How Are LLCs Taxed?

Limited liability companies (LLCs) are one of the most popular types of business entities. What they are not is a tax classification. In fact, an LLC’s flexible taxation options are one reason it is the preferred choice of enity; LLC members can, for the most part, choose how they would like to be taxed. The LLC enjoys this flexibility because the Internal Revenue Service does not recognize it as a distinct entity for federal tax purposes. It must, therefore, be taxed as one of the four taxable options already available:

  1. Disregarded Entity. A disregarded entity is a business structure that is not recognized as distinct from its owner for tax purposes. If you are the sole owner of a single-member LLC, the IRS classifies your company as a disregarded entity by default and taxes the LLC as a sole proprietorship. As a result, the owner of a single-member LLC must report the LLC’s income and expenses on the member’s Form 1040 Schedule C. A separate tax return for the entity is not required. 
  1. Partnership. When an LLC has multiple members, the IRS’s default classification for tax purposes is the partnership. Partnerships, like disregarded entities, pass their income and expenses down to their owners, and LLC members are responsible for paying taxes proportionate to their ownership interests. Income, credits, and deductions are reported to the IRS using Schedule K-1 (Form 1065). 
  1. Corporation. If the member or members of an LLC don’t want it to be taxed as either a sole proprietorship or a partnership, they can elect to have it taxed as a corporation by timely filing Form 8832. Electing taxation as a corporation may be beneficial in several ways. If the company does not intend to pay out dividends, electing to file taxes as a corporation allows LLC members to avoid reporting the business’s income on their personal income tax returns. Because personal income tax rates are often higher than corporate income tax rates, this may allow individuals to benefit from the lower corporate income tax rate. Additionally, LLC members may avoid paying self-employment taxes. Thus, corporate taxation may have money-saving benefits for LLC members.
  1. S Corporation. The S corporation tax election is unique. Unlike the other three options described above, the S corporation is not a different entity type. Rather, it is a corporation that meets all of the following criteria:
  • it has less than 100 owners
  • all of its owners are United States citizens or residents
  • it has only one class of membership
  • its membership is not comprised of any partnerships, corporations, or non-resident aliens

If members choose to have their LLC taxed as an S corporation, the LLC members enjoy pass-through taxation unlike a standard corporation. Moreover, the income that is taxed as a distribution is not subject to self-employment tax. Finally, an S corporation allows its owners to take advantage of the Qualified Business Income Deduction of up to 20 percent. There are some limitations as to which industries qualify for this unique deduction. You must timely file IRS Form 2553 to elect S corporation taxation.

We Can Help

Choosing the right structure for your business can be challenging and involves all kinds of considerations in addition to how the LLC should be taxed. Be careful you don’t willy nilly allow the IRS tail to wag the LLC dog. Have a conversation or two with your attorney and your CPA (you do have a CPA, don’t you?), then make the tax decision.

Your LLC Up and Running in 6 Steps

One of the first decisions to make when starting a business is what type of business entity to form. The limited liability company (LLC) is one of the most popular business structures because it offers a level of flexibility and legal protection that is attractive to many people who are starting their own businesses. The following six steps will help you get started if you are interested in forming an LLC.

