Taxation Of Corporations
There are generally two ways corporations may be taxed under the federal rules. By default, a corporation is taxed under Subchapter C of the Internal Revenue Code. However, a corporation may instead elect to be taxed under Subchapter S of the Internal Revenue Code.
The selection of a certain type of entity structure or election of a particular tax status is an individualized decision that will depend on the characteristics of the business itself and the business owner’s surrounding circumstances. In one aspect, there may be certain advantages in choosing one type of entity or tax structure over another, while there may be disadvantages in another aspect. For example, in the context of investment real estate, it is sometimes preferable for the property to be held by an LLC rather than a corporation. Whether a corporation should refrain from making the ‘S’ election and continue to be treated as a C corporation or in fact make the ‘S’ election and become subject to the rules that govern S corporations is a decision that should be guided by a qualified advisor.
WHAT STANDARDS APPLY TO C CORPORATIONS?
In order to qualify as a C corporation, the entity must meet the following requirements: (1) it must be a domestic corporation that is in existence for the tax year; (2) it must file Form 1120 annually even it does not have any business activity or profits unless it is a tax-exempt organization (in which case it must file Form 990); and (3) it must file quarterly estimated tax returns if the entity expects for its taxable income to exceed $500 during the tax year.
A C corporation may be an ordinary corporation, professional corporation, non-profit corporation, closely held corporation, public corporation, or even a single owner-shareholder corporation. A C corporation is generally taxed on its earnings on two separate occasions, once when the income is earned by the corporation and again as the earnings are distributed to the shareholders.
Under the new tax laws (“TCJA”), C corporations are now required to pay a 21% flat tax on their corporate earnings. For purposes of this example, assume the corporation’s income is $100,000. After applying the 21% rate, the net amount to the corporation is $79,000. After making distributions to the shareholder in the full amount, the shareholder pays 23.8% capital gain tax, which amounts to $18,802. As such, the total amount of taxes paid by the corporation and the shareholder may be as much as $39,802. Therefore, the combined tax rate on the $100,000 business income may be as much as 39.8%.
Capital Contributions by Shareholders
The capitalization of a corporation is initially effectuated by a shareholder who transfers money, property, or services in exchange for ownership of stock. The contribution of cash to the corporation in exchange for stock is generally not a taxable event. The amount of cash contributed by the shareholder will generally determine the shareholder’s basis of stock in the corporation.
On the other hand, transfer of property is treated as a sale to the corporation. As a result, there may be tax owed by the shareholder if the property’s adjusted basis is less than the fair market value at the time of transfer. In such instances, the shareholder’s basis of the contributed property transfers to the corporation. However, if the shareholder contributes property in exchange for stock and controls the corporation immediately after the transfer, the shareholder will generally not recognize the gain on the transfer.
The standard for control within the meaning of Section 351 of the Internal Revenue Code is met if the shareholder owns 80% or more of the total combined voting power of each class of voting stock and 80% or more of the outstanding shares of each class of nonvoting stock. This rule applies to both individuals and entities that transfer property to a corporation.
If the shareholder receives anything other than stock, such as cash or property, he would have to recognize gain to the extent of the money received plus the fair market value of the property received. However, if the corporation assumes liabilities as a result of a property transfer, it is generally not deemed as money received by the shareholder except under certain circumstances, such as if there is no legitimate business purpose for the corporation to assume the liabilities or if the liabilities assumed by the corporation are more than the shareholder’s adjusted basis in the property transferred.
Earnings and Profits
Earnings and Profits (“E&P”) are critical for measuring corporate transactions and calculating a C corporation’s taxable income. E&P is used to determine whether a distribution is a taxable dividend for the C corporation, a nontaxable return of capital to the shareholder, or a capital gain to the shareholder. As a general rule, a distribution is treated as a dividend to the extent of a C corporation’s current-year E&P. If there is no current-year E&P or the current-year E&P is depleted, the distribution will constitute a dividend to the extent of the corporation’s accumulated E&P from the prior years.
