10% of it, then if I am sued personally (for something that is unrelated to the LLC in any way) my share of the LLC is exposed to the personal liability and there is nothing I can do to prevent that. It is just as though I owned 10% of the stock in a corporation -- that is a personal asset that can be attached against personal liabilities. Correct?

    That being the case, it would seem that there is absolutely no advantage to not distributing every penny of an LLC's profits once the "adequate funding" requirement is met. You are going to pay taxes on it all right away, anyway. You are going to lose it if you are sued on a personal basis anyway. But if you take it out as a matter of course (particularly if it is backed up by the LLC's Operating Agreement), then that removes as much money as possible from the LLC's books and shields it from exposure in the even the LLC is sued.

    Does that make sense or sound reasonable?

    So in that case, the Operating Agreement might say that each quarter all funds beyond those needed to pay for the following quarter's expected operating expenses plus an additional 90-days (or whatever) of expenses per the preceding year's closing books (or higher as approved by the membership) will be distributed to the members. It would probably also say in the Operating Agreement that major capital expenditures will be approved and funded by the members on a case by case basis and that, in the event that members are unable or unwilling to invest additional funds in proportion to their ownership percentage, that the ownership percentages will be adjusted accordingly.

    If this agreement were in place and say you have a lawsuit that drags on for several quarters. Is it reasonable to expect that you could continue distributing profits according to this agreement and not have them reversed since it would be hard to claim that the distribution was because of the lawsuit?
     
  4. WBahn

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    So I was just looking over the links you provided and saw that in the Operating Agreement that one thing that it can provide is a provision that members can draw money from the LLC "at will". So that would raise the question of whether or not a court would/could reverse a distribution made to a member as a result of the "at will" clause in the operating agreement. It would seem that the LLC is not electing to make a distribution for the purpose of moving assets out of the company, but merely honoring a request made by a member per the Operating Agreement. In fact, short of a prior court injunction prohibiting such distributions, it would seem that the LLC has the legal obligation to make them or be in breech of its Operating Agreement. But I don't know if it would raise an issue that the court might assign liability to the member that took the at-will distribution. Does it matter why a member requested a distribution that they are entitled to? Would doing so to shield the money from the lawsuit (and, again, the LLC is not making any such decision at all) constitute a action that would be considered negligent/fraudulent and make the member personally liable for the LLCs debts?
     
  5. killivolt

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    Jan 10, 2010
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    I think it depends on the Lawsuit, if an Injunction is filed and accepted by the court that would freeze all asset and holdings of the company. If distributions are made during that time it would be deemed and Indirect contempt of the courts wish's, now that individual responsible for payments and the individual who received payment is liable.

    However, this does not exclude ones responsibilities prior to an injunction, if payments were to be paid, these individuals would suffer the same liability, if the court should established that it was an act to limit penalty of the company's profits and further limit dividends to shareholders, in which shareholders who received dividends, pertaining to a lawsuit wherein as criminal intent is established, if such a lawsuit and preliminary injunction were filed due to personal injury. The court could find those parties of the corporation liable for such acts. Only if such acts can be established.

    Anything, prior is not deemed and should not be deemed liable to shareholders or their parties, no such liability can be establish without cause, such cause, pre-dates due cause. If just cause can be establish under personal injury in which an act of or deemed an act of criminal intent for which there is no insulation from liability and is in the hands of the court to render just cause to the injured person's or people. Allowing the court to seize all assets and money's held and pursue those responsible for such acts, to the extent of the law, from which there is no limited to pursue individual asset and money's held by Shareholders or corporate entities and individuals, personally responsible for such acts.
     
  6. WBahn

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    This starts out almost making sense and then plunges quickly and deeply into legal-babble that is indecipherable (at least to me).
     
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  7. killivolt

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    Which is why Lawyers and Law firms, or Government entities. Commit Legal Extortion nearly everyday in this Country and nobody hears of it. You and I have little ability to understand law let alone protect ourself, from harm. If these entities want to pursue a case and if they have the right attorney or Law-firm, we'er screwed. If Henry the Lawyer in town is without knowledge of Corporate Law, your screwed. Most egregious is the Government Practice of Legal Extortion.

