June 4, 2008

Corporate Compliance Scams and Flimflams

llccorp053008.jpgEven Nolo, my corporate-law publisher -- a company loaded with lawyers and staff personnel who can easily separate legal wheat from chaff -- gets bogus corporate correspondence selling ersatz compliance services. One official-looking legal letter came into the controller's office recently. It was from an "agency" calling itself the Corporate Minutes Compliance Counsel, or somesuch, and it strongly advised (warned, really) that Nolo send the Board a payment of $125 to prepare its state-mandated domestic corporation statement. Failure to do so could result in dire consequences, the letter advised, including a loss of corporate status with the Secretary of State.

Nolo's controller, who has years of experience with real and bogus corporate service solicitations, shredded this letter immediately. Even though the letter contained a statement that was carefully designed to mimic the official state form, she knew she had already filed the real statement with the state for the much lower $25.00 state filing fee.

This and other corporate compliance scams are rampant. Another common one is a warning letter that solicits corporations to engage the company to prepare state-mandated annual corporate minutes forms. Again, these letters, which appear at first glance to be sent out by a state "agency", warn that a failure to prepare the minutes will result in loss of the corporations status. These annual minute compliance solicitations are bogus, for several reasons:

  • Corporate minutes are a private document. They are not filed with the state.

  • No corporation has ever been suspended by any state for failure to prepare annual minute forms.

  • State corporate statutes usually require some, not all, corporations -- those whose directors serve only for a one-year term -- to hold an annual shareholders' meeting to elect or reelect directors. If they don't hold the meeting for some reason, the existing directors continue to hold office and the corporation continues (under most corporate bylaws, directors are elected for their stated term and until their successors are elected and qualified). The corporation does not lose its status (or even its current board) for failure to reelect directors with a one-year term.

  • Even if states were serious about making sure corporations held and prepared written minutes for meetings required under provisions of the state law, they would be unable to determine -- at least without a huge, unjustifiable allocation of human and financial resources -- what corporations actually had or had not held annual meetings and prepared or not prepared contemporaneous minutes of those meetings.

Any time your corporation or LLC gets a questionable solicitation for services, or a threatening or even friendly reminder to comply with a state or federal requirement, the first thing to do if you don't immediately toss the letter is to read all the small print -- you may discover a disclaimer that uses round-about legal language to say that the letter does not (despite all appearances to the contrary) come from a state agency.

The next thing to do if you still have questions is to perform a search online for the name of the "agency" sending the letter. Chances are, you'll get back a bunch of links to blogs that broadcast the bogusness of the agency and its bid for your money.

When I searched for annual minute compliance solicitations online, I was led to a private blogs and a Better Business Bureau article that contained numerous complaints about misleading and overpriced corporate compliance solicitations. Apparently, these solicitations continue to be sent out to registered LLCs and corporations under several aliases from several post office boxes in several states. Unfortunately, a number of unsuspecting corporate mail recipients have been taken in.

One final tip I use to filter questionable mail: If the sender did not pay full first-class postage -- and I don't mean pre-sorted or pre-stamped with another special category, I mean full price postage -- I toss it, contents sight-unseen, into the circular file.

Copyright 2008 by Anthony Mancuso. This blog is provided as information and opinion. Please check with a legal or tax adviser for legal or tax advice.

May 10, 2008

Converting an LLC to a Corporation - It's Not as Simple as It Seems

State entity-filing offices -- typically a division or department of the office of the Secretary of your state -- have made it simple to convert one type of entity to another. Many provide a simple entity conversion form for this purpose. Just check the appropriate boxes on the conversion form, add some simple boilerplate as explained in the instructions to the form, file the form, and you're done. The new business is formed, the assets of the old business are transferred to the new business, and the old business is dissolved. All of this happens automatically by operation of law according to each state's entity conversion statute. What could be simpler?

Of course, nothing is quite so simple when law and taxes are involved, and both come into play when a business is converted to a new legal form.

