We are often asked whether it would be a good idea to have your spouse as a member of your LLC (Husband and Wife LLC) to make it a multi-member LLC. When you are looking for another member in your LLC, the best solution is to have a member who is not related to you and will participate in the LLC. If both you and the other member put up capital to start the LLC and both of you contribute to building the LLC, the court should provide charging order protection to the LLC if one of the members gets in trouble.
The spouse as a second member can work, but it has the most dangers. The benefit to having a spouse as the second member is that you aren’t really giving away any of the company. At least you are keeping the ownership “in the family.” The problem is that the courts may consider a husband and wife as one unit and disallow the charging order protection. This is particularly true in a community property state.
Unfortunately, some of you won’t have the option of having a truly independent person as the second member. Often people will start a business on their own using their own ideas and capital. In this type of situation, picking someone to be a second member can get a bit trickier. So if you are going to use your spouse as a second member, there are a few things to consider.
First, do not elect to have the LLC treated as a disregarded entity for tax purposes. A disregarded entity is an LLC taxed as a sole proprietorship, and the taxes are filed using a Schedule C attached to the owner’s 1040 tax form. An LLC owned by a husband and wife can elect to be a disregarded entity in certain situations. Courts have used an LLC’s status as a disregarded entity as a reason to treat the LLC as a single-member LLC. You should probably have the LLC taxed as a partnership, which requires more than one member, or as a corporation (C or S).
Second, make sure your spouse contributes to the initial start-up costs of the LLC. You want the husband to make a contribution and the wife to make a separate contribution. This makes it look as though the business truly is a partnership between the husband and wife, and that they each have a separate interest in the LLC. You may have to set up his and her bank accounts to show the proper paper trails of contributions coming from two different sources.
Third, the spouse needs to actively participate in the LLC operation. Again, you are trying to show that the spouse has a separate interest in the LLC. By having the spouse actually participate in the LLC, the court is going to look more kindly on the LLC as a multiple-member LLC instead of considering it a single-member LLC.
The other option that most people consider is to have a child or other relative as a second member. In this type of situation, courts have been a bit nicer to the LLC. The biggest problem occurs if you don’t give the other member a big enough ownership in the LLC. If it appears that you just gave the second member a token membership in the company, the court will say that the other member is just a “peppercorn member” and consider the LLC as a single-member LLC.
In order to avoid this problem, the member should have at least a couple percentage points of interest in the company. To be safe, you should probably have the second member have at least a 5% interest in the LLC. There isn’t really any precedence for the recommended 5%, but the IRS argues that if a person has at least a 5% interest in a company, they are not merely a passive investor. I would argue that if it is good enough for the IRS, it should be good enough for the court. In any case, make sure that you treat the second member as a real member according to the requirements in your operating agreement.
When a court looks at an LLC and determines whether or not it is a multiple-member LLC, it will consider multiple factors, shoot some darts, and come to a decision. The more you keep up the formalities and include the other member(s) in the operation of the LLC, the more likely it is that the court will give you the protection you seek. Charging order protection is important. Make sure you do what you can to ensure that your LLC gives you the maximum protection available.
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Guest post by: Lee Phillips. Lee is a business lawyer and owner of LLC Wizard Business Magic and LegaLees. Lee is a Counselor to the United States Supreme Court and has a law practice to help people structure their personal and business affairs, so they can prevent personal and business disasters. His two companies exist to educate people through a combination of seminars, boot camps, and publication of books and articles. Lee’s expertise area lies in Trust and Estate Planning, Limited Liability Companies, Living Revocable Trust, and Wills. The post originally appeared on his blog in January of 2015 and is reproduced here with the author’s permission.