COVID Funding Tips for Small Businesses
The proper LLC strategies will help ensure your assets are really protected. Unfortunately, most will file a “simple LLC” online for the least amount of money and are later surprised when they are not protected.
First, let’s look at the history of the LLC. The Limited Liability Company (LLC) is a powerful entity that originally started in Wyoming in 1977 and became more popular in the late 1990s. It is a hybrid between a partnership and a corporation. Most are unaware that an LLC can be taxed in four ways: disregarded, partnership, and S or C corporation.
The IRS established federal default rules to simplify this determination in 1997. A one-member LLC by default will be taxed as a disregarded entity for tax purposes, and a two-member LLC will be taxed as a partnership for tax purposes.
Now let me share with you 12 LLC secrets that will not only keep you up out of tax trouble but help you better avoid pitfalls down the road.
- Can an IRA invest in an LLC? Yes, but…This is a popular strategy when looking for different investment options for retirement funds. Many are looking to take advantage of the real estate market to invest in and find they do not have the money personally to invest, but their IRA does. This strategy involves moving your IRA to a self-directed IRA, and the IRA becomes a member of an LLC. In other words, the investment is in the membership interest of the LLC.
There are a couple of major issues with this strategy that could create problems with the IRS. First, if you are the LLC manager and you are on the LLC checking account that has IRA funds, that means you have “checkbook control.” There are prohibited transactions where you cannot use that money, but more importantly, the signer on the account may use the LLC money for personal use, which is a big problem and could create serious IRS issues. The second issue centers around who can be the manager of the LLC. Can it be you also? Is that self-dealing?
That means you are running the same entity owned by the IRA in which you own, which is an issue by the IRS. It appears that having a separate self-directed IRA only to own the real estate may be a better approach. You do want to isolate the safe and risk investments also.
- What are the advantages of an LLC over an S corporation? Assuming the LLC is taxed as a partnership vs. the S corporation, there are differences. When you capitalize on an S corporation, code section 351 allows shareholders to transfer appreciated assets to the corporation tax-free. BUT…the shareholder who is transferring the asset MUST own 80% of the S corporation. This is fine if you have a one-person corporation, but what if you have a partner? What happens if you own it 50/50? Is it now a taxable event? Yes! How does an LLC taxed as a partnership differ?
There is no such rule for an LLC. Transfers are tax-free under IRC §721 to an LLC taxed as a partnership. There is no 80% rule. An LLC can rarely lose its status as a partnership for tax purposes. Still, the S corporation can forfeit the S election, in many ways, including having a foreign owner, an owner that is a C corporation….(the S corporation has restrictions on who can be a shareholder. This is especially important when you are looking for investors.
The LLC has the charging order protection, which offers more protection vs. an S corporation. Yes, you can get the best of both worlds and have an LLC taxed as an S corporation and have the charging order protection (which will be covered in bonus point #12).
- When should an entity convert to an LLC? Yes, in many states. This comes up when someone has had a corporation for several years, and they would like it to “become” an LLC. If you formed a corporation recently, it might be fewer steps and cheaper to form a new LLC. Many statues authorize the merger of an LLC with another entity like a partnership or corporation.
Some state LLC acts provide that an LLC may NOT merge with another entity unless there is unanimous consent of the members for such a merger. For states that do not have a specific statute authorizing such a merger, an indirect merger can be accomplished by transferring stock, interests, or assets. A second method is to use another state’s merger statute. After that, the LLC can foreign register in your state of the business.
- What are the consequences if an LLC is “doing business” in a state but is not registered as a foreign LLC? This is very common when the entity formation industry will promote incorporate in tax-free Nevada and claim your business can be based anywhere. Typically, the entity will need to foreign register where nexus (or a business presence) is located.
Even an internet business can make the argument you can be based from anywhere. Still, if you are working in your home office in California with a Nevada LLC, you have nexus in California. Besides, how do you claim a home office deduction when the LLC is not in your state doing business? It does not make sense. A more common issue may be that you have an LLC in your home state, and you are actually doing business in another state and have nexus there, which will cause the need for you to foreign register the LLC, but what if you did not know that?
Here are some of the consequences. An LLC that is not registered to do business would NOT be allowed to bring suit in that state. This is a big one. However, the LLC would remain liable for any act or contract entered into while it was operating in that state. A party could bring an action against the LLC, and the lack of registration does not prevent the LLC from defending the action. The LLC will be liable for registration fees, taxes, and penalties that it would have owed during the period of time it operated in that state. Many states impose penalties when an LLC transacts business in the state without being registered.
- When do LLC members have limited liability? No member of the LLC is personally liable for the LLCs debts and obligations (as opposed to individual action, such as by personal guarantee or commission of a tort).
A member of the LLC has personal liability if a creditor of the LLC has the right to require a member to satisfy the LLC’s debt to the extent that the LLC’s assets are insufficient to satisfy the LLC’s debt to the creditor. Members and managers of an LLC are, by statute, generally not liable for the LLC’s obligations. But anyone who acts on behalf of the LLC without the authority to do so will be liable for any liabilities as a result of their actions. A member may also have liability to the extent of the member’s contribution (or capitalization). Members and managers are always liable for their own torts. The members could lose their liability protection if the LLC veil is pierced.
- How will a single-member LLC, taxed as a disregarded entity for federal income tax purposes, be treated for state tax purposes? State laws follow federal laws. A single-member LLC would be disregarded for state income tax purposes when disregarded for federal income tax purposes. If the single-member LLC is taxed as an S or C corporation, the state tax laws will follow suit.
- How much capital must be contributed to an LLC? Except when required by state law, there is no minimum amount that must be contributed to an LLC in exchange for an interest in the LLC. Some states statutes provide that members do not have to make any capital contributions to be admitted as a member of an LLC (Michigan is an example).
Adequate capitalization is usually left up to the members. However, a member who receives a capital or profit interest in the LLC with a fair market value above the fair market value of the capital contribution may be subject to tax on receipt of that interest to the difference’s extent. Therefore a good CPA is recommended when you have partners in an LLC!
- What type of reporting is required if real estate is contributed to an LLC in exchange for a membership interest? According to the Treasury Regulations Section 1.6045-4(b)(1), a transfer of real estate to a partnership must be reported, even though it is tax-free under Code Section 721 (a). The required information includes (1) name, address, and TIN (tax identification number) of the transferor; (2) a general description of the real estate; (3) the date of closing; (4) the amount of the entire gross proceeds (to the extent required by Form 1099); (5) a statement that the partnership receives the property (if the transferor received such a statement); and (6) the real-estate-reporting person’s name, address, and TIN. [Treas. Reg. § 1.6045-4 (h)] The preceding information must be filed with the appropriate IRS Service Center by February 28th in the following year of the transfer. [Treas. Reg. § 1.6045-4(h)]
- When can an LLC make distributions to members? LLCs can generally distribute cash or property, whether income or capital, to the members, provided in the Operating Agreement or otherwise agreed by the members.
Most LLC acts prohibit any distributions to members if, following the distribution, the LLC’s liabilities (other than liabilities to members) would exceed the LLC’s assets’ value.
Most LLC statutes hold members liable to creditors for wrongful distributions, although some states elect to treat wrongful distributions under their fraudulent conveyance statute.
- What is a series LLC and what issues does it bring? In a series LLC, the corporate structure looks as though each part of the business or “series” looks and functions in many ways as if it is a separate LLC. The series is a creation of state law. Delaware first enacted the LLC series legislation in 1996. Delaware also provides for series limited partnerships. Sixteen states permit series LLCs. The series LLC is similar to a corporate-controlled group with several operating corporations, but there is only one legal entity.
The benefit is that you could put 10 rental properties into one series LLC and protect each property from the other because each is owned by one cell. This saves you from having to form 10 separate LLCs and save on the state filing fees. The challenge is that you still need to have a separate LLC record book for each cell, separate operating agreement, separate bank accounts, and books…and if not done properly, there may not be any additional protection. Plus, there are many grey areas as to whether or not the liability protection would hold up (lack of cases on it).
The IRS finally came out with federal tax guidance a few years ago, and the states are a different matter. Still uncertain about the tax consequences. In the end, it is better to form a separate legal entity vs. saving $200 on state filings fees.
- How are interests in an LLC transferred? An LLC interest may be transferred by a bill of sale, assignment, or comparable document as personal property. If the interests are documented with certificates, like stock certificates, it should be possible to transfer an interest by endorsing the certificate, by granting a power of attorney to the transferee, or by granting a type of power as a stock power. To be effective, the transferee must also cause the interest transfer to be reflected in the LLC’s books.
The transfer must first be approved under the LLC’s requirements. An LLC should record the transfer of membership interests in the same fashion as a corporation uses a stock transfer ledger. The transfer of an interest to a person does not by itself bestows a member’s status in the LLC. Rather, the transferee is merely an assignee of certain economic rights unless the other members by a requisite vote approve membership interest transfer.
If you have a buy-sell agreement, that will have restrictions on how a transfer may occur. The LLC operating agreement may also have restrictions.
- What is the “charging order”? A charging order is a statutory remedy of a creditor available under state statute when the creditor cannot force a partner or LLC member to assign his or her partnership or LLC interest to the creditor. A charging order is neither an assignment nor an attachment. It is a court order, somewhat like a garnishment, that directs the partnership or LLC to make any distributions it would have made to the partner or member to the creditor. The creditor will not get “stuck” with the tax bill, as others promote, but rather have access to an “economic interest” only.
The theory is that to allow a creditor to access the partnership or LLC assets and record due to the creditor’s claim against one partner/member would disrupt the entity’s business to the other owners’ detriment, especially if management rights were also involved. Thus, it is used to protect the business and the other owners, typically from a creditor of the owner or ex-spouse. Therefore, many times an LLC taxed as an S corporation is much better than an S corporation.
There is more protection if the owner is sued personally for something unrelated to the operating entity to protect the member’s profits interests.
There are a few states where the charging order is not recognized for a single-member LLC. They include Colorado, Florida, and New Hampshire.