Let's look at a common type of conversion: the conversion of a co-owned LLC to a corporation. Normally, an LLC-to-corporation conversion is tax-free if the prior business owners are in control of 80% or more of the stock of the new corporation (see IRS Publication 542, Corporations, and my Nolo book, Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State).

But there's more to it, as explained in IRS Revenue Ruling 84-111. This ruling puts partnership-to-corporation conversions into one of three slots, and applies to LLC-to-corporation conversions since co-owned LLCs are treated like partnerships. Here are the three conversion categories:

  1. "Assets-Over" conversion. The LLC transfers its assets and liabilities "over" to the new corporation, the corporation issues its stock to the LLC, the LLC transfers the stock to its owners in proportion to their LLC capital interests, then the LLC dissolves.

  2. "Assets-Up" conversion. The LLC distributes its assets and transfers it liabilities "down" to its owners in proportion to their capital interests, the LLC dissolves, and then the owners transfer their individual share of received assets and liabilities "up" to the new corporation in return for a proportionate share of its stock.

  3. "Interests-Over" conversion. The LLC owners transfer their LLC capital interests "over" to the new corporation in return for a proportionate amount of corporate stock, and then the LLC dissolves.

Each of these conversion methods can have a different effect on the corporation's tax basis and holding period in the assets it receives. Further, LLC owners can end up with a different tax basis in their corporate stock, and each can end up with a different immediate tax result depending on the conversion method used. For instance, an owner may have to pay taxes at the time of the conversion.

OK, this is already sufficiently complicated, but there's more to consider (clue: it's the subject of this article): Converting a co-owned LLC through the use of a state-provided entity-conversion form without an actual (legally documented) transfer of assets or interests. Let's call this type of conversion an "Automatic" conversion.

Revenue Ruling 2004-59 explains how the IRS treats an automatic conversion of an LLC to corporation through the filing of a state conversion form. This ruling says that when an entity treated as a partnership (again, which includes a co-owned LLC) is converted to a corporation through the filing of a state conversion form without an actual transfer of assets or interests, the IRS assumes the following steps occur, in this order:

  1. The partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation.

  2. The partnership liquidates, distributing the stock of the corporation to its partners.

This assumed sequence of events looks familiar, doesn't it? It matches the sequence of events described in the assets-over conversion described earlier, which means it's likely that the IRS will consider the conversion of an LLC to a corporation through a state conversion form filing to be an assets-over conversion. This leads to further complications that can have significant tax effects.

Here's one: Internal Revenue Code (IRC) Section 1244 allows business owners to treat worthless stock as an ordinary loss, which can be deducted against ordinary income on their tax returns. However, one of the requirements of using Section 1244 is that the shareholder claiming the loss must be the original owner of the stock. But if you re-read the description of an assets-over conversion, you'll see that the LLC entity, not its owners, is considered to be the original owner of the shares under that conversion scenario, and the corporation's shareholders are considered to be the second set of shareholders (they receive their shares from the dissolving LLC).

What this means is that the use of a simple state conversion form to convert an LLC to a corporation may eliminate the future ability of the corporation's shareholders to take a large deduction on their individual tax returns. Instead, the shareholders may be limited to claiming only a capital loss if their corporation fails. Since a capital loss can only be used to offset capital gains, the owners may be unable to deduct the loss on their capital investment, or may have to wait several years to do so.

Complications and unexpected tax results of this sort are why it's best to check with a tax advisor before making even the simplest type of filing with the state to form a business entity or convert an entity from one form to another.

Copyright 2008 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.

April 28, 2008

Can Sole Owners Check the Corporate Tax Box?

After I read the new check-the-box tax regulations that provided default tax treatment for different types of businesses, I suffered the usual post-traumatic tax research distress: sinus pressure, slight dizziness, and irritability.

The language was arcane and circular - for example, a one-owner business is referred to as "an entity with a single owner that may be disregarded as an entity separate from its owner" and the organization of the material was all over the place. Nonetheless, I was impressed that the IRS seemed to have decided to treat business entities in a sensible way. The way I read it, the new regs said that a one-person unincorporated business, including a one-owner LLC, would be treated for tax purposes as a sole proprietorship; a two-person unincorporated business, such as a co-owned LLC, as a partnership; and a corporation as a corporation. The regs also seemed to say that any business could change its tax treatment by filing an election form.