  1. Choose a name. To form an LLC, you must select a business name that complies with state regulations. The name you select cannot be the same as or even too similar to any other LLC’s name; it must be unique to avoid consumer confusion. Next, states often require that the name of your LLC include one of the following at the end: “limited liability company,” “LLC,” or “Limited.” This requirement gives the public notice of your business structure. As simplistic as this step may seem, it is critical to successfully establishing an LLC and being able to take advantage of the legal protections this business structure provides.
  2. Select a registered agent. In addition to selecting an appropriate name, you must select a registered agent. A registered agent, also known as a statutory agent, is the party appointed to receive service of process and communication from your state’s secretary of state. If you live in the state where you form your LLC, you may be your own registered agent. Registered agents must provide an address where important correspondence can be sent. Typically, post office boxes are not acceptable places for a registered agent to receive these communications—rather, a physical address is usually required so the agent can receive service of process. When deciding who should serve as the registered agent, keep in mind that the registered agent will typically be the first person to whom the state reaches out if any issues arise with your LLC. As a result, it is important to ensure that your registered agent consistently checks incoming correspondence and relays that information to you as the business owner. If you are not interested in being your own registered agent, consider using one or more commercial registered agents in your state to do the job. Generally, they perform their services fairly inexpensively.
  3. File documents. Perhaps the most important step in creating your LLC is filing the required documents. The articles of organization (referred to in some states as the certificate of formation or certificate of organization) are usually filed with the secretary of state and include such information as the company’s name, the registered agent’s name and address, and the business’s purpose. This information becomes public record, so be mindful of what information you are comfortable sharing with the world. Keep in mind that there is a fee to file these documents; however, any start-up costs and filing fees you incur are tax-deductible. 
  4. Get a tax identification number. Another essential step in starting an LLC is obtaining a Tax Identification Number. Your LLC’s Tax Identification Number, also known as an Employer Identification Number or EIN, is provided by the Internal Revenue Service (IRS). After completing a successful application, the IRS assigns a unique number that links the identity of the responsible party to the business for income tax purposes. 
  5. Open a business bank account. After you have filed your LLC’s formation documents with the state and obtained a Tax Identification Number, you will be ready to open a business checking account. This step must not be overlooked in order to enjoy the benefits of an LLC. Maintaining this separate business checking account prevents you from commingling your personal funds with the business’s funds. Failure to maintain this separate business account could result in losing the business’s limited liability status because of a legal concept called “piercing the veil.” If this happens, you could be held personally liable for the LLC’s debts and liabilities.
  6. Draft an operating agreement. Finally, to form an LLC, you must create an operating agreement. This document outlines the rules and regulations governing the LLC. Think of it as a contract or agreement between you and the other members of the LLC or between you and the LLC if you form a single-member LLC. In some states, business owners are required to file this document with the articles of organization. 

Once your LLC is formed, it is critical to remember and adhere to the compliance requirements to keep your LLC in good standing. These requirements vary by state but often involve some form of annual reporting. In most states, for example, Utah and Wyoming, you may also be required to pay an annual fee. Failure to comply with these requirements will result in the suspension of your LLC and put your personal assets at risk.

The Impact of Transferring a Property in or out of an LLC on the Underlying Mortgage

The purpose of the Garn-St. Germaine Depository Institutions Act of 1982 is the “permanent preemption of state prohibitions on the exercise of due-on-sale clauses by all lenders, whether federally or state-chartered, [and] to reaffirm the authority of Federal savings associations to enforce due-on-sale clauses, and to confer on other lenders generally comparable authority with respect to the exercise of such clauses.”

That said, the Act contains some limitations on that authority:

§ 591.5  Limitation on exercise of due-on-sale clauses.

(a)  General.  Except as provided in § 591.4(c) and (d)(4) of this part, due-on-sale practices of Federal savings associations and other lenders shall be governed exclusively by the Office’s regulations, in preemption of and without regard to any limitations imposed by state law on either their inclusion or exercise including, without limitation, state law prohibitions against restraints on alienation, prohibitions against penalties and forfeitures, equitable restrictions and state law dealing with equitable transfers.

(b)  Specific limitations.  With respect to any loan on the security of a home occupied or to be occupied by the borrower,

(1)  A lender shall not (except with regard to a reverse mortgage) exercise its option pursuant to a due-on-sale clause upon:

(i)  The creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property: Provided, That such lien or encumbrance is not created pursuant to a contract for deed;

(ii)  The creation of a purchase-money security interest for household appliances;

(iii)  A transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;

(iv)  The granting of a leasehold interest which has a term of three years or less and which does not contain an option to purchase (that is, either a lease of more than three years or a lease with an option to purchase will allow the exercise of a due-on-sale clause);

(v)  A transfer, in which the transferee is a person who occupies or will occupy the property, which is:

(A)  A transfer to a relative resulting from the death of the borrower;

(B)  A transfer where the spouse or child(ren) becomes an owner of the property; or

(C)  A transfer resulting from a decree of dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement by which the spouse becomes an owner of the property; or

(vi)  A transfer into an inter vivos trust in which the borrower is and remains the beneficiary and occupant of the property, unless, as a condition precedent to such transfer, the borrower refuses to provide the lender with reasonable means acceptable to the lender by which the lender will be assured of timely notice of any subsequent transfer of the beneficial interest or change in occupancy. (Emphasis supplied)

A cursory reading of this statute will demonstrate that though transfers to inter vivos trusts are exempted from the due-on-sale provisions of Garn-St. Germain, for example, transfers to LLCs are not. Thus, if your clients deeds her personally own, mortgage-encumbered rental property into her single-member LLC (SMLLC) of which she is the sole member, she risks her mortgage lender calling the loan—that is, the loan being immediately due and payable.