E&P should be tracked from the date of the corporation’s formation until the current tax year. If it is not tracked, it may become very difficult for even the most experienced tax specialists to backtrack (in some instances for decades) and examine all of the corporation’s records ever since its inception, including its financial statements and tax returns.
It should be noted that while some transactions may increase or decrease a corporation’s E&P, the very same transactions may have no effect on the federal income tax calculations. The opposite also holds true. For example, life insurance proceeds are not taxable to the corporation, yet they increase a corporation’s E&P. Similarly, the annual federal income tax amount is generally reduced in the E&P calculation, however, it cannot be deducted on the federal taxes.
Accumulated E&Ps are the earnings and profits that a corporation had acquired in a prior year but did not distribute to its shareholders. In the event the corporation’s E&P for the current year is less than the amount of the distributions it made during the current year, a part or all of the distributions are treated as accumulated E&P. Therefore, if the corporation does not have sufficient E&P for the current year to offset the amount of dividends it distributed to its shareholders, the difference is treated as accumulated E&P.
If the accumulated E&P is depleted (meaning it reaches zero), the remaining portion of the distribution to the shareholder reduces the adjusted basis of the shareholder’s stock. This portion is not taxable because it is deemed a return of capital. If the corporation makes nondividend distribution which exceed the adjusted basis of the shareholder’s stock, the difference is treated as a gain from a sale or exchange of property. Therefore, the shareholder would owe capital gain taxes under that scenario.
To illustrate the application of E&P, consider the following hypothetical. Sherry, a shareholder of C Corp stock, has an adjusted basis of $10,000. C Corp’s accumulated E&P was $30,000 for the prior years and $60,000 for the current year. C Corp makes a distribution to Sherry in the amount of $100,000. The first $60,000 portion of the distribution will be treated as a dividend from the current year’s E&P. The next $30,000 portion will be treated as a distribution from the accumulated E&P from the prior years. The remaining $10,000 will reduce Sherry’s basis in C Corp’s stock to zero.
Accumulated Earnings Tax
One of the advantages of C corporations is that it may be allowed to withhold distributions of its earnings to its shareholders. Generally, C corporations may accumulate their earnings up to $250,000 ($150,000 for personal service corporations). If the accumulated earnings exceed the specified amount, 20% tax may be assessed on any portion that exceeds the allowed threshold unless the accumulations are for the reasonable needs of the business.
If the accumulations are for the reasonable needs of the business, the 20% tax generally will not apply. Reasonable needs include possible expansion or other reasonable business reasons. Other examples include construction of new facilities, purchasing new equipment, and acquiring another business through the purchase of stock or assets. However, granting shareholders the ability to draw personal loans from the corporation is generally not deemed a reasonable business reason.
Distributions to Shareholders
A corporation may receive profits from a variety of sources, including from sales of goods, services, and income-producing assets. Unlike S corporations, the character of the income is not retained by the shareholder of a C corporation when a distribution is made to the shareholders. For example, if a corporation receives income from rental property, the shareholder merely receives a dividend. This is significant if you consider that the capital gain rates may potentially be more favorable than the ordinary rates. Therefore, if a capital asset (e.g., real estate) is sold by the corporation, the shareholder will not be able to retain the capital nature of the asset.
If a corporation earns profits, it may retain the profits to the extent allowed under the law. Alternatively, the corporation may declare some or all of the profits as distributions to the shareholders in the form of dividends. Dividends are usually distributed in cash. There are other forms of corporate distributions including distributions of property, nondividend distributions, capital gain distributions, and distributions of stock or stock options.
The amount of dividends the corporation pays to its shareholders are not deductible by the corporation. Unlike shareholders of S corporations, shareholders of C corporations cannot deduct the losses of the corporation. Since C corporations are also taxed on the entity level, only the corporation can deduct the corporate losses.
The dividends a corporation declares to a shareholder of a C corporation stock may either be treated under the ordinary rates or the more favorable capital gain rates. The treatment will depend on whether the distribution is in the form of a qualified dividend or a non-qualified dividend. If the distribution is a byproduct of a qualified dividend (i.e., distributed from a typical corporation formed under the laws of the United States), the shareholder may pay tax on the more favorable capital gain rates. If the distribution is a byproduct of a non-qualified dividend, the shareholder may pay tax under the less favorable ordinary rates.
