Just because a taxpayer can form an LLC, doesn’t mean they should.
By Sandy Weiner, J.D. and Renée Rodda, J.D.
In a recent article in FTB Tax News, Steve Sims, the FTB’s Taxpayer Advocate, warns taxpayers that “people are often quick to form a limited liability company (LLC) without full consideration of their specific business needs.”
This is a good reminder about an issue that we see more and more of.
Many people feel they need to form an LLC to protect themselves and their assets. But often these concerns can be more easily addressed with insurance.
Furthermore, clients should be aware that the liability protection provided by an LLC is limited, and there are annual taxes and fees that must be considered.
Also keep in mind that the FTB’s aggressive pursuit of nonresident LLC members may deter investors.
Limited liability protection
Members of an LLC are not personally liable for the debts of the LLC. A member’s acts may bind the LLC, but they generally do not subject individual members to personal liability. However, like the corporate shareholder, the LLC member is personally responsible for his or her tortuous or malpractice acts.1 Also, the sole member of a disregarded entity may be held personally liable.
An LLC member’s non-LLC assets may be attached if:
What about insurance?
For LLCs that hold property, all lenders will require the owner of the property to carry insurance on the property. In checking with various insurance agents, we determined that property insurance policies generally carry between $250,000 and $500,000 in liability protection. This will not only cover any liability but at least a portion of legal expenses incurred in a lawsuit.
Depending on the owner’s needs, an individual can purchase an additional $1 million of insurance for in the neighborhood of $250. Cost of insurance is based on a number of factors, including who the carrier is and what other coverage the carrier provides.
In short, here’s the choice:
Pay the $800 LLC annual tax plus the cost to prepare the return, or pay $250 for $1 million of additional coverage.
Lance Landlord owns a rental property. He is concerned about being sued by a tenant, so his cousin, an attorney, forms an LLC for him.
Lance’s tenant trips on a downed tree branch and incurs significant medical bills and time off work, eventually resulting in the loss of his job. The tenant sues Lance’s LLC and Lance personally because he had reported the downed tree, and Lance still had not removed it a week later. The injured client’s attorney will vigorously attack Lance personally and may get a judgment against him because he was negligent in fixing the problem.
If Lance had avoided the LLC route and instead purchased liability insurance, the carrier would have paid for his legal fees as well as any settlement (up to policy limits).
With the LLC, Lance will have to pay an attorney to defend himself in the lawsuit.
The annual tax and fee
People also need to understand that, at a minimum, the LLC is liable for an $800 annual tax fee, and that obligation is indefinite until the LLC formally dissolves.3 LLCs that have gross receipts attributable to California of $250,000 or more must also pay an LLC fee.
All too often, taxpayers find out the hard way that limited liability for an LLC does not include limited liability for taxes. In a recent BOE appeal,5 an LLC that failed to timely file and pay the $800 annual tax had to pay late-filing and late-payment penalties even though the LLC:
The case is a good example of how an attorney’s advice to form an LLC can be costly.
The members, who were siblings who inherited a house, formed an LLC on the advice of their attorney when they thought they would turn the property into a rental.
However, after they fixed it up, they sold the house and told the attorney to “put a hold on the legal services in progress related to the LLC.”
Unfortunately, the attorney never advised them to dissolve the LLC or to file LLC returns, and they were held liable for $1,600 in unpaid annual tax and over $400 in associated penalties.
Nonresident member liability
If the entity is looking to attract nonresident investors, forming an LLC may have negative consequences. The FTB is taking the position that nonresident members of an active California LLC are themselves “doing business” in California and therefore are required to file a California return.
If the nonresidents are LLCs themselves, each of them will be subject to the $800 annual tax and potentially to the LLC. This could be a deterrent to out-of-state investors.
Sal Censoprano is a Certified Public Accountant (CPA) and tax practice owner for over 40 years. He was born and raised in Brooklyn, New York and earned his master’s degree in taxation.