What to do? Interestingly, different attorneys give different advice. Some will say that the safest path is to call the mortgage lender and let them know what is going on—essentially ask permission. They’ll then say, “but why bother? The lender will never find out anyway.” Actually, it may be true that lenders don’t spend much time policing property records in an effort to catch borrowers transferring real estate into their LLCs—I’ve heard this a lot, but who knows if it’s true? However, the safest path is also the best path, and in most cases, it will be a relatively easy one. But when you make that call, make sure you keep talking until you talk to a person who knows what they’re doing.

The due-on-sale concern will arise in two situations: 1. In a new purchase where the lender says the purchaser/borrower must buy the property in her own name, and the purchaser/borrower intends to transfer it into an LLC post purchase; and 2. Where the purchaser/borrower has owned the property in his own name for a while and decides he wants to transfer it into an LLC—the old purchase.

New Purchases. In this situation, it’s simply a matter of being up front with the lender from the beginning. The borrower should explain their intentions and get the lender’s approval in writing prior to signing the loan, when she has leverage. Lenders see these situations all the time, and most will agree and even facilitate the transaction. Some may require guarantees by the LLC, signed by its members or managers accompanied by a resolution or other statement of authority evidencing their authority to sign.

Old Purchases. This situation is more problematic. The lender has the leverage, and if rates are up, it’s in the lender’s interest to call the loan. In such an environment, it may be worth the risk to transfer to the LLC and ask forgiveness later—if ever. Chances are, the lender will never know. But if the lender discovers that your client transferred the property and if rates are up and the client’s financial situation has deteriorated, trouble may ensue. If rates haven’t changed much and if the client is able to refinance if necessary, the existing lender may be more willing to allow the transfer without calling the loan.

It’s virtually always best to talk to your lender before you make a transfer; otherwise, you risk the lender calling your loan. And besides, do you want a good or a bad relationship with your lender. Yeah, I thought so.

Business Trademarks: What’s Really in a Name?

This name is not available.

If you’re thinking of starting a business (or already have a business in the works), make sure that the name you use is not already taken.  Original names are essential for three reasons:  marketing power, clarity, and trademark infringement avoidance.  For example, if you’ve decided to open a coffee shop, it’s fairly easy to determine that the name “Starbucks” is notan option.  But, what about “Smith’s?”  And what happens if the “Smith’s” trademark is an auto insurance company in your town? 

What’s Really in a Name When it Comes to Business Trademarks?

Before attempting to trademark your business’s name, find out if the name is available on the U.S. Patent and Trademark Office’s website.  TESS, the Trademark Electronic Search System database, will indicate whether someone else has already claimed the name or symbol you want to use. 

  • While U.S. trademark protection is granted to the first company to use it in its operational geographic area (regardless of registration), a company that grabs the trademark first will generally have a stronger case in court.
  • In some situations, the similarities between names or symbols may be negligible.  That’s where an experienced business attorney with intellectual property experience can help. 

Often, there’s generally a way to accommodate both companies – especially when it comes to businesses with similar names, but dissimilar products (the “Smith’s” example above); those whose geographical locations may not conflict; and those whose names are too generic (for example, “The Clothing Store”).

Domain Extensions as Trademarks

In today’s marketplace, many businesses have both a physical location and an online presence.  The question then becomes whether to trademark the company name (for example, Amazon), the URL (www.amazon.com), or both.  It’s generally recommended that companies with an internet presence not register their web extensions (such as .com, .net, etc.) with their name unless planning to register the mark both with and without the web extension.  The reason is that other businesses registering the same name can do so by just adding a different (non-registered) extension and cause a great deal of confusion for customers.

A prime example is Craigslist.  The multi-purposed classified ad site is technically a “.org” site, but those who searched for craiglist.com or craiglist.net were often led astray.  The company now has trademarks for all, so typing in the latter extensions now brings you to the main .org site.

Series LLCs: (Some of) What You Need to Know

A series LLC, a relatively recently authorized form of LLC, is composed of a master LLC—the Mother Ship—which houses a series of LLCs. Each series, silo, or cell (the potential synonyms are almost endless) within the series LLC often has separate owners, and each must always maintain separate records, especially records that account only for the assets of that series—at least if the series LLC is formed in Utah or Wyoming and other ULLCA states that allow for series LLCs.

Series, Silos, or Cells: more protection at less cost?

Similar to a corporate/subsidiaries business model and like their more well-known parent LLCs, series LLCs offer asset-protection benefits, but they avoid the complexities of corporate taxes, structure, and other required formalities. 

