Notes & Comment
Vol. 2005, No. 4
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Business Entities
Single Member LLC: "Not a Personal Piggy Bank"
Sometimes, with the help of providence and good judging, a seemingly complicated case of corporate, tax and bankruptcy law can teach very basic lessons. With respect to business law and entity formation, In re KRSM Properties, LLC, BAP Nos. CC-04-1113-KMaN, CC-04-1191 KMaN (U.S. Bankruptcy Appellant Panel of the Ninth Circuit, December 1, 2004) is one such case.
The Facts
People who are operating as sole proprietors or starting from scratch typically decide to incorporate or form some other legal entity for tax reasons or to protect them from business liability -- or both. We don’t know why Michael and Stella Gilliam formed their limited liability company (LLC), but we do know what happened later.
They created a "single member" LLC under California law. A single member LLC means that they were sole owners of the company. The Gilliams designated the LLC as a "pass through" entity that was not taxed, much like a partnership or a "subchapter S" corporation. Through the LLC, they purchased commercial real estate.
At some point, the couple incurred substantial personal tax liabilities. At some point, the LLC sold the real estate for a net gain of some $150,000. To satisfy their personal tax obligations, the Gilliams, at some point, used the LLC’s proceeds from the sale of that real estate to pay their personal tax obligations. Finally, at some point, the Gilliams and the LLC ran into financial difficulty and all three filed for bankruptcy. The issue was whether the Gilliams were entitled write checks from LLC accounts to pay their personal taxes; to use proceeds from the sale of commercial property owned by the LLC to meet their personal financial obligations.
What Exactly Is An LLC?
It’s a rare court decision -- much less one stitching together corporate, tax and bankruptcy law issues -- that produces a basic set of legal principles in simple and straightforward language. Yet, this is what the Bankruptcy Appellant Panel accomplished and what they taught about California LLCs in In re KRSM Properties, LLC (citations are omitted):
- "California authorizes the LLC form of business organization."
- "The LLC is a hybrid business entity that consists of one or more "members" who own membership interests and that has features both of partnerships and of corporations."
- "The LLC is a distinct legal entity with a separate existence from its members and with all the powers of a natural person in carrying out its business activities."
- "The LLC can [among other things] transact business, sue and be sued, incur liabilities, and own and deal in property in its own name."
- "The LLC may engage in any lawful business activity other than in the banking, insurance, and trust company businesses."
- "The LLC's members (i.e. owners) have no direct ownership interest in specific LLC property."
- "Nor, consistent with general corporate shareholder liability law, do the members have personal liability for any debt of the LLC solely by virtue of being a member of the LLC, the acts of the LLC being deemed independent of the acts of its members."
- "Members can, however, actively participate in management of the LLC."
- "Correlatively, members of LLCs cannot assert causes of action derived from causes of action owned by the LLC."
- "A tax advantage in the LLC form of business is the ability, assuming proper organization, to avoid the double taxation of corporate income and shareholder dividends by having an eligible LLC elect to be treated as a partnership for federal tax purposes without being subject to as many restrictions as "subchapter S corporations.""
- "Moreover, a "single-member" LLC, such as [the LLC involved here], has the option of electing either to be taxed as an association (i.e., a corporation) or, like a sole proprietorship, to be disregarded as an entity separate from its owner. If the single-member LLC elects to be taxed as a sole proprietorship, the LLC itself does not pay taxes and does not have to file a separate tax return. Rather, the single member reports all LLC profits or losses on a personal tax return as if the business was a sole proprietorship."
Business Entities Mean Something
Treating the LLC as a sole proprietorship, the Gilliams wrote checks from the LLC account to pay personal tax obligations. When the LLC’s bankruptcy trustee tried to recover those payments from the IRS and California’s Franchise Tax Board, the Gilliams argued that their single member LLC’s pass-through (non-taxpaying) status essentially converted the LLC into a sole proprietorship which they could use to pay personal taxes. Not so fast, the court ruled. The LLC is a separate legal entity which owned both the property that was sold and the proceeds generated from that sale. The Gilliams could not appropriate LLC assets to pay personal debts when the LLC’s creditors had made claims against those same LLC assets in a bankruptcy proceeding.
As the court concluded, "[A]n LLC is not a personal piggy bank and, under the [bankruptcy laws], payment of the owners' personal income taxes must first give way to payment of the LLC's creditors."
Conclusion
Complicated circumstances often result in simple truths. People tend to incorporate or set up LLCs to shield the owners from business liability, and courts frequently are asked by others to ignore those legal entities and hold the owners personally accountable for business liabilities (so-called "piercing the corporate veil"). In re KRSM Properties, LLC turns that principle around. There, the bankruptcy court was asked by others to respect the legal entity -- to not permit use of company assets to meet personal obligations of the owners. The taxpayers apparently used the "corporate shield" selectively, ignoring the entity’s status to pay personal bills. The court held that taxpayer-members could not raid the LLC cookie jar -- at least when that would harm third party creditors of the bankrupt LLC.
This outcome is not unusual in a bankruptcy context, where one goal is to protect the estate for the benefit of creditors. But the case also teaches a simple truth that legal entities mean something.
© Matthew Joseph 2005. Law Offices of Matthew Joseph, San Mateo, California, practices in the areas of intellectual property licensing, commercial real estate leasing, and corporate and business transactions. No legal advice is intended by the information provided herein and recipients should independently consult counsel before taking any action related to this subject matter.