It is not uncommon for a real estate or business client to inquire about forming a limited liability company (LLC) out of state. Two states often mentioned are Nevada or Wyoming. The impetus for selecting these two states is usually asset protection and income tax savings.
It is true that both Nevada and Wyoming do not have a state income tax and that LLCs formed in those states provide greater asset protection benefits compared to California LLCs. The reality, though, is that for most California residents looking to form an LLC, a Nevada or Wyoming LLC will not provide the expected asset protection and income tax benefits.
Generally speaking, an LLC, like a corporation, is an entity that affords its owners (called members) limited liability from the debts and obligations of the LLC. Further, the assets of an LLC are generally shielded from the creditors of the LLC’s members.
If a creditor of an LLC member seeks to satisfy the creditor’s judgment with the member’s interest in the LLC, the creditor can obtain a charging order against the member’s LLC interest. A charging order constitutes a lien on the member’s LLC interest and entitles the creditor to the LLC distributions that would otherwise be made to the member. However, if the LLC never makes any distributions, then the creditor has no ability to force distributions to be made in order to satisfy the judgment.
In this situation, California law allows a creditor to go further and foreclose on the member’s LLC interest.[i] The ability to foreclose gives the creditor more favorable settlement possibilities and options to satisfy the judgment.
Unlike California, both Nevada and Wyoming’s charging order statutes do not allow the creditor to foreclose on the LLC membership interest.[ii] Consequently, if no distributions are made from the LLC, then the creditor is unable to satisfy its judgment, which gives the LLC member/debtor more favorable settlement possibilities.
As good as the charging order limitations in Nevada and Wyoming appear compared to California law, those benefits would not apply if the LLC member is a California resident and the judgment creditor sought to satisfy the judgment in California courts.
This is because the law of the state of LLC formation applies only in limited circumstances in California courts, primarily in instances regarding the organization and internal affairs of the LLC.[iii] Unfortunately, the rights of a creditor against a member of an LLC do not pertain to the organization or internal affairs of the LLC. Consequently, in the case of a creditor obtaining a charging order against a California resident who is a member of a Wyoming or Nevada LLC, California’s charging order statute would apply, entitling the creditor to foreclose on the member’s LLC interest.
While both Nevada and Wyoming do not have an income tax, California does. Consequently, if a California resident is a member of a Nevada or Wyoming LLC, then California would tax the income the member attributable to the LLC, whether the income was earned outside or within California.[iv] This is because most LLCs are pass-through entities, and income earned by the LLC is passed through to the LLC’s members. Consequently, a California resident who is a member of an LLC is receiving income from the LLC while residing in California, resulting in California income tax.
While there can be good reasons to form a Nevada or Wyoming LLC for a California resident, every California resident looking to form an LLC in those states should consult with qualified tax and legal counsel to confirm whether the formation of an LLC in those states will truly provide the benefits they seek.
Timothy Boone is an attorney in Berliner Cohen’s Modesto office. If you have questions about LLC formation, please contact Tim at 209.576.0111 or email@example.com.
This article is not intended to and does not constitute legal advice or a solicitation for the formation of an attorney-client relationship. Anyone with questions about this topic should consult an attorney.