This type of entity is well suited for certain businesses that may benefit from its relative simplicity, reduced costs, and increased asset protection. But especially because they are so new, there are also some uncertainties associated with the series LLC.

Potential Benefits of the Series LLC:

1. Simplicity

  • Reduced Administration

Although each series must be administered separately, series LLCs have the potential to save time and administration costs.

2. Reduced Costs

  • One Registration

Each of the individual series is formed and governed by the master LLC’s operating agreement.  In most states—Wyoming and Utah, included—only the master LLC must be registered with the state, which means reduced fees.

  • Potential Sales Tax Savings

Some states may not require sales tax to be paid on rent that one series pays to another series.

3. Asset Protection

  • Mixed Signals

Under most series LLC statutes, each series is protected from judgments against assets in other series under the master LLC.  But it’s not clear that this protection will be respected in bankruptcy proceedings or in states that don’t recognize series LLCs.

Potential Downsides of the Series LLC:

1.  Some Additional Costs

  • Registered Agent

Many states require a separate registered agent for each series in the series LLC, which may mean additional expenses.

  • Formation Cost

The up-front registration fee for a series LLC may be higher than the registration fee of a regular LLC.  In some states, it may be less expensive to register multiple single-member LLCs rather than a series LLC with multiple series. This is generally not the case in Wyoming and Utah.

2. Governance Issues

  • Overlap Jeopardy

The operations may not be as streamlined as anticipated. The records of each series must be maintained separately, and each series must have its own separate bank accounts.  Can administrative functions among the series overlap without jeopardizing the limited liability? Can the ownership or management overlap? Does inadequate capitalization of one series impact the other series in the series LLC? At this point, these types of questions remain unanswered.

3. Liability Questions

  • Bankruptcy Issues

Federal bankruptcy laws do not yet address series LLC issues.  Can an

individual series within a series LLC file for bankruptcy? Are the assets of the non-filing series and the master LLC protected from the filing series?  At this time, there are no clear answers to these and other bankruptcy-related questions.

  • Choice-of-Law Issues

If a series LLC gets sued by a third party in a state that doesn’t authorize series LLCs, the assets of each series and the master LLC may be at risk. For LLCs that operate in states with and without series LLC statutes, this may make a series LLCs much less attractive.

The series LLC is potentially a star on the rise and is definitely worth watching.  If your business is particularly well suited to this compartmentalized approach—real estate investing, for example—and you live in one of the states[1] that currently authorizes series LLCs, you may want to this novel entity.


[1] As of November 2019, Alabama, Delaware, DC, Illinois, Indiana, Iowa, Kansas, Missouri, Montana, Nevada, North Dakota, Oklahoma, Tennessee, Texas, Utah Wisconsin, Wyoming, and Puerto Rico provide for series LLCs in their statutues.

Kanban Boards, Focus, and Productivity

One of my many weaknesses is maintaining focus. Often it seems squirrels are everywhere. And that’s frustrating because when I am focused, my head down, I move forward quickly and accomplish a lot.

So it was that I got excited when I heard John Grant describe so-called Kanban Boards on a Legal Talk Network podcast. (Warning, the podcast starts out slowly and Grant can be a bit jargony–so much so that I almost turned the podcast off–but it gets better and when he began talking about Kanban Boards, I was hooked.)

I rushed home, watched his video on the the subject and created my own  board. I’d show you my board, but I have client names on some of the Post-it Notes–did I mention that a Kanban Board is essentially a white board divided into columns and covered with Post-It Notes? Since I began using my board three weeks ago, I’ve been multiple times more focused and productive. Can’t recommend the tool highly enough.

By the way, Kanban Boards are not just for attorneys. They’ll improve anybody’s life.

Here’s the video:

 

What’s the Value of Water?

The answer to the question, “what’s the value of water?” is it depends. No surprise there, but to be clear, I’m not talking about the value of the water that runs out of your tap. I speaking of the value of water that is appurtenant to your farm or ranch land. What’s it worth in an of itself?

Well, Deborah Stephenson of DMS Natural Resources LLC, writing at Hall and Hall makes clear that the answer is in no way clear and depends on a number of things, including:

  1. Quantity – The quantity of water that a water right yields.

  2. Marketable Region – The feasible region in which the asset can be transferred to a new user.

  3. Alternative Water Supply Options – Availability of existing water supplies and future water development opportunities within the region.

