Advanced LLC Tax Issues

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An LLC is a hybrid between a corporation and a partnership. An LLC can be taxed as a partnership, S or C corporation or a disregarded entity. The IRS established federal default rules in 1997 to simply how an LLC is taxed. One member is a disregarded entity and two members are tax as a partnership. In either situation, you can file form 8832 to have an LLC taxed as a Corporation or form 2553 to be taxed as an S corporation.

One of the subjects that 90% the people who have an LLC do not properly handle the transfer of an LLC interest to another.

As personal property, an LLC interest may be transferred by a bill of sale, assignment, or comparable document. If the interest are documented certificates, like stock certificates, it should be possible to transfer an interest by endorsing the certificate, by granting the power of attorney to the transferee, or by granting a type of power like a stock power. To be effective the transferee must also cause the transfer of the interest to be reflected on the LLC’s books. The transfer must first be approved under the LLC’s requirements (e.g., approval of at least a majority in interest of members). It is recommended that an LLC record the transfer of membership interests in the same fashion as a corporation uses a stock transfer ledger.

This is a key point…the transfer of an interest to a person does not by itself grant the status of a member in the LLC. Rather, the transferee is merely an assignee of certain economic rights unless the other members by a vote approve the transfer of the interest.

The various state acts generally provide that unless the members have otherwise agreed, a membership interest is assignable in whole or in part. Although some statutes may refer to the free assignability of a membership interest, what is actually meant is the free assignability of the financial rights, not governance rights.

Typically, members will want to impose restrictions on assignability, and the operating agreement would provide this language. An operating agreement also should define if the transfer restrictions did not apply to transfers to members, non-members, or both of the LLC.

This may surprise you, but an LLC member can assign his or her interest without anyone’s consent. Although the transferee will be an assignee and NOT a member. Only members can vote and exercise other rights of members, but not an assignee, like a member, may receive distributions of cash or property.

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Distributions from an LLC

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After your LLC is formed and your business is up and running and revenue is flowing in it will come to that important point where you will distribute money to the partners. That may be just you, your spouse or other outside partners.

Most simply think about writing a check from the LLC to themselves as the owner and really do not consider the tax ramifications of their actions. This is especially important any time you have a partner, whether that is a spouse, outside partner, separate legal entity.

Let’s address some basic fundamentals first then get into more details:

The first step is to be aware of how your LLC is taxed. Are you a single member LLC taxed as an S corporation, or disregarded for tax purposes? If you have earned income and a single member LLC that will flow through to schedule C (basically you are operating as a sole proprietorship, but have the liability protection of an LLC). Test question: Is there any payroll for a single member LLC? The answer: depends. If the LLC is disregarded for tax purposes there is NO payroll to the owner. Is it possible for a single member LLC to have employees? Yes. If the single member LLC is taxed as an S corporation, the active member (owner) would have payroll and distributions. If you have a single member LLC taxed as an S corporation, of course, the only member is active. If you have a two-member LLC taxed as an S corporation, it is possible that the second member could be passive (this could be a spouse or silent partner). Would the passive member be the manager of an LLC managed by managers? No. By definition, if passive they would not be running day to day operations. Keep that in mind.

A single member LLC taxed as a C Corporation; there would be at some point some type of payroll to the owner of the C Corporation. Is it possible that there was only enough revenue in the LLC taxed as a Corporation to pay business expenses only and not enough profits left over for any type of payroll? That is possible. You may take dividends out of the LLC taxed as a C Corporation, but keep in mind dividends are NOT deductible to the LLC taxed as a C Corporation’s profits.

An LLC taxed as a partnership is a very common structure. The big mistake you want to avoid is doing payroll for partners. There is NO payroll to partners in an LLC taxed as a partnership. There is something called, “guaranteed payments” to the manager of the LLC for their role in the day to day operations of the LLC which is subject to employment taxes, but it is not payroll. The members (or partners) of the LLC will receive distributions in profits. If the member or partner is actively involved in operating the business those distributions will be subject to employment taxes.

Let’s get into more detail about when an LLC can make distributions to members. Absent any agreements with third parties restricting distributions, LLCs generally can distribute cash or property. Here is an important point (a reason to have great accounting records from the beginning); most LLC acts prohibit to members if, following a distribution, the LLC’s liabilities (other than liabilities to members) would exceed the value of the LLC’s assets. Most LLC statutes hold members liable to creditors for wrongful distributions under their fraudulent conveyance statute.

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