Single-Member LLC vs Multi-Member LLC: Conversion, Taxes & Ownership

Key Takeaways:

• Ownership Transition: Converting a single-member LLC to a multi-member LLC involves adding members and modifying operating agreements and tax status.
• Tax Implications: The tax classification of an LLC changes upon adding a member, typically defaulting to partnership taxation unless an election is made for corporate taxation.
• Legal and Compliance Considerations: Amending the articles of organization and updating the operating agreement is crucial to ensure clarity on ownership structure and decision-making.
• Liability and Asset Protection: Both single-member and multi-member LLCs offer liability protection, but proper documentation and financial separation are critical to maintaining this protection.
• Decision Factors: Choosing between a single-member or multi-member LLC depends on business goals, tax preferences, and management preferences.
• State Variations: LLC regulations, including taxation and member addition procedures, vary by state, requiring due diligence before making changes.

Converting a single-member LLC to multi-member LLC occurs when the ownership stake of a limited liability company is divided among additional owners, referred to as "members." Limited liability company LLC is a common organizational structure for small businesses because of their flexible management structure and ease of establishment. This business entity offers the tax structure of a partnership combined with the limited liability protection of a corporation.

Single-Member LLC Characteristics

An entrepreneur may form a single-member LLC to enjoy tax benefits and protect personal assets from business liability. An LLC can have any number of members and can choose to be taxed as a C corporation, S corporation, partnership (multi-member), or disregarded entity (single-member). A single-member LLC is taxed as a disregarded entity, and a multi-member LLC as a partnership by default unless the LLC elects C corporation taxation by filing IRS Form 8832 or S corporation taxation by filing IRS Form 2553.

Unlike corporations, LLCs are governed at the state level, and their operation varies by state. However, in most states, rules about adding new members to an LLC are the same.

Pros and Cons of a Single-Member LLC

A single-member LLC provides simplicity and control but also has some limitations.

Pros:

• Ease of Management: The sole owner has complete control over business operations and decisions.
• Simplified Taxation: Income and losses are reported on the owner's personal tax return, eliminating the need for a separate business tax return unless electing corporate taxation.
• Limited Liability Protection: The owner’s personal assets are generally protected from business liabilities.
• Flexible Taxation: Can elect to be taxed as a sole proprietorship (default), S corporation, or C corporation.

Cons:

• Limited Growth Potential: Business financing options may be restricted since investors often prefer corporations or partnerships.
• Increased IRS Scrutiny: Single-member LLCs may face a higher risk of audits compared to multi-member LLCs.
• Self-Employment Tax: The owner is subject to self-employment tax on all business earnings unless electing S corp taxation.
• Potential for Piercing the Corporate Veil: Courts may hold the owner personally liable if proper LLC formalities, such as separate bank accounts, are not maintained.

Adding Members to a Single-Member LLC

LLC members are listed in the articles of organization when the LLC is formed. If you created an operating agreement for your LLC, it may detail the procedures for adding members, which should be followed if you opt to do so. If no such procedure exists, the new member or members must agree on the terms of membership with the existing LLC member, including the new members' ownership percentages. The written agreement must be signed by both new and existing members.

To convert a single-member LLC to a multi-member LLC, you’ll need to check with the secretary of state. The secretary of state is responsible for business filings. Since most states require an operating agreement, it’s essential to outline each member’s roles, responsibilities, and decision-making authority to prevent future disputes. This will help with any future disputes among the members.

In addition, the LLC member can transfer a portion or all of his or her membership interests to another individual if he or she has the power to do so under the operating agreement. The new member would have to comply with the terms of this assignment as well.

The articles of organization must be amended to reflect the new member, and if applicable, the operating agreement must detail the change in membership interests and address other potential issues.

Steps to Convert a Single-Member LLC to a Multi-Member LLC

To convert a single-member LLC to a multi-member LLC, follow these steps:

1. Review the Operating Agreement: If your LLC has an operating agreement, check for provisions related to adding members and modifying ownership structure.
2. Obtain Consent from Existing Member(s): If required by state law or the LLC's governing documents, obtain formal consent for new members.
3. Prepare a Membership Interest Purchase Agreement: If selling part of the ownership interest, draft an agreement outlining the terms of the transfer.
4. File an Amended Operating Agreement: Specify the rights, duties, and ownership percentages of all members.
5. Amend the Articles of Organization (if required): Some states require an official amendment to reflect new members.
6. Apply for a New EIN (if required): The IRS mandates obtaining a new Employer Identification Number (EIN) when an LLC’s tax classification changes.
7. Update Business Licenses and Permits: Notify relevant authorities and update state and federal filings to reflect new ownership.
8. Adjust Financial and Banking Accounts: Modify business bank accounts, financial records, and contracts to align with the new structure.

Tax Consequences of Adding a Member to an LLC

Although most property exchanges are subject to tax gain or loss for the parties involved, this is not true for contributing funds to an LLC in exchange for membership interest. That's because an LLC is considered a disregarded entity for tax purposes, so ownership transfers do not carry federal tax consequences.

If you add a member to your single-member LLC and are currently taxed as a disregarded entity, you will now be taxed as a partnership. This means you'll need to close your books and records for the year in question and file a short-year tax return to cover the period in which the LLC has only one member, along with another short-year return that covers the period in which the LLC had more than one member.

If your single-member LLC already has an employer identification number (EIN), you must file Form 8832 with the IRS to elect partnership taxation. You'll also need to provide them with the names of your new LLC members.

If your LLC was formed within the past 75 days, you can often retroactively elect C or S corp tax status to prevent the need for these short-year returns. In Revenue Ruling 99-5, you can seek guidance about what happens when:

• The owner of a single-member LLC sells half of his or her interest to another person
• A new member contributes cash or property to a single-member LLC in exchange for an ownership stake

How the IRS Treats Multi-Member LLCs for Tax Purposes

When an LLC transitions from a single-member to a multi-member structure, its tax classification automatically changes to a partnership unless an election is made for corporate taxation.

Key Tax Considerations:

• Pass-Through Taxation (Default): Multi-member LLCs do not pay federal income tax at the entity level; profits and losses "pass through" to individual members’ tax returns.
• Self-Employment Tax: Members may be subject to self-employment taxes unless they elect corporate taxation.
• Profit Distribution: Unlike corporations, where dividends are taxed, members receive distributions based on their agreed ownership percentage.
• Filing Requirements: Multi-member LLCs must file IRS Form 1065 (U.S. Return of Partnership Income) and provide members with Schedule K-1 forms for reporting income.
• Electing Corporate Taxation: LLCs can choose to be taxed as an S corporation or C corporation by filing IRS Form 2553 or Form 8832, respectively.

Partnership Taxation

Like a disregarded entity, a partnership is subject to pass-through taxation. Profit and losses are reported on each member's individual income tax return. The LLC does not pay income tax but provides each member with a Schedule K-1 detailing his or her percentage of the business profits and losses.

Partners can take guaranteed payments that are deducted as a business expense as well as cash draws on their share of net profits, which are not deductible. Partners don't need to withhold payroll taxes but may need to make personal estimated income tax payments.

Is it better to be a single-member LLCs or multi-member LLCs?

The first step you’ll want to consider is your ownership interest:

• Management/ Business structure
• Ownership
• Income tax treatment
• Asset protection
• Compliance

Both single-member and multi-member LLCs have distinct advantages and disadvantages, depending on factors such as ownership structure, tax treatment, and management preferences.. The main difference between the two is the number of owners or members. Another difference is the way they are taxed. A single-member LLC is easier to tax because it does not require a federal tax return unless the business elects to be taxed as a corporation. As a sole proprietorship owner, you have full control over the company. Whereas a multi-member LLC has the authority to decide what percentage of profits and losses will be shared among its members. There is no limit on the number of members. They can choose to be taxed as an S corporation or C corporation. The income is stated on the tax returns of the member. All LLC members must file a tax return and schedule K 1 forms to its members to include with their returns. 

Key Differences Between Single-Member and Multi-Member LLCs

The decision should be based on business goals, tax benefits, and operational complexity. If you plan to have multiple owners and want increased liability protection, a multi-member LLC may be the better choice.

Frequently Asked Questions

1. Can I convert my single-member LLC to a multi-member LLC without changing my EIN?
   • If you remain taxed as a disregarded entity, you may not need a new EIN. However, if the tax status changes to a partnership or corporation, a new EIN is required.
2. Does adding a member to my LLC impact my personal tax return?
   • Yes. As a single-member LLC, income is reported on Schedule C. After adding a member, the LLC is taxed as a partnership, requiring a separate Form 1065 filing.
3. How do multi-member LLCs handle profit and loss distribution?
   • Members agree on an allocation percentage in the operating agreement. The IRS requires reporting via Schedule K-1 to reflect each member’s share of profits and losses.
4. What legal documents do I need to add a new member to my LLC?
   • You will need to amend the operating agreement, update the articles of organization (if required by your state), and potentially file an EIN update with the IRS.
5. Is an attorney necessary for converting a single-member LLC to a multi-member LLC?
   • While not legally required, consulting an attorney ensures compliance with state laws and proper documentation, reducing legal risks.

Legal Support to Add a Member to an LLC

When choosing what limited liability is appropriate for your business consult with an attorney or other trusted advisors. They can provide answers to your questions and help as guidance. If you need help with adding a new member to your single-member LLC, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.