    Case in Point:

    I was one of 25 founding members of a Corporation. However, under said Corp, I was viewed as a 1099 entity within the Corp. Further limiting me from prosecution, but the holdings of the Corp grew to 2 million in it's first quarter, if a Cooperations growth is exponential. growing to quickly, it will be investigated, as was this Case.

    I received, $10,000 paid over 3 months of the 1st Quarter. The Suit was filed along with Injunction freezing Company's Assets. To avoid further action an Appeal was made, but it was languishing and a percentage of suspected fraud was paid to the Government for which no Criminal Intent had been established.

    Forfeiture of the Corporations profits of 1 million was paid to the Government for which the Government, having to pursue do Cause and for which Just cause had not been established. However, the Corporation was found Liable and Panelized for Prompting the Government to pursue a Just Cause against the Corporation. e.g. Legal Extortion.

    The Corporation, lied to me and my organization, by passing the buck and reneged on Contracts with my Organization, 400 individuals. That's when I pulled the plug and picked up my bags. The Corporation is still in operation today, under a new name. Launching a new campaign, with residual profits from the former Corporation.

    Otherwise I would be speaking to as a self made Millionaire, but in my life that just doesn't happen, and if I were, I would have Lawyers and Law Firms nibbling at my heals. I'm quite content, for now.

    kv
     
  8. THE_RB

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    If the company at risk remains deep in debt, and pays it's profits etc to another company (preferably offshore) then the offshore company cannot be targeted for the debts of the company at risk.

    So if the company at risk gets sued, it is deep in debt, and can go bankrupt (which clears the majority of debt, a very profitable situation for the company) and also means the company is basically impossible to sue. Somebody considering a lawsuit would soon find the company is badly in debt, and their legal people would advise against suing.

    On the other hand, a small naive company full of cash profits and assets is absolutely ripe for being sued by anyone. :)
     
  9. JoeJester

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    I never thought about the "growing too fast" aspect. It is an anomaly in a lot of businesses, so I guess it would "catch the eye" of the government and they would pursue an investigation.

    I would suspect that if normal distributions are made on a schedule, and the distribution history shows that, any distribution before the court filing could be safe. The emphasis is on what they can prove and the LLC acted with a non-frivolous position.

    Mark Cuban's trial is still going on. He became the subject of insider trading because he withdrew from an internet company before the sale.
     
  10. WBahn

    Thread Starter Moderator

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    While I'm aware that operating deep in debt is one way to make the company very unattractive to lawsuits, it is anathema to how I operate. My company (a sole prop) has always operated debt free and any LLC I form will do the same. I'm willing to accept the increased lawsuit risk that that entails. In order to decrease the risk otherwise, I plan on having two or three LLCs. The first would be the one that interacts with the customers directly and, hence, the one that has the bulk of the revenue and the one that has the greatest risk getting sued. In order to keep the assets of this LLC to a minimum, it would own very little. Instead, it would lease equipment (everything from office space to computers to office furniture) from a second LLC. I would be very careful to maintain records on exactly what is leased and set the rates at reasonable levels. I would probably also not have the members work for the LLC directly, but instead contract with another LLC to provide contractors (namely me and my wife, at first) to manage and operate the business.
     
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  11. THE_RB

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    I'm not from the U.S. and don't know the details of your LLC system which probably changes year by year anyway.

    But, I think what you are proposing would likely be investigated, especially if your name was associated with all or most of those LLCs (which it needs to be or you can't control them). It would look like a deliberate papershuffling by an individual or small group.

    The key thing is to separate liability from assets, like separating a SMPS from an amplifier. So A holds the liability, B receives the assets. In between is a shield that allows the profits to go one way.

    What I suggested was basically a manufacturer/reseller as company A, paying large sums to investment company B. The "debt" is the sum company A owes company B.

    Like this;
    A has a product idea, wants to make and sell it. They borrow money from B, under contract to pay B a dividend of 70% of gross income from that product forever into the future.

    A owns all the liability. After a year A has made gross income 100k, but running costs etc is 40k. They owe B 70k, so pay 60k and keep a debt of 10k they still owe to B.

    So each year A gets a bit deeper in debt to B, this allows easy transfer of large sums from A to B later (paying off the "debt"). So if A has a windfall year, instead of paying tax on a large profit they just pay some of their debt to company B, eliminating the tax.

    Obviously company B receives the profit, so must pay tax, which is why company B would be an overseas company probably somewhere the tax rates are lower.
     
