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Lev
Lev, Tax Advisor
Category: Tax
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Experience:  Taxes, Immigration, Labor Relations
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I am a freelance software engineer performing services for

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I am a freelance software engineer performing services for clients in California. I intend to establish an LLC. My plans and assumptions are below. I'm looking for a confirmation or rebuttal of these assumptions:

I plan to set up the LLC with my wife and I as the only members.

It would be taxed as a partnership (the default) and manager-managed (as opposed to member-managed) by me alone. I would be performing all work. My wife would perform no work, have no managerial capacity, and not be able to sign for anything (a passive LLC member).

The LLC would pay me each month for my services with a reasonable Guaranteed Payment.

At the end of the year, the remaining profit would be divided between us according to our LLC percentage share (let's say this is 60/40 in my favor.)

Assumptions:

* In California — a community-property state — I understand that for husband-wife LLCs, the LLC's assets are not protected from personal creditors, but our personal assets would be protected from LLC creditors. Is that the case? (The latter is the important direction for us.)

* As an active LLC member, I would pay Self Employment Tax on both my Guaranteed Payments and end-of-year profit distribution. But, as a passive member, my wife would not pay Self Employment Tax on her profit distribution. (I know this is the case for normal passive members, but what about husband-wife LLCs? If true, what would stop us from giving her 90% of end-of-year profits, for example.)

Thanks in advance.

Lev :

Hi and welcome to our site!
If you plan to save on self-employment taxes - the best option would be to select S-corporation treatment for your LLC. You will be an employee of said S-corporation - and as such will receive reasonable wages reportable as taxable income for you and deductible expense for the S-corporation.
The remaining profit will be passed to you and to your spouse as shareholders and will not be subject of neither employment nor self-employment taxes.

Customer:

Hey there,

Lev :

hi

Customer:

But that would also be possible with a passive LLC member, right?

Customer:

I'm just wondering if it would be affected by us being married.

Lev :

Your spouse will not be treated as having passive income based on your active participation.
That stricture will not work as designed.

Customer:

So, solely because she is my spouse, her passive income would be determined to be active income?

Lev :

That is correct.

Customer:

Is that because we're in a community-property state? Or would that be the case anywhere?

Lev :

That is from IRS publication 925 - Spouse's participation. Your participation in an activity includes your spouse's participation. This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year.
Regardless if you are in community property state or not.

Customer:

Interesting. Thanks.

Customer:

Do you have any thoughts on the liability protection? Or is that outside of your speciality? (I realize I combined two areas of law in my question.)

Lev :

That would be too easy to avoid self-employment taxes...

Customer:

If I give my wife 2% of the LLC, then would that potentially give our personal assets protection from LLC creditors?

Lev :

California provides relatively good protection for your personal assets.
There is a cost for that - as the LLC is subject or additional tax in California.
That would be true if you do not mix your personal and business assets and funds.
That is regardless if the LLC is treated as a partnership or as a disregarded entity or as a corporation for tax purposes.
The LLC is a separate legal entity created under your state business laws. So as long as it stays separate and you as a manager do not violate any laws - your personal assets are protected.

Customer:

Yeah, I've been a member of an LLC previously, so understand most of the liability protection. But, from what I understand, a single-member-LLC (very likely) has no liability protection in either direction: a personal creditor could claim the LLC's assets, and an LLC creditor could take personal assets, because there is no shared liability.

Customer:

In a community-property state, a husband-wife-only LLC is treated like a single-member-LLC for liability for personal creditors who want the assets of the LLC. But, I think, that there is protection the other way.

Customer:

Like, the usual suggestion to establish liability protection in a single-member LLC is to give someone else 2% or something, right? That's usually enough. But, giving a spouse 2% makes things a little more complex?

Lev :

Indeed - a single-member-LLC does provide personal liability protection.
The member is NOT personally liable LLC's debts unless committed any violations as a manager of that LLC,
Personal creditor could claim any assets owned personally - that includes the interest in the LLC - but not LLC's assets 's assets.
In real life - it is very often - personal and business assets are mixed - and creditors might file a claim against both - the LLC and the owner - but such claims are not always granted by courts.

Lev :

"giving a spouse 2%" makes no difference - just because you are in a community property state - and your spouse owns 50% regardless - assuming the LLC is not a separate asset.
If you want better protection and if the protection is an issue - you may want to register a corporation or an irrevocable trust. But these issues are a little away from the tax category.

Customer:

Ah, so it would work that way (protection against LLC creditors taking personal assets) even with a single-member LLC? (I want some protection against patent-trolls taking legal action against any software I develop and sell, which sadly, seems largely random and unpredictable. I'm not really worried about protection for the LLC against personal creditors.)

Lev :

Yes - the LLC is a separate legal entity - and does provide some level of protection against personal assets. That means - you personally is not responsible for obligations and judgments against the LLC.
However that doesn't prevent third parties to sue you personally for your personal actions. So far - there is NO 100% protection.

Customer:

Okay, neat. Thank you for your help.

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