Tax Audits and Creditor Protection
LLCs may reduce IRS tax audit risk and offer third party creditor asset protection.
IRS Tax Audits
For individual taxpayers the IRS audit risk:
1. All Taxpayers (2013), 1.0% (1 in 100);
2. Taxpayers earning over $1m (2012), 12.48% (1 in 8);
The audit risk for LLCs is 0.4% (4/10 of 1%; i.e. 1 in 250).
Investment assets, held by an LLC, which generate income have 40%, the audit risk of all taxpayers, 3% of the audit risk of taxpayers who earn over $1m.
Investment assets held by the LLC are not subject to creditor attachment. In California, the third party creditor’s sole remedy against the debtor (i.e. LLC member) is a “charging order”, attached to their LLC membership interest. Under a charging order, the creditor becomes an LLC “economic assignee” who has the right to receive distributions paid, but no rights to management, and no right to attach the underlying investor assets held in the name of the LLC.
In addition, as a creditor protection strategy, the third party creditor may be subject to income tax on LLC income, earned but not distributed to LLC members. If the LLC income is allocated to LLC members, but is undistributed, the creditor owes income tax on the LLC “income”, since no income was distributed, the creditor owes income tax (on the allocated LLC distribution) without an LLC cash distribution to pay the tax.