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  12. killivolt

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    You and RB, are talking really close to the same thing.

    But, live here in Utah, and people know how to make and keep, money, they are very good at it.

    There are a lot of individuals who maintain business as usual, while not possessing anything property, cars etc. Family, or Trusted members thereof, in name only, own all property of said business of individuals. They invest all their money's into income property etc. while maintaining a cash poor and asset free life. They pay all Taxes due, pay insurance or what ever of the Property Asset.

    While creating wealth, they pay a percentage to the holder, of said assets. Leaving, the business or Corp and said entity without income or very little. Anything filed against that individual or Corp, is thwarted, e.g. nothing to be gained. If there is a persuancy or a willing need to pursue, of Lawyer or Lawyers willing to pursue, nothing to be gained.

    They will have to establish in the eye's of the court, which is blind to the idea of that same of shore or your 2 corp inception, even more so to the idea of a Family member who is innocent in the eyes of the Law, that should be investigated and held liable. But there is a cost, which is a cash deal and no record is obtained or revealed, a loss do to a taxable right off, will be lost, but it does insulate all and even those who created the Corp.

    Only if there is criminal intent of the business, then all bets are off.

    They do it all the time and do it so well, it confounds and disrupts any further action.
     
    Last edited: Oct 3, 2013
  13. JoeJester

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    RB's scenario is a viable one, and would draw attention.

    If you have three LLCs, each should be able to stand on their own. If your leasing office equipment or whatever, you should have more than one customer and pursuing multiple customers offering the same product and services to them. This shows your intent to make a profit and not shuffle money around. Someone must be working enough hours at each company to ensure the company is a business and not a hobby.

    The U.S. still wants to know your worldwide income as it all is subject to tax. There are foreign exclusions available for taxes paid .

    Bear in mind with each company comes a separate set of records. Separate tax filings and you receiving a K-1 from each.

    Professional Gamblers must put in the hours also to claim that as their business. I'm sure those that play pool (billiards) professionally, put in enough hours per week between practice and playing. Contemporaneous records of events keep the IRS satisfied.
     
  14. WBahn

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    Mar 31, 2012
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    My understanding is that the scheme I proposed is not only legal but very common. I know several companies (worked for one for 14 years and was a member in the LLC) in which the primary owner also owns a separate LLC that acts as a holding company. The holding company owns the building and the main LLC leases the building from the holding company.

    The notion of leasing myself to the company is something I hadn't thought of, but was recommended by several of the sites on LLC structuring that I was looking through last night. I don't think there would be any eyes raised here, though it is something I would sit down and talk to a knowlegeable attorney first.

    I do see what you are saying about having the company with exposure be in debt to another company, both of which are owned by me and my wife. I'm not likely to get into doing any kind of overseas company arrangements (though it would be nice to have that problem someday).
     
  15. WBahn

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    Isn't this the case only if you are reporting losses? If you are reporting profits each year, then don't you have the presumption of profit seeking?

    Of course, we are talking two different issues -- tax issues and running afoul of the IRS and legal issues and shielding assets from lawsuits. My gut feel (never a reliable indicator on anything like this) is that, from a asset protection standpoint, it shouldn't matter whether the entity that the LLC is leasing equipment from is another LLC, a corp, a sole-prop, or an individual. As long as the terms of the lease are reasonable, the asset itself and the funds expended to pay the lease should be off the table in terms of assets for lawsuits.

    In my particular case, I've been leasing equipment to the company I used to work for (way back when they were a Corp and not an LLC) since 1996 and have been doing so continuously and continue to do so. My plan is to use the same lease terms that I have with that company with the new LLC, with parameters that might be different based on class-life of the items leased but all in a very reasonable way.

    In fact, this dovetails a couple of goals. Back when I started doing side jobs the primary incentive wasn't to make a bunch of money to live on, but to earn money to buy equipment to build up my lab capabilities. To that end, I generally bought equipment each year that took my profits down between $0 and $400 (usually tried to get it near the $400 but not over). I was originally concerned that this pattern would raise red flags for an audit, but I've talked to a few CPAs and also a couple of IRS agents and someone in their legal division and all of said that not only will this not raise red flags, but that it is a very common and reasonable business strategy for sideline businesses. They said it could raise questions if I didn't have other sources of income sufficient to live on.