Now, this "elect your own tax treatment" idea really was different. For example, if a partnership wanted to be treated and taxed by the IRS as a corporation, it could check the corporation box on an election form, and the IRS would treat it as a corporate tax entity, allowing it keep its books, deduct expenses, report and pay taxes on income, just like a corporation, even though the partnership had not changed its legal form. I wasn't sure it made a whole lot of sense for a partnership legal entity to be taxed like a corporation, but it seemed very gracious of the IRS to let businesses do it. In fact, I was a bit taken aback by the apparent flexibility afforded by the new rules. This wasn't the cranky, status-quo-preserving language I was used to seeing in IRS pronouncements.

When I could muster the courage, I reread the new regs, and I was at least a little reassured to find that it did indeed seem to contain a few if not unfriendly, at least familiarly opaque, provisions. One thing I noticed was that the rules harped on the term "eligible business entities." This phrase was peppered throughout the text, and I suspected that the IRS rule writers were using this term as code for some unpleasant type of tax result (they often hide traps for the unwary in their language, and I suspected they were having a bit of fun with this one).

Sure enough, the more I re-read the rules, the more convinced I became that sole proprietorships, which were "disregarded as entities separate from their owners" (there's that crazy phrase again), were not, in fact, "business entities," and therefore were not eligible to be included in the magical "eligible business entities" category. This in turn meant that they could not change their tax status, for example by electing to be taxed as a corporation.

Later, I read somewhere that a Congressional sponsor of the new regs had indeed not wanted sole proprietorships to be able to change their tax treatment, but no doubt the drafters got a kick out of keeping this tidbit to themselves.

Tax interpretation uncertainties like this can ensnare even the most experienced tax advisors. In one of my masters tax classes, a very smart tax prof who had an active private tax practice mentioned that any type of business, even a sole proprietorship, could avail itself or the new regs and elect corporate tax treatment. I just had to raise my hand.

I mentioned that I thought the regs might consider a sole proprietorship to be an ineligible business entity since they apparently weren't treated as business entities at all under the rules. He screwed up his face and told me he would look into it and get back to me. He didn't.

So, just keep in mind if you want to change your sole proprietorship tax status, there may be a little mud in the water. Check with your tax advisor to get some clarification before you jump in.

Copyright 2008 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax adviser for legal or tax advice.

April 26, 2008

Hedgehogs, Tax Havens, and Other LLC and Corporate Chicanery

istock_000004831034xsmall.jpgSome entrepreneurs, with the help of their legal and tax advisers, use the LLC or corporation as a tool to minimize taxes, avoid personal liability, and generally help them provide legal cover for their personal and business assets.Asset protection strategies range from the mundane to the exotic. Having witnessed several clients and friends suffer through lawsuits and IRS tax audits, my preference is for the use of LLCs or corporations only when they make sense in the context of a real-world business: to lower taxes on profits, or to protect the personal assets of business owners from claims made against their solidly financed and adequately insured operations.

However, when business owners attempt to use entities primarily as a means to achieve a legal or tax advantage unconnected to their actual business operations -- for example, as an asset-protection device -- they may find that the time, trouble, and expense of defending later lawsuits and IRS audits outweighs or frustrates the legal and tax benefits they had hoped to achieve.

Here are just a few strategies meant to leverage the LLC or corporate entity as a hedge against legal and tax consequences. If you decide to adopt any of them, proceed with extreme caution and get the expert help of a seasoned tax adviser:

Out-of-state Entities. The Nevada and Delaware LLC and corporation have been touted as a great way to side-step state regulation and taxes on business operations. These states have a reputation of being relatively regulation-and-tax-free (or at least -friendly). Since each state regulates and taxes a business in the state where it really earns its money, has assets , and hires employees, this strategy makes little sense except to advance the interests of those who are selling out-of-state formation services. And watch out for services that attempt to camouflage the source of revenue of the entity through revenue-assignment contracts -- for example, an out-of-state corporate formation package includes a contract in which the all locally-based revenue is assigned to the out-of-state head office. State tax agencies easily see through these sleight-of-hand, revenue-shifting strategies.

