THE LIMITED LIABILITY COMPANY STRUCTURE: IS IT HEAVEN OR HELL?

By: Larry Goldsmith, J.D., C.P.A., C.F.F.A.

The limited liability company, or “LLC”, was first introduced in the State of Illinois in 1994 and is now well known and accepted in the market place and amongst professionals. Created to be a combination of a partnership and a corporation, the LLC grants its investors/equity holders, (known as “members”), limited personal liability for the obligations of the LLC company.

Lawyers and accountants have long touted the LLC as the perfect vehicle for asset protection. The LLC has become the vehicle of choice for estate planning, protection of family assets, and the preferred structure for incorporating businesses. However, recent court decisions, Internal Revenue decisions, and new creditor attacks/theories have limited the effectiveness of LLCs and may be making the corporate structure obsolete for some intended purposes.

How Does an LLC Work?
LLCs are different from corporations and one should not assume that both have the same attributes. For income tax purposes the LLC is treated in a manner consistent with that of a partnership where the individual partners report the earnings and losses of the LLC on their own personal tax return. Unlike the general partnership, where the individual partners have unlimited personal liability for the obligations of the partnership, the members in an LLC have, as the name implies, limited personal liability.

In an LLC and partnership, the partners/members do not receive W-2 earnings; rather the partner/member receives distributions of earnings and guaranteed payments. The distribution of earnings may not be equal to the profits of the LLC. Many LLCs have provisions in their operating agreements that provide the members of an LLC a minimum paid annual cash distribution to cover the income tax liability to be realized by the individual member for their prorated share of the LLC’s profits. These required distributions are known as ‘tax distributions’. When a member provides services for the LLC and is paid remunerations for services, these regular stipends for said labors are known as ‘guaranteed payments’.

The Changing World…
In our litigious society and in our uncertain times we attempt to limit our risks and protect our assets whenever possible. The law changes and we must be vigilant in protecting our interests. There is a need to review our business and personal planning regularly.

In a recent case in the United States Bankruptcy Court in the Northern District, the Court ruled that the income tax distributions paid to the members of an insolvent LLC were recoverable by the bankruptcy estate. The theory was that the member’s tax distributions were a violation of the Illinois Fraudulent Transfer Act. The fraudulent Transfer Act states that a violation occurs when, property is transferred to;

1. Hinder or delay in collection by a creditor, and/or
2. Transferred for less than fair value when the debtor was insolvent (constructive fraud).

The Court concluded that the discounted fair value of the assets was less than the company’s liabilities and therefore the LLC was insolvent. The working capital of the LLC when formed had less working capital than other companies in that same industry, therefore the Court gave credence that it was too thinly capitalized when formed. Finally, the Court found that the tax distribution payments to the members provided no value or benefit to the LLC.

For example; let’s say I formed a company, purchased assets and after one year, took the LLC’s earnings and reinvested the majority of it back into the company and only took out a tax distribution to cover my income tax obligation. Then the LLC gets sued. The fraudulent Transfer Act empowers creditors to recover property transfers for a four year look back period. So I could become personally liable to repay to creditors of the LLC the tax distributions or profit distributions that I received if the assets are less than the obligations of the LLC. Given that the fair market value of the assets I purchased is likely to have significantly decreased after the first year, it is highly probable that the LLC would be by definition insolvent, regardless if it had profits and was paying its obligations at the time the tax distribution was paid to the member.

Other Factors to Consider…
Under 805 ILCS 180/30-20(e), it is believed that a creditor of an individual who is a LLC member would be limited to a charging against the LLC to collect the obligation of the individual. The creditor of the member would be able to receive whatever distributions from the LLC that the member would be entitled to receive. Since many LLCs are composed of family members and friends it has been common for the LLC to play games so that the member’s distributions are reduced or eliminated thereby defeating and frustrating the collection efforts of the creditor. Many times the judgment creditor was forced into an unfavorable compromise of their unpaid obligation to collect a fraction of what was owed.
Creditors have interpreted the Illinois compiled statutes so as to permit the creditor who has a judgment lien to foreclose on the debtor’s LLC membership interest thus forcing the winding down of the LLC and sale of its assets to satisfy the debtor member’s obligations to the extent of his/her interests.

The Internal revenue Service has ruled that in a single member LLC, the single member is personally liable for all payroll tax obligations of the LLC, including non trust fund obligations, penalties, and interest. The IRS says that it ignores the LLC protections and holds the individual personally liable.

It is unsettled with the Internal Revenue Service if an inactive member in a LLC which operates a trade or business has earned income subject to self employment taxes. The distinction can result in an additional tax equal to the LLC’s profits times 15.65%.

LLCs are still useful planning tools but the usage of an LLC may need to be reviewed to determine if it has the intended value for your company. Sometimes establishing entities in other States whose law may differ is an alternative that one should investigate.