  4. Water Quality – The quality of a water source can influence the suitability of a water right for a potential new use.

  5. Reliability – The amount of water that is regularly available to the water right holder compared to the claimed or stated volume on the water right. The amount of water available is determined based on a combination of water source yields, hydrological conditions, and the water right’s legal attributes –  mainly priority date.

  6. Seasonality – The period during which the water right holder can divert or withdraw water from the source.

  7. Highest and Best Use – The highest value use to which the water right can physically and legally be put to use.

Using those seven criterion, you can arrive at an appraised value of the water in question. But that only gets you so far, Stephenson says. No, you also have to look at water in the operational context, and that assessment is based on three considerations:

  1. Utilizing the water in the current agricultural operation.

  2. Utilizing the water on-site, but changing the use to a non-agricultural purpose.

  3. Decoupling the water and transferring it off the property.

You should be able to readily see that each of those factors will influence the value the water. I’m going to leave it at that. Stephenson covers the topic quite well, so click on the link above and continue–if you’re interested.

Value Water? Listen to The Water Values Podcast!

In an effort to keep abreast of water, water law, and water rights, I listen regularly to David T. McGimpsey, host of the Water Values Podcast. An attorney with Bigham Greenebaum Doll, David does water law, among other things. In his podcast, he interviews water experts and professionals from all walks of life–engineers, lawyers, hydrologists, water administrators, entrepreneurs, anybody and virtually everybody who does anything with water. I almost always come away from his podcast thinking that was time well spent.

My interest in water law stems from my estate planning and business practice. Water is property and proper estate and business planning ensures that property stays in the right hands over time.

Of course, I’m also interested in water because, as McGimpsey says at the end of every podcast, “Water is our most valuable resource, so please join me by going out into the word and acting like it.” Words to live by.

To C or LLC? That’s Today’s Question

I just read an interesting post over at The Startup Law Blog, a post written six years ago. The writer lists “12 Reasons For A Startup Not To Be An LLC.” The key word in that post is “startup,” and key thing to understand is the author’s audience, largely captured in the following paragraph from the post:

For tech or growth companies planning to follow the traditional path of regular and ongoing equity grants to employees, multiple rounds of financing, and reinvestment of as much capital into the business as possible, with the goal of an ultimate sale to a big, maybe public, company in exchange for cash and/or stock, LLCs are typically not the way to go.

If that paragraph describes you, then maybe the C corporation should be the entity of choice for you.

As for the C corp, the author makes another important point. We’ve all heard that one reason–if not the major reason–to avoid the C corp is the possibility of double taxation. Well, maybe:

The bogeyman that you will hear about most frequently is the “double tax” bogeyman. You will be told—don’t form a C Corporation because you will be subject to a double tax.

What is meant by this is that if the C Corporation makes money, it will pay tax on that money. And if it pays dividends to its shareholders, they will pay tax on the dividends. This is true. And so if you anticipate your business being a cash cow, and immediately generating so much money that you will earn more than you can reasonably pay out in salary to the owner executives, then maybe an LLC is a good choice for you. But for most growth businesses, whose goal is to raise capital, reinvest capital, grow fast, grant equity incentives, and ultimately be acquired or go public, a C Corporation is the way to go.  For these businesses, the double tax bogeyman rarely appears, and most exits are structured as one layer of tax stock sales. (Emphasis supplied)

In the end, the real lesson, make that two lessons, from the blog post is that one size doesn’t fit all and that there are lots of questions to answer on the road to choosing an entity for your new business venture.

Will you know the answers? Better yet, do you know the questions?

Just Leave It Alone?

As many will recall, then candidate Trump promised to eliminate the estate tax. That was then. This is now–he’s the President. What will he actually do? Will he also eliminate the estate tax’s two siblings: the gift tax and the generation skipping tax? No one knows, though many people care, especially those who preach tax fairness.

Given that married couples currently have to be worth almost $11 million dollars before  the estate tax kicks in–it’s more complicated than that, but still–eliminating the estate tax is going to help only the very, very wealthy. And maybe that’s a bad (or a good) thing.

I’m here to argue for the advisor. Estate planning attorneys, life insurance and investment advisors, CPAs and financial planners. I’m betting that each and every one of them agree with the following:

Because the estate tax generates a meager 0.005 percent of annual tax collections, according to I.R.S. figures, it generates far more political debate than federal revenue. And among many tax planners, the calls aren’t so much for reform as for stability, or at least a period of benign neglect.

“Just leave it alone so we can plan,” Mr. Jenney said. “But every administration seems to want to put their own twist on the estate tax.”

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