Off-Shore Shells. Some susceptible entrepreneurs continue to get lured into setting up one or more off-shore LLC and corporate "shell" entities with the hope that income transferred and banked there will escape the grasp of the IRS, creditors of the business, or the trustee in bankruptcy should the business go belly-up. Some of more adventuresome wrap up personal as well as business assets in an offshore shell, hoping to shelter both their business and lifestyle assets from attack by mainlanders. Part of this type of asset-protection package can include a manager agreement that, at first glance, cedes control of the transferred business and assets to an offshore manager or management company. This manager-control agreement is added to help make the off-shore entity look independent and separate from the personal and business assets and affairs of the original owner.

Of course, under the fine print in the agreement, the original owner retains ultimate control of shell operations and access to its assets and can override decisions made by the manager, so the manager agreement has no practical impact. These types of off-shore entities and agreements normally don't impress a state or U.S. bankruptcy court or the IRS, and off-shore owners can end up in some very deep water indeed: They can be forced by a court or the IRS to pay legal damages, attorney fees, IRS back taxes, late-payment penalties, and interest.

Series LLCs. A relatively new real-property protection strategy is setting up an out-of-state series LLC in Nevada, Delaware, or another state that authorizes this special type of LLC. These special entities can work well for large subdivision or other multi-parcel property developers. Each property can be segregated under a separate set of books yet subsumed under a central management structure. But be forewarned - these complicated entities are normally overkill for individuals who own just one or a few commercial properties. The legal, tax, and accounting paperwork involved with these entities is normally a bear of a task. Of course, this is just what some of the sellers of series LLC have in mind: for annual fees, they will act as your out-of-state agent, plus pass you along to affiliated legal, tax, and accounting firms to help you outsource some of the heavy legal and tax lifting that can be part-and-parcel of this asset protection package.

Family LLCs. Even though the federal estate and gift tax rules and rates have been relaxed (at least for a while), some wealthy individuals continue to try to get the best of the IRS by setting up an LLC into which the wealthy LLC founder pours personal assets. Following the transfer, the founder grants minority or non-voting interests in the LLC to his children. The idea here is to pass along personal wealth to the next generation during the parent's life while getting a tax discount on the value of the LLC interests transferred to the children (since the children hold non-controlling interests in the LLC). Of course, there is no real business being done by the LLC and the parent typically retains control over and access to the personal assets transferred into the LLC, so the IRS regularly puts the kibosh on these inter-family tax-evasion entities.

Hedgehog LLCs. I couldn't resist adding this LLC strategy, which represents the gold standard in LLC tax aggressiveness and greed (I don't really expect this strategy to be used by private entrepreneurs). I coined this term as shorthand for the LLC hedge fund, a private investment company that acts as a miraculous ordinary-income-to-capital-gains tax converter for LLC hedge fund managers and officers. The ploy here is that instead of paying managers and officers regular commissions or other types of earned income -- which is subject to ordinary income tax rates of up to 35% -- they are treated as investors who receive a "return" on their "investment" in the LLC, which is taxed at 15% capital gains rates. It doesn't matter that these people get paid overwhelmingly large amounts of money and can afford to pay tons of taxes and still walk away with a fortune each year. They want it all, including the lowest possible tax rate. Of course, this fiction is founded on the shaky premise that LLC managers and officers, who get a piece of the profits but not the losses of the LLC, are bona-fide investors in the business. So far, the IRS has not gone hedgehog hunting, but some members of Congress are talking about getting out their legislative guns. Let's wait and see.

Copyright 2008 by Anthony Mancuso
This article is provided as information and opinion. Please check with a legal or tax adviser for legal or tax advice.

April 21, 2008

Are Property LLCs Worthwhile?

A colleague pointed me to a blog (Dos and Don'ts of Holding Home's Title in LLC) that recommended several strategies for limiting an owner's legal liability for rental properties. One was extending the owner's homeowner and umbrella insurance policies to cover rental properties; another was the use of separate LLCs to hold title to each rental property. A third recommendation was to add a second member to each property LLC to help make it more official and less prone to legal attack. Here is the response I posted as a comment to the blog:

I'd like to offer several observations and critiques of this article's analysis:

The article implies that homeowner's and umbrella policies automatically extend to commercial real estate. This is probably the case for single-family income property owned by a homeowner, since insurers sometimes agree to extend a homeowner policy to single-family rentals (for an extra cost). But if the rentals are multi-family, the owner probably needs to take out a separate commercial policy on each property.

Also, it is unlikely that an existing lender will allow the assumption of existing property debts (mortgages, equity lines, etc.) by the LLC. The owner will need to be negotiate new notes on each LLC property (which should be done prior to forming the LLC), and he no doubt will have to personally sign on each LLC note. The bottom line is that the owner will remain personally liable for the most important type of ongoing LLC liability -- LLC real property indebtedness.

Another complication: Generally, entities, such as co-owned LLCs and partnerships, can't qualify for favorable (tax-deferred) tax treatment when they trade one commercial property for another. Clever financial and tax advisors structure complicated property ownership arrangements and transactions that seek to get around the technical problems that can arise in this context, but expect to pay extra for these inventive and sometimes uncertain LLC-like-kind property swap strategies.

Forming a single-member LLC, which will be treated as the sole proprietorship of the property owner for tax purposes, can be burdensome in some states, in terms of annual filings and fees. For example, in California, the LLC has to prepare and file a separate annual state LLC informational return, must pay an annual $800 entity-level fee, and is subject to additional annual entity-level taxes that can reach almost $12,000. This additional tax can pose a real problem for property LLCs, since the additional tax is based upon gross receipts, which can include the value of real property owned by an LLC. When you multiply these costs by the number of separate LLCs (one per property, as recommended in the article), the tax and time expense to maintain the LLCs can be onerous.

Finally, co-owned LLC's involve even more tax complexity (the article recommends adding a second LLC member). In that case, the LLC is treated for tax purposes as a partnership, which means, essentially, that contributed real property is considered sold to the separate LLC tax entity (it is no longer consider a separate asset of the owner in which she holds a separate tax basis). After a property transfer, the LLC will have its own basis ("inside basis") in the property, and each co-owner calculates their basis in their LLC interest ("outside basis") separately. The basis of the non-contributing member will get the benefit of a share of existing indebtedness on the property (according to the non-contributing member's interest in the LLC), and the original owner's basis will be correspondingly reduced. There's a whole lot more complexity, such as special presumptions and tax consequences that occur if there are distributions of property of cash within two years of the transfer of property to an LLC, special LLC-level tax elections, necessary adjustments of each LLC member's basis each time the LLC pays down the debt on the property, and much more. In short, co-owned LLCs, like partnerships, requires expert (and costly) tax expertise.

Is it worth forming an LLC to try to limit the owner's personal exposure to liability that may arise in connection with the operation of rental property, such as slip-and-fall claims and other non-debt related legal liabilities? Normally, it isn't, as long as the owner carries a reasonable amount of commercial insurance on each property.

Copyright 2008 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax adviser for legal or tax advice.

December 6, 2007

Qualifying to Do Business Outside Your State

If your LLC or corporation is new, there's something you may not have heard about. If your LLC or corporation operates outside your home state, you may have yet another bureaucratic hurdle to tackle: qualifying to do business in other states. The question of whether or not you need to qualify or register in other states depends on a number of factors, including whether the business you do in other states is considered "intrastate" or "interstate."

Qualification is fairly simple -- you file a form in each state you do business and pay a fee ($100 to $300), but the penalties for not doing so can be high. I just published an article on the subject in the Nolopedia, Nolo's encyclopedia of free legal information - check it out.

October 15, 2007

S Corporations: A [Fill-in-the-Blank] Tax Dodge

Business formation websites, business books and magazine articles, and self-help hotel seminars still flog the S corporation as a clever way to avoid paying self-employment taxes on earned business income-namely, by reducing your S corporation salary and paying out S corporation profits to yourself as unearned income, which is not subject to self-employment (Social Security) taxes. Just form a corporation, then fill in the blanks on a simple-to-use one-page IRS tax-election form and voila, you're home free (tax-free).

I don't agree. First of all, the IRS sometimes [fill in the blank: "challenges on audit, "successfully sues," "seizes corporate profits paid out to"] business owners who work for their S corporation for free (that is, without paying themselves any or much of a corporate salary).

Second, this S corporation tax strategy seems penny-wise and pound-foolish ["dollar-dumb," converted to US currency].

Even if a Social Security payout cannot, by itself, adequately fund retirement, the fully-funded, top Social Security benefit of [fill in your projected maximum benefit as shown on your most recent Social Security Administration earnings and credits report mailing, such as "$1,500" or more per month, ] can put a serious dent in what you owe for [insert basic household necessities, such as "groceries, utilities, high-speed Internet, digital cable TV, cat food, etc."].

A typical riposte is "It doesn't make sense to pay into Social Security since the fund will go broke by the year [insert worst-case scenario date, such as 2040], after payouts to retiring boomers and excessive borrowing from the fund by the feds have drained the fund dry."

Again, I don't agree. Even if the fund needs replenishing to make up for a flood of baby-boom claimants and years of deficit-driven borrowing by other federal agencies, the majority of federal legislators have consistently expressed and shown their resolve to protect it, come hell or high-water or [insert other future fund-balance challenges, such as occasional pushes for privatization, investment-industry lobbying for opt-out alternatives, and the like].

In short, I think Congress will keep the fund functioning and afloat, and I believe it makes sense to plan ahead for the best possible Social Security payout after you reach the mandatory Social Security retirement age (even if you decide to continue working).

Copyright 2007 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.

October 2, 2007

LLCs and Real Property - Benefits and Pitfalls

Do LLCs work well to hold title to and deal in real property? Here are some benefits and potential pitfalls.

Benefit: They insulate property owners from personal liability

Pitfalls: The LLC normally protects the personal assets of the members from slip-and-fall and other on-site tort claims, as well as protects them from contract and transactional claims related to the property. However, the LLC should get commercial insurance to protect its big asset, the property itself, from being subject to claims made directly against the LLC. And don't forget that any sensible lender (and many have come to their senses following the subprime credit slide) will require the personal guarantees of LLC members when they finance property owned by the LLC. In other words, the members will be personally liable for the loan - their LLC's limited liability protection will not insulate them from this major liability.

Benefit: Property can easily be placed in an LLC

Pitfalls: You can transfer title to an LLC in minutes--the forms are short and clear. But don't forget that most existing property loans require you to obtain the consent of the current lender before you transfer ownership to another person or legal entity. And most will NOT agree, because they want to re-qualify the new entity as a borrower (and possibly charge new loan origination points and a higher interest rate). Anticipating your lender's firm "No," before you make the transfer you must make sure you can refinance, by paying off the current loan and taking out another in the name of the LLC. And, as mentioned above, the LLC members probably will have to personally guarantee the new loan. So a transfer may not be worth it. Also, a transfer of property to an LLC may have significant collateral effects, such as triggering a real property tax reassessment at the property's current market value. You may also face potential tax issues to deal with (more on this below).

Benefit: Property can be transferred into and out of an LLC tax-free

Pitfalls. Transfers of property into and out of an LLC are free of IMMEDIATE tax consequences. But what this really means is that taxes that would normally be due on gain built into the property are only DEFERRED until later when the property or the LLC is sold. The magic that makes this tax-deferral happen is a complicated set of rules that adjust the members' and the LLC's basis in the property and the members' interests. The downside is that it takes an expert tax advisor who is steeped in LLC taxes to get this to happen correctly. And, of course, there are plenty of gotcha's that can come up to make many transfers of property into and out of an LLC immediately taxable. Another big potential wrinkle is the set of tax rules that applies to encumbered property--that is, property subject to a debt. Since most real property is subject to a first mortgage, and maybe even a second note or a line of credit, this is a big wrinkle. The tax rules that apply to property loans require additional adjustments to the basis of the LLC and its members, and these adjustments have to be continuously made as the loans are paid off. In other words, expect more complications, and the need for more tax help, if the property is leveraged (subject to debt).

Benefit: The series LLC is ideal for property-development LLCs

Pitfalls: Delaware, Nevada and other states have enacted special sections of their LLC law to allow the formation of special "series" LLCs. Separate assets, such as separate parcels of real estate, can be isolated behind separate legal and tax firewalls within one series LLC. Each asset is subject to its own liabilities, but not those of the other assets in the series LLC. In other words, a real property developer can create one series LLC for a multi-property development project, and keep each property's liability status isolated from the other properties in the LLC, even if they share a common membership and management structure. Further, because the properties are not owned by separate legal entities, each may qualify under the federal tax law for like-kind exchange treatment--that is, the ability to swap one for the other without incurring a tax bill. Sounds too good to be true, doesn't it: A form of state-sanctioned smoke and mirrors? It may be ... and it may be best to take a wait-and-see approach to make sure state courts and the IRS approve of these series LLC statutes and tax-transfer tactics. A downside of setting up a series LLC is its complexity: It requires a separate set of financial books for each series LLC asset, and you may have to set one up in a state that is different from the one where the property is located. Setting up an out-of-state series LLC raises additional "home-vs.-foreign" state legal and tax issues--for example, how will your home state treat and tax your out-of-state series LLC income and loss allocations on each property? You'll need expert tax help from someone who is familiar with series LLCs.

Benefit: Putting property in an LLC places it out of reach of personal creditors

Pitfalls: An interest in an LLC is personal property that may be subject to attachment and liquidation by creditors. The LLC statutes of each state give creditors various rights to obtain charging orders, which are formal court orders to seize the economic rights associated with an LLC interest. If this happens, the creditor steps into the shoes of an LLC member and collects the member's share of LLC profits and property as they are paid out by the LLC. Some states also allow LLC creditors to exercise the debtor's LLC voting rights, which makes the creditor a substitute member in the LLC. Finally, some states go whole-hog and let a creditor petition a court to force a sale and liquidation of the LLC's property to pay off the creditor's claim immediately. Obviously, it's important to explore LLC state charging order and creditor-rights rules if you want to satisfy yourself that your interest in your LLC's property is beyond the grasp or at least realistically out of reach of your personal creditors.

Copyright 2007 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.

September 27, 2007

LLCs: Still in the Headlines

I was interviewed recently by Kelly Spors of The Wall Street Journal for a Q & A piece ("Steps to Take to Form an LLC," published in the WSJ, March 13, 2007). After going through the usual informational spiel I am accustomed to providing to reporters, it occurred to me that since LLCs are no longer the new kid on the business entity block, having reached at least adolescent age among its business entity peers, it was time to take inventory of its current pluses and minuses:

+ State-law limited liability law still provides relatively cheap protection against personal liability for business debts and claims.

- In some states, LLCs are charged an extra $500 or more annually to do business as an LLC. In California, for example, an LLC can be charged up to $12,000 annually in state fees and taxes if it has significant gross receipts.

+ Forming an LLC will not normally change the current tax status of a business. A sole owner of an LLC continues to file Form 1040 Schedule C to report profits and losses; a co-owned LLC continues to file a 1065 partnership tax return.

- Any co-owned business is treated and taxed as a partnership. Partnership tax law is no piece of cake, and it takes a real tax expert - someone who normally charges a lot - to handle these taxes and tax calculations correctly. Further, co-owned LLC treatment under the partnership tax rules is even more complicated. You'll need to find a good tax person, steeped in partnership taxation, to handle a co-owned LLC's taxes.

+ LLCs are good for setting up special management arrangements among co-owners. LLC law is flexible and allows an LLC operating agreement to be custom-tailored to fit special management needs (with special member-managed or manager-managed rights and responsibilities).

