Contents
- The ontological divide: state-law entity vs federal tax classification
- The erosion of the Single-Member LLC shield
- Veil piercing (and reverse veil piercing): where tax behavior shows up
- Tax elections as procedural defense (S-election discipline)
- Operating agreements + bankruptcy: hidden tripwires
- The IRS as “super-creditor”
- A practical playbook: what to do (and what to stop doing)
1) State-law LLC vs federal tax identity: the “disregarded paradox”
LLCs are creatures of state statute, but the IRS forces them into existing tax buckets (sole proprietorship/partnership/corp). The danger is psychological: “disregarded entity” language can encourage owners to treat the business as a personal extension, even though liability law demands separateness. :contentReference[oaicite:2]{index=2}
The Schedule C trap
When taxes flow straight onto the owner’s return, owners often mirror that informality operationally (commingled accounts, personal bills paid from business funds). That’s exactly the factual pattern creditors use to argue “unity of interest.” :contentReference[oaicite:3]{index=3}
2) The erosion of the Single-Member LLC (SMLLC) shield
Charging orders were built to protect “pick your partner” economics in multi-member entities. In single-member contexts, courts have repeatedly found that rationale weaker—especially in bankruptcy—making SMLLC asset protection far less reliable than many owners assume. :contentReference[oaicite:4]{index=4}
Bankruptcy risk (Albright-style outcome)
In certain bankruptcy scenarios, a trustee may step into full management rights of a debtor’s SMLLC interest, enabling liquidation of LLC assets—functionally collapsing the “shield.” :contentReference[oaicite:5]{index=5}
Judgment collection (Olmstead-style logic)
Where statutes don’t clearly make charging orders the exclusive remedy for SMLLCs, courts may allow broader remedies (foreclosure/transfer of control). :contentReference[oaicite:6]{index=6}
3) Veil piercing (and reverse veil piercing): where tax behavior becomes evidence
Piercing is fact-intensive. But recurring evidence themes overlap heavily with tax posture: commingling, failure to maintain separate books, undercapitalization, and “cash sweep” behavior that leaves the entity judgment-proof while owners benefit. :contentReference[oaicite:7]{index=7}
Traditional piercing: company debts → owner
Courts often look for “unity of interest” and an inequitable result. Tax filings and financial practices can help prove both, especially where owners harvest tax benefits while leaving the entity unable to pay creditors. :contentReference[oaicite:8]{index=8}
Reverse piercing: owner debts → company assets
Increasingly relevant when valuable assets sit in LLCs but the owner has personal liabilities. If the LLC is treated like the owner’s alter ego, creditors may try to reach LLC assets to satisfy personal judgments. :contentReference[oaicite:9]{index=9}
4) Tax elections as procedural defense: why “discipline” matters
Tax elections don’t magically improve legal protection. But the compliance they force—separate returns, payroll, W-2s, K-1s, distributions—creates a paper trail of separateness that makes “alter ego” arguments harder to win. :contentReference[oaicite:10]{index=10}
Counterintuitive point
A non-compliant S-Corp posture (e.g., distributions without reasonable wages) isn’t just a tax problem—it can become “bad facts” in litigation, because it suggests the entity is being used to evade obligations. :contentReference[oaicite:11]{index=11}
5) Operating agreements + bankruptcy: hidden tripwires
Bankruptcy trustees read operating agreements like hackers. Passive agreements can make it easier for a trustee to step into the member’s rights. Separately, “mandatory tax distribution” clauses can become fraudulent transfer targets if the company is insolvent. :contentReference[oaicite:12]{index=12}
Executory vs non-executory risk
If the agreement imposes no real ongoing duties, courts may treat it as non-executory—reducing contractual barriers to a trustee. :contentReference[oaicite:13]{index=13}
Tax distributions ≠ always safe
If tax distributions are paid while creditors go unpaid, trustees may attempt clawback as fraudulent transfers; solvency caps can help. :contentReference[oaicite:14]{index=14}
6) The IRS is the super-creditor
State-law creditor remedies don’t bind the IRS in the same way. Disregarded status can make it easier for federal collection to treat LLC assets as the owner’s for income tax debts, and the IRS routinely uses alter ego/nominee theories to levy assets when facts support it. :contentReference[oaicite:15]{index=15}
7) Practical playbook: protect the shield with boring behavior
Do this
- • Separate bank accounts + clean bookkeeping (no personal expenses through the LLC)
- • Document major decisions (loans, distributions, officer roles, compensation policy)
- • Follow your tax posture: payroll rules, reasonable comp (if S-election), timely filings
- • Draft operating agreements with bankruptcy + solvency guardrails in mind
- • For meaningful assets, consider multi-member structures or stronger jurisdictions where appropriate
Stop doing this
- • Treating “disregarded” as permission to commingle
- • Cash sweeps that leave a liability-bearing entity unable to pay its own debts
- • Paying owners “however” without matching the required tax mechanics
- • Copy-pasting operating agreements without thinking about creditor/bankruptcy posture
Source basis: “Asset Protection, Liability, Tax Interplay” document. :contentReference[oaicite:16]{index=16}