Note that salaries or wages paid to employee-shareholders are not considered distributions. Instead, the wages are treated as business expenses similar to the wages of the corporation’s other employees. Consequently, the wages are deductible by the corporation and taxable to the employee-shareholder. In addition, a C corporation may deduct the fringe benefits it provides to its shareholder-employee. For the shareholder-employee, the fringe benefits are tax-free.
There are special standards for distributions of property to the shareholders. If the corporation distributes property to a shareholder, the fair market value of the distributed property becomes the shareholder’s basis in the property. However, the amount of the dividend may be reduced by the amount of liabilities assumed by the shareholder, or any liability that is subject to the distributed property (e.g., mortgage). The fair market value of the property is determined by the greater of the actual fair market value of the property or the amount of liabilities assumed by the shareholder.
Distributions of property to shareholders are generally treated as sales just as when shareholders transfer property to a corporation. As such, the corporation would have to recognize a gain if the fair market value of the property exceeds the corporation’s adjusted basis in the property. For example, if the distribution includes a tractor with an adjusted basis of $20,000 and fair market value of $45,000, the corporation would have to recognize the gain of $25,000. However, if the fair market value of the property is less than the adjusted basis of the property, the corporation generally cannot recognize a loss on the distribution to the shareholder.
Distributions of stock occur when the corporation issues additional shares of its corporate stock to its shareholders. Neither distributions of stock nor stock options are generally taxable to the shareholders. However, they are also not deductible by the corporation. The distributions of stock or stock options may be deemed taxable property distributions under some circumstances, such as when the shareholder has an option to receive cash or property but chooses instead to receive stock or stock options.
Constructive distributions occur in the event that the corporation confers a benefit upon the shareholder. If such a transaction was previously categorized as an expense, it may later be reclassified as a constructive distribution. As a result, the transaction would generally be nondeductible for the corporation and taxable to the shareholder. Examples of constructive distributions include payment of personal expenses, cancellation of shareholder’s debt, unreasonable compensation, and property transfers for less than fair market value.
Capital Losses
Where individuals are generally allowed to offset their capital losses against their other income up to a certain limit, C corporations cannot offset their capital losses against their other income. For example, let’s assume a C corporation which operates a pizza parlor had a capital loss of $20,000 in 2018 when it sold its delivery vehicle (capital asset). It cannot deduct the $20,000 loss from the sale of the vehicle against the profits it made from the sales of pizzas. On the other hand, if it recognized a gain in the amount of $20,000 from selling a pizza oven (capital asset), the $20,000 gain from the sale of the pizza oven would likely offset the $20,000 loss from the sale of the delivery vehicle.
As a general rule, if the capital losses exceed the capital gains for the tax year, it cannot deduct the excess losses for that year. Instead, it may only carry the losses back or forward to other tax years in order to deduct the losses from any net capital gains it had during those years. Generally, it can carry back the net capital losses to three years and carry forward to five years. Any unused portion after the five-year period will be lost.
Net Operating Losses
Net operating losses (“NOL”) occur when a corporation’s deductions are greater than its taxable income. NOL can effectively reduce the income taxes for the subsequent years. Prior to TCJA, C corporations were allowed to offset their NOL with 100% of their taxable income, subject to the two-year carryback and 20-year carryforward periods. Under TCJA, the NOL deduction is now limited to 80% of the taxable income. Subject to some exceptions, the carryback rule has been largely eliminated. However, TCJA allows for an indefinite carryforward instead of the 20-year carryforward period permitted prior to TCJA.
To illustrate the impact of TCJA in the context of NOL, suppose that a C corporation incurs $200,000 NOL in 2019 and generates $100,000 taxable income in 2020. The NOL of $200,000 for 2019 can be indefinitely carried forward to subsequent years. Since the corporation may only offset 80% of the taxable income for the 2020 tax year, it is only eligible to offset $80,000 from its $100,000 taxable income. The remaining NOL of $120,000 may not be carried back, but it may be carried forward indefinitely to offset up to 80% of the taxable income in the subsequent years.