Bottom Line: I usually conclude all interviews with the following tagline: Make sure to tell people to decide they definitely need an LLC before they form one ("if it ain't broke, don't fix it"). If your business is reasonably insured and not subject to special risks, and if you don't need to set up a special type of management structure to suit your special business needs, you can probably get by just fine without filing LLC formation papers with the state.

Copyright 2007 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.

September 26, 2007

LLCs and the Dreaded Tax Code

I have a confession to make: LLC taxes scare me. I have been studying LLC taxation on and off for more years than I care to count, and I still break out in a cold sweat whenever a reader asks me why my LLC books do not contain special allocation language.

Let's back up a little. LLCs are taxed just like any other business: a one-owner LLC is just like a sole proprietorship; and a co-owned LLC is like a partnership, with a few special tax wrinkles (let's ignore the wrinkles for now).

Early in my LLC research, when I started my first LLC book for Nolo, Form Your Own Limited Liability Company, I realized that taxes were a big part of the picture when one surveyed the LLC landscape. So I decided to enroll in MBA tax classes to supplement my law school taxation curriculum. That's when the trouble started.

Sitting as a somewhat-senior member in a classroom filled with wide-eyed, soon-to-be tax professionals, I would occasionally raise my hand to ask the long-toothed professor ‑ my teeth weren't a whole lot shorter ‑ some real-world LLC tax questions, such as:

Is it easy to adopt the safe-haven special allocation language contained in the Internal Revenue Code to be sure that disproportionate allocations of profits and losses set out in an LLC operating agreement are respected by the IRS?

The immediate answer seemed to be "No, not really." I say "seemed" since tax professors rarely provide direct answers to direct questions ‑ given the enormity of the tax code and the muddiness of its clarifying regulations, they've understandably learned to hedge their bets by providing multiple-answer responses.

Over the next several months, I gradually coaxed the following fuller answer from the professor:

If two people form an LLC and make special allocations of profits and/or losses ‑ for example, one person gets a larger slice of the profit pie because she puts up cash and the other owner agrees to work for the business it may be necessary under the technical regulations that apply to special allocations for the co-owners to agree in the LLC operating agreement to be personally liable for any losses incurred by the LLC that exceed the balance in their capital accounts. If they don't add this provision to their LLC operating agreement, the IRS may not respect their special allocation of extra profits to the cash-contributing owner, and it may recalculate the owners' prior-year profits (and taxes) if the LLC or its owners' tax returns are audited.

Gee, I concluded aloud, doesn't that type of "I'll pay back the LLC" provision in an operating agreement defeat the whole purpose of forming an LLC, which is to be free from personal liability for business debts and claims?"

Yes it does, he answered, moving back to his prepared lecture notes.

In the course of several more tax classes, I received equally daunting and surprisingly unhelpful answers to my real-world LLC tax questions. For example, it turns out that when a person contributes property to a co-owned LLC, in effect, each person sells their property to the other owners, and from then on the computation of the owner's tax basis in the property becomes amazingly complicated and subject to a number of special technical tax elections, which most LLC owners never find out about.

Here's another example: when an LLC borrows money, as many must, the owners personally get a boost in their tax basis, which is a good thing. But as the LLC pays off the debt, the owners are supposed to lower their tax bases each year. Many don't. In other words, many tax advisors don't do this for the owners, nor do they report the lowered basis correctly to the IRS. Since tax basis is used to figure out the amount of LLC losses that can be passed through to the owners, and how much tax each owner pays when an LLC interest is sold, a lot of people are getting the math and the tax results wrong.

I, too, have learned to hedge my bets when discussing LLC taxation. I also try to temper some of my gloomier tax thoughts with the good news that even though LLCs, like partnerships, have significant tax complexity and uncertainty, they provide the unique advantage of limited liability legal protection to all LLC owners. Thanks goodness for silver linings.

Copyright 2007 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.

September 14, 2007

About This Blog

Anthony Mancuso, J.D., a corporations and limited liability company expert, writes on LLCs, corporations, entity choice, and taxation.