Governor Davis recently signed Assembly Bill 831, authorizing the use of California single-member limited liability companies beginning January 1, 2000. This legislation provides California business owners and investors with increased flexibility and cost savings. It is no longer necessary to form a Delaware single-member LLC and then qualify the entity in California as a foreign organization.
What Is A Single-Member LLC?
A limited liability company is a business organization that provides its owners corporate-type limited liability protection, but without the drawbacks of corporate taxation. An LLC is easily formed by filing articles of organization with the Secretary of State and executing an operating agreement.
From an income tax perspective, a single-member LLC is disregarded as a separate entity; instead, all of its assets and liabilities are treated as belonging to its single member. A single-member LLC provides flexibility by allowing its owner to transfer assets and liabilities to and from the LLC without incurring income tax. This flexibility is not available to a shareholder of a corporation.
Common Uses Of Single-Member LLCs
Real Estate Finance. Single-member LLCs are commonly used in real estate financing transactions where the secured lender requires a “bankruptcy remote” entity. In many cases, the lender will not make the loan unless the property is owned by a single-member LLC.
Liability Isolation. Business owners and real estate investors are using LLCs for liability isolation by transferring riskier investments or lines of business to a newly-formed single-member LLC to protect other investments or lines of businesses from potential liabilities arising from the riskier investments. For example, real estate partnerships have found it beneficial to transfer each of their major properties to separate single-member LLCs so that a liability from one property will not “infect” any of the other properties.
1031 Like-Kind Exchanges. Single-member LLCs are also useful in real property like-kind exchanges. Recent IRS rulings allow the owner of the LLC to transfer his LLC ownership interest directly to the buyer. It is not necessary to remove the property from the LLC before making the transfer. This transaction form may save substantial documentary transfer taxes.
Corporate Subsidiary Alternative. Corporations frequently form corporate subsidiaries to isolate liabilities. Now,corporations can use single-member LLCs to achieve many of the same objectives but without the complications and pitfalls associated with “consolidated tax returns.”
Reduce Sales and Documentary Transfer Taxes. In the proper circumstance, single-member LLCs can be used to reduce transfer taxes which might otherwise be incurred in merger and acquisition transactions. Under California law, sales tax is generally imposed on the sale of tangible personal property. California, unlike many other states, does not provide for a sale-of-business exemption. But, sales tax generally does not apply to the sale of intangible assets, such as stock of a corporation or a membership interest in an LLC. As a result, the strategic plan of a business should consider conducting business activities in a separate LLC to allow for the future disposition of unwanted assets or the sale of the business to an acquirer. Also, California law allows counties and cities to impose documentary transfer taxes when title to real property is transferred. In some instances, documentary transfer taxes can be substantial. These taxes may be avoided if the seller transfers its interest in the single-member LLC, rather than the real property, to the buyer.
Estate Planning. From an estate planning perspective, it is important to consider the use of a single-member LLC for holding real property located in other states to avoid an ancillary probate proceeding in a foreign jurisdiction.
Cautions And Limitations
Not All Businesses Qualify. Unlike the garden- variety corporation, an LLC cannot be used by businesses and professions regulated by the California Business & Professions Code (e.g., accountants, brokers, contractors, etc.). This, however, does not exclude the use of an LLC by a licensed business for holding assets or separate lines of businesses which are not required to hold a special license.
California Taxes. Unlike federal law, California charges a small “toll charge” for using an LLC. In this regard, California charges an annual $800 minimum
franchise “tax” and imposes a gross receipts tax based upon a sliding scale from $865 (receipts greater than $250,000 but less than $500,000) to $7,785 (receipts greater than $5,000,000).
Negotiation Traps. Be extremely careful in negotiating with a secured lender who requires a single-member LLC as part of a financing transaction. Some lenders require the right to co-manage the LLC or request a membership interest on the premise that they must participate in order for the LLC to be “bankruptcy remote.” However, the IRS has allowed only certain minimal participation by lenders without causing the LLC to lose its status as a “disregarded entity” for tax purposes.
Additionally, practical business issues must be addressed before blindly forming an LLC in connection with a real estate finance transaction. This is especially true with “conduit lenders” (e.g., REMICs) who often impose terms that significantly hinder future transfers of the real property. In addition, the owner of an LLC must be careful to maintain the integrity of the entity by maintaining separate bank accounts, separate accounting records, and liability insurance so that a creditor cannot “pierce the liability veil” by claiming that the member operated the LLC as its alter ego.
Beware of Simple Form Agreements. Many operating agreements for single-member LLCs are very perfunctory and non-comprehensive. As a result, these agreements often need substantial revisions before a second owner is brought on board.
Recent Tax Developments
Recently issued IRS revenue rulings allow for the conversion of a single-member LLC into a multiple- member LLC or vice versa on favorable terms, but numerous pitfalls associated with a “conversion” should be carefully addressed before embarking on these transactions. For example, the admission of a new member will cause a “debt shift” which may result in taxable income to the original member.
Downey Brand’s Business Department
Practice groups within the Business Department advise and represent clients in connection with a broad range of business and corporate matters. We provide business counseling to companies of all sizes, from formation through every step of corporate growth. We maintain expertise in the areas of business and corporate law, tax law, financial institutions, real estate and construction law, securities and franchise law, intellectual property, antitrust and trade regulation, bankruptcy, estate planning and administration, and employment law.