    I still want to continue doing this, so my thinking is like this:

    Financial LLC -- the main entity that will (hopefully) generate the bulk of the revenue.

    Technical LLC -- basically the sideline sole-prop that I've run for over two decades (at times being my primary income stream).

    Holding LLC -- the entity that will own the property and lease it to the other two, both long-term and short-term.

    Consulting LLC -- the entity that will contract out my services to the other two on a task-based basis.

    All four actually already have external customers that I do things for that would be placed with the appropriate entity and I would have no qualms doing a bit of advertising offering to do it for others as well, though I doubt I would be competitively priced and so that portion of the business would be small.

    Now, I'm not wedded to this idea. In fact, it's undergone a bit of revision as I've typed this.
     
    Last edited: Oct 3, 2013
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  16. killivolt

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    However, now comes the hard part of hrs worked. 27.5 is limit for an hourly worker and is subject to insurance benefits, as long as this will not cross the streams e.g. (Ghostbusters)

    It might not, blow up the Universe.
     
  17. killivolt

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    Now that I think of it, yes it might. But, usually it comes with a business making profit and somehow falls, and continues to do business. This rise and fall causes a knee jerk reaction, from the IRS. Then you will be do for an audit. But, if all is hunky dory, and your records are clean.

    Mark my words, you will pay at least $500 for the IRS to audit you.

    This is their minimum charge, and will find any and all reasons they can to make you pay. If not they will dig in with a fury. Until they get something.

    If not, you'll walk calmly out while they grinch in anger.

    kv

    Edit: I suddenly remember, my old age. The IRS of old, would pursue until they having fully consumed all assets, to the point of which they rendered in judgement any and all individuals. Who, trying to prevail against the government of access to and from which allows the law to obtain taxes, rights to establish or rights or privilege to garner, said compensation under the law. In the end we want the money either pay or be imprisoned, or both.

    Most did both and paid the ultimate sacrifice. The IRS of old, is coming back with a vengeance.
     
    Last edited: Oct 3, 2013
  18. WBahn

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    This isn't a problem for us. We need to have health insurance (ObamaCare totally beside the point) and so we either have it through another employer or we need to provide it via our self employment. Right now I have good insurance through the school, but before that I hired my wife specifically so that we could qualify for small group health insurance. She opted to take it and I waived it because I then had insurance through my spouse. Since 50% of all eligible employees had to participate, the fact that my wife participated and I didn't meant that we met the requirement. The hard part was finding enough stuff for her to do to justify 30+ hours a week. Right now we wouldn't be able to, so she is still an employee of the company but is on unpaid leave with minimal benefits -- which is how we want it so that we can ramp it back up easily if I am unable to get a permanent position with the school.
     
  19. WBahn

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    My business has had years in which it made a couple hundred dollars profit surrounding by years (sometimes just one or two at a time) when it made fifty or sixty grand in profit. It was all the ebb and flow of consulting. Some years I wasn't looking for much consulting work because I was busy with regular employment. Other years me "regular employment" was structured as a contracted position through the sole prop. It bounced all over the place. Never a hint of an audit. I even had a couple of years in which I claimed significant losses because of home office expenses and equipment depreciation in a year in which I had almost no consulting income because I was working overtime in an employee setting. The losses were limited in some categories, which just meant that they were carried forward to the next year. But everything when without a hitch. I was always very careful to show a profit in at least three of the prior five years (counting the one being filed). There were a couple of times when I elected not to claim some expenses that I otherwise could, such as home mortgage interest and property taxes on the home office, and instead carried those on the Schedule A in full. I specifically got guidance from the IRS on that one and they said that I can split up those expenses as I see fit as long as I do not claim more against the business than I am allowed and as long as each dollar of expenses is claimed at most one time. So a couple of times I claimed just enough of the expenses that that could be counted either way against the business to reduce my profit to $399 and claimed the rest on the Schedule A. In most years, I avoided doing this, however, because I try to not itemize deductions and, instead, take the standard deduction while putting otherwise itemizable deductions against the business as much as possible.
     
  20. killivolt

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    You will fall outside any reason to show cause, but you will need diminish any or all payments. If it will exceed her income by a percentage within the law, it will become precedence. Therefore, that will lead to weather she is employed or is a contractor. This limit must not be exceeded.
     
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