WHAT STANDARDS APPLY TO S CORPORATIONS?
An S corporation is a pass-through entity. Even though both partnerships and S corporations are pass-through entities – unlike partnerships – shareholders of S corporations do not have the ability to form advance agreements in order to allocate the entity’s profits and losses. Instead, all of the earnings and expenses pass through to the shareholders based on their percentage of ownership in the corporation.
Requirements for Qualification and Compliance
In order to qualify as an S corporation, the entity must meet the following requirements: (1) it must be a domestic corporation; (2) it generally cannot have more than 100 shareholders; (3) it must have only one class of stock; (4) the business must satisfy the definition of a small business corporation under Section 1361 of the Internal Revenue Code; and (5) shareholders that are individuals must generally be U.S. citizens or residents (shareholders that are corporations or partnerships are generally excluded).
For a calendar year corporation to be eligible to make the ‘S’ election, it must file Form 2553 generally within the first two and a half months of the tax year, if it is seeking for the S corporation treatment to be effective for that tax year. The S corporation must always file a tax return irrespective of its income and losses unless the corporation has been dissolved. The tax returns are filed on Form 1120S.
The shareholders are required to pay estimated taxes if their own tax returns have exceeded or are expected to exceed $500 when the returns are filed. The shareholders are required to report all applicable categories of earnings and losses on Schedule K-1. Shareholders of S corporations must pay taxes on their share of the corporate income regardless of whether distributions are made. The amount of taxes the shareholders may pay is contingent upon their stock basis in the S corporation.
Determining Stock Basis
The basis of the corporate stock is critical since both the taxability of a distribution and the deductibility of a loss are contingent upon the shareholder’s stock basis. The basis may be adjusted annually. It is the individual shareholder’s obligation to track his or her own basis in the corporate stock.
The starting point for determining a shareholder’s basis in an S corporation stock is the initial contribution by the shareholder. Basis is generally determined by how the stock was initially acquired. Generally, the stock of a corporation may be acquired in a number of ways including by purchase, gift, or inheritance.
If the stock was acquired by purchase, the basis of the stock is generally the initial cost of the shares. If it was acquired by gift, the shareholder’s basis is generally the donor’s basis in the stock. If it was acquired by inheritance, the shareholder’s basis is generally the fair market value of the stock on the date of the former shareholder’s death. If it was acquired by the shareholder’s performance of services, the basis of an S corporation stock is measured by the fair market value of the stock at the time the services were rendered (unlike in C corporations where the basis is determined by the fair market value of the services rendered).
If the stock was acquired in accordance with Section 351 of the Internal Revenue Code (where the shareholder acquired control of the corporation immediately after the transfer of property), the basis of the stock is any cash invested, increased by the basis of the property transferred to the corporation, increased by any gain recognized on the transfer, decreased by any boot received from the corporation. If the corporation was operating as a C corporation prior to making the S election, the basis in the S corporation stock is the basis in the C corporation stock at the time of transfer.
Distributions to Shareholders
Distributions by S corporations are generally not treated as dividends. The distributions themselves are not subject to income tax unless they exceed the shareholder’s adjusted basis in the stock. If the corporation makes a distribution of property, the distribution is treated as a sale to the shareholder. If the fair market value of the property exceeds the corporation’s adjusted basis, the corporation would recognize the gain. However, the corporation would not recognize a loss if the fair market value of the property was less than the corporation’s adjusted basis in the property.
Distributions that exceed the shareholder’s basis in the corporate stock are treated as capital gains. When the gain passes through to the shareholder, yet a distribution is not made to the shareholder, the gain increases the basis in his stock. However, if a distribution is made, the shareholder’s basis may be reduced to the extent of the difference between the distribution and the shareholder’s basis in the stock.
To illustrate how basis calculations are relevant to shareholders of S corporations, consