Do “Disregarded Entities” Really Protect You?
When you think of something as “disregarded” it might sound, unimportant. Like, dismissed or abandoned. In asset protection, this isn’t the case. Disregarded or, “pass-through” entities can be crucial to a proper estate plan.
What does the word mean in this context? Well, by default, both sole proprietors and limited liability companies are disregarded, meaning for tax purposes they’re not recognized as a separate being to the IRS. This sparks a lot of misconception that LLCs are useless for asset protection, which is not true.
“Disregarded” is the adjective the IRS uses. All they see is “you.” You use your own social security number, and you file what you need to file directly on your Schedule C. These can be a sole proprietorship, a single member LLC, partnership, etc.
So, what about this topic is confusing or controversial? I mentioned it briefly; the label “disregarded” is a bit of a misnomer. A common selling point against LLCs is that a “good lawyer” will show that you and your company are one in the same, leading to the corporate veil being pierced on grounds of operating as an alter ego. While this can happen, the speculation of it occurring has been blown out of proportion.
“Formalities” are a list of tasks for the owner to comply with that aren’t necessarily illegal to not follow. Formalities for an LLC could be keeping board meeting minutes, proper filing, having a separate business bank account, etc.
In Gennsler v Harris County, the plaintiffs claimed Gennsler was responsible for numerous environmental violations committed by a group of entities that he owned which operated two waste water facilities. It’s here the court provides specific conditions for an entity to be considered an “alter ego.”
-There is such unity between the business entity and the individual that the business entity has ceased to be a separate entity; ¹
-and allowing the individual to avoid liability through the use of the business entity would work an injustice.²
The court dismissed the complaint stating that there was no evidence of either condition, and when the plaintiff tried to argue once more that Gennsler was “the man in charge” and made all the decisions, that court concluded with the following:
“[the] individual’s status as an officer or director, standing alone, was insufficient to support application of the alter ego theory.” ³
With all the complicated wording of the case, it simply boils down to this; he operated the company as a company. He kept formalities and was deemed completely separate from the faults of the entities.
When explaining this case to a client, I said “even though the lack of formalities aren’t sufficient enough to warrant piercing, they can either be the icing on the cake or the straw that breaks the camels back.” More on that quote in a future topic.
If you’d like to hear more examples of the “disregarded entity protection myth” and how it can serve to reduce your tax burden, consider opting in to my newsletter.
If you have more questions on the topic please reach out to me on LinkedIn or the email found on my publication’s page. Thanks for reading.
— — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — —
ALL INFO GIVEN IS FROM EXTERNAL STUDY AND CONTRIBUTIONS FROM LICENSED ATTORNEYS, CPAs, AND PREVIOUS IRS EMPLOYEES.
I AM NOT A LICENSED ATTORNEY OR CPA.
¹²³All Footnotes cited are from the Gennsler v Harris County Court Opinion.
