One advantage of a single member LLC (SMLLC) is that it is a disregarded entity for tax purpose, and thus generally files no entity-level income tax return. However, a multi-member LLC/LLC provides enhanced charging order protection. Thus we have an apparent dilemma: we seem to be forced to choose between the less cumbersome filing requirements and other tax advantages of an SMLLC, and the enhanced protection of a multi-member LLC, which is required to annually file IRS form 1065. Fortunately there is a way to get the best of both worlds. Enter the Disregarded Entity Multi-Member LLC (DEMMLLC.) This is a multi-member LLC that is taxed as a disregarded entity instead of a partnership. (The fact that a multi-member LLC or LP can be structured so as to be taxed as a disregarded entity is confirmed by IRS Rev. Rul. 2004-77.)
A DEMMLLC is created by structuring an LLC so that, although it has more than one member, all underlying tax liability lies with a single individual. To do this, one uses a (preferably irrevocable) grantor trust or another SMLLC as an additional member. In the case of a grantor trust, the grantor is the same person as the original LLC’s first member, however the fact that a trustee is now involved (who should hold discretionary powers so as to hold voting rights within the LLC) makes the trust “count” for determining whether this LLC has the enhanced charging order protection of a multi-member LLC. In the case of using a second SMLLC, the member of this second LLC should be the same person as the first member of the first LLC, and ideally this 2nd LLC should have a manager other than its member. This manager, therefore, would also be able to have a ‘vote’ in regards to how the first LLC is run. Thus in both instances we have at least two people who may vote as LLC members, yet only one person with any underlying tax liability.
The Advantages of Using an Offshore DEMMLLC
The advantages of disregarded entity tax status become especially apparent with offshore LLCs. If an offshore LLC elects to be taxed as a disregarded entity (by filing IRS form 8832) then it may avoid painful tax consequences. For example, U.S. owners of offshore corporations or partnerships must have 30% of their share of company gains withheld and turned over to the U.S. government. Transfers of appreciated property to the offshore entity may result in a 35% excise tax being assessed on any appreciation. In addition, there may be additional reporting requirements for certain offshore entities, such as IRS form 5471 for offshore corporations with a U.S. citizen who holds 10% or more company stock. Note, however, that a disregarded entity offshore LLC must elect disregarded entity status by filing IRS form 8832, and then annually filing the IRS form 8858 informational return.
In addition to tax savings and reduced reporting requirements, the DEMMLLC allows for additional planning opportunities that are not available to SMLLCs taxed as disregarded entities. For example, a DEMMLLC will have the enhanced charging order protection typical of multi-member LLCs if it is structured properly. Furthermore, a carefully structured DEMMLLC could allow for a transfer of a debtor-assignee’s voting rights to a creditor assignee of a member’s interest, while insuring that the LLC’s management could not be replaced by a the creditor-assignee’s exercise of his newly-acquired power. This would allow a clever planner to lay a painful trap for any creditor who obtains a charging order. Essentially, we could structure a plan so that the charging order assignee receives no money from the LLC, but becomes liable for the debtor-assignor’s share of LLC taxes. Because of the obscurity of the underlying law that allows such a trap to be laid, the creditor will almost certainly not suspect such a trap until it is too late. At that point, the creditor will probably be very eager to offer a pennies-on-the-dollar settlement!