Larry Goldsmith can be reached at; larry@cjbs.com 847-580-5427

Alternatives to Bankruptcy: Business Survival in Tough Times

By: Larry Goldsmith, J.D., C.P.A., C.F.F.A.
Partner at CJBS, LLC

In these difficult economic times, there will be many businesses that will no longer be able to meet their current obligations. Their lenders will refuse to advance additional capital and the financial pressures will force the closely held business owner into Chapter 7 bankruptcy. There are better alternatives than bankruptcy, but your lender and trusted advisors may not tell you about these options.

Bankruptcy is not always the answer for many business owners who have decided to liquidate their distressed businesses. Upon filing Chapter 7 bankruptcy, an overburdened bankruptcy court system appoints a Chapter 7 trustee to manage the case. The trustee’s duty is to investigate if the owner is guilty for the business’ failure. He also investigates whether preferred customers, or the owners, received fraudulent transfer payments or preferences during a period that in the State of Illinois may deem as long as four years from the date of the transfer.

The system is flawed because bankruptcy is a slow and costly process. The trustee often has many cases and is fortunate to close a case and sell the assets within a year or two. During such time, the business and its assets could have lost much of its value to potential purchasers. The bankruptcy process also invites litigation. Litigation is expensive and has a tendency to diminish the proceeds from the sale of the assets. Litigation against former owners is common.

An Assignment For The Benefit of Creditors, known as an ABC or an assignment, is a common law remedy governed by state law. An experienced professional, known as an ‘assignee,’ is appointed by the corporation’s board of directors to take charge of the business assets and to liquidate the business and its assets to pay the creditors of the failed business. The assignee’s goal is to quickly take complete control of the business and its assets and then determine the best means of selling the business, either as a going concern or sell the assets at auction. Then the assignee, as the fiduciary for the creditors, determines which creditors get paid and in what priority.

The assignee has a flexibility that the bankruptcy trustee does not have or may not be willing to assume either because of liability issues or because of the administrative problems associated with the Federal Bankruptcy Court. To maximize the return to creditors, an assignee may decide to employ former employees or owners to run the business in the short term because a going concern can be sold for greater dollars than an auction of unused machinery and inventory. The assignee will then try to collect all of the receivables and sell all of the assets within months of his appointment.

There are no back room deals or midnight sales in a properly administered assignment. The assignee is required to notify the creditors upon receiving the assignment. At the close of the assignment, the assignee will send out a final letter and accounting to all creditors. The assignee will then publish, with at least ten days advanced notice, where and when the assets are to be sold in the local newspaper. If there are related purchasers or initial bids for the assets, the assignee should disclose these matters to the public and creditors. The assignee is most productive if there is a working relationship with both the creditors and the former business owners.

AN ASSIGNMENT IS A BUSINESS SURVIVIAL OPTION
If the business is inundated with both secured and unsecured creditors and the lender is unable or unwilling to advance additional capital to permit the company to meet its current obligations, potential equity investors will not want their monies to be used for paying the old debts of the company. The equity investor will want their capital to be used to grow the company and grow its profits. The equity investor may recommend that the business be sold in an assignment for the benefit of creditors. The new equity investor forms NEWCO to purchase the assets of the old business in an advertised sale. In many cases, the assets of the company have a fair value which is less than the secured creditor’s security interest in the assets of the company. NEWCO may be able to acquire all of the business assets of the former company by working out a deal with the secured creditor. Newco has the assets of the old company without the old company’s obligations, creating a fresh start.

Now the equity investor’s actual capital can be used to grow the business and grow the profits in the new company. Former employees may be offered new positions with the new company, former owners may have an interest in the new company and the business will continue as a going concern benefiting both society and the local economy. The creditors of the old company receive just as much, if not more, than they would have received had there been a Chapter 7 bankruptcy.

For the closely held business owner, having a failing business is a nightmare. Business friends are calling the office and the owner’s residence demanding immediate payments. Threatening letters greet the owner at the office. Letters promising quick fixes are delivered daily. The business owner does not sleep. He prays that they will be able to cover the next payroll and hopes that there are sufficient funds for the payroll taxes. Sadly, too often the secured creditor has the business owner’s residence as additional collateral, compounding the owner’s fears.

The assignment brings greater peace to the business owner than a bankruptcy. The assignee communicates with creditors when the assignments begin and often the creditors will cease the harassing telephone calls. The speed of the assignment is able to put an end to an ugly chapter in the business owner’s life quickly, without protracted years in bankruptcy court with court appearances, depositions and creditor meetings. Since assignments are more cost efficient and can result in a greater return to the creditors, there is greater likelihood that secured creditors can be satisfied and personal assets can be saved from the demise of the business. The former owner can help the assignee to collect receivables and maximize the proceeds to the creditors, which is an additional advantage to why the assignment for the benefit of creditors has been a successful legal tool for so many informed business owners.

Larry Goldsmith is an attorney, Certified Public Accountant and a member of CJBS, an accounting and financial consulting firm in Northbrook, Illinois. Larry has been in active in performing Assignments for the Benefit of Creditors, as an assignee for over fifteen years. Larry can be contacted via email at LARRY@CJBS.COM, or by telephone at 847-580-5427.