A single-member LLC is an attractive option for a sole proprietor who wants the liability protection provided by an LLC. The LLC offers flexible management options, typically less paperwork than a corporation, simplified income taxation, and liability protections.
Here are the main elements at work in a single-member LLC in California.
California's Franchise Tax Board says that it treats an LLC and its owners for income tax purposes in the same manner the LLC is treated for federal tax purposes. This means that for both state and federal income tax, a single-member LLC will be treated as a sole proprietorship unless it elects to be taxed as a corporation.
For the small business owner this is an important saving of time and labor, being able to file taxes as a sole proprietor receiving purely personal income (continuing, for example, simply to use Form 1040 with the IRS). This is called being treated as a"disregarded entity" - you have a business entity but the entity is being disregarded and you're being treated just as a self-employed individual for income tax purposes.
There are additional taxation costs however, on the entity rather than its owner. California levies a minimum franchise tax of $800 per year on most business entities in the state. Your single-member LLC is required to file the business tax Form 568, which will also assess an LLC fee based on your gross receipts.
What about liability protection? The multi-member LLC is valued for its "charging-order" protection, whereby a litigant against the LLC or a creditor against a member can only win an economic interest from a member, not a management interest. So a creditor could be awarded a $50,000 judgment against an LLC member, but get nothing unless the LLC chooses to distribute money to that member.
These protections stem from the interests of the other members –if a management interest could be won by lawsuit, the other members could end up with a new member-manager forced on them without their vote. This partnership-based rationale for liability protection has held strong for multiple-member LLCs throughout time, but with a single-member LLC, this protection has come under fire in some venues across the country.
At least one court in the US has "pierced the veil" of entity protection and tied liability back personally to the owner of a single-member LLC. Some legal commentators have advised that a single-member LLC owner should take care to have an operating agreement and keep relevant company records, so as to provide less fuel for the argument in court that the LLC is a "sham". Currently, only an attorney can advise you reliably on the strength of your liability protection with a California single-member LLC in your particular situation.
Should a single-member LLC create an operating agreement? Here are some arguments in favor.
- California statutes provide a default situation for anyone forming an LLC, whether with single or multiple members. You should at least examine this default situation to see how well it fits your best interests, and use an operating agreement to change it if necessary.
- Practically everything can be changed in the operating agreement, which is a company record that costs nothing to create. The operating agreement creates your company governance, manages its capital and distributes its profits. This is precisely where the legal, tax and estate-planning professionals who advise you will do their work, now and in the future.
- It is always advisable to keep the business and personal spheres separated, certainly with finances and especially perhaps with liability issues, given the history of challenge to single-member LLC protection. Keeping good company records and a founding document can be a part of this effort.
- Just as a business plan is a good exercise in knowing your business and charting its course over time, so an operating agreement can perform a collateral function. You should be able to state in your business plan the reasons for choosing your business entity, and your operating agreement should reflect those reasons to your best advantage.
- Will your business survive your death or incapacity? The operating agreement can help ensure succession of your interest to your spouse, or help your family dispose of it unencumbered.
This introduction to the single-member LLC shows some of the possibilities as well as the unknowns. Nothing in this article can be construed as legal, tax or accounting advice. You should consult licensed professionals to give you specific advice for your situation.
Download our Free California LLC Operating Agreement for an attorney-drafted, sample Operating Agreement for a Single-Member LLC. Also see our SunDoc Guides to the Member-Managed LLC, the Manager-Managed LLC, How to Form an LLC in California and How To Form an LLC in California.