Tony Mancuso: April 2008 Archives

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.