Tony Mancuso: October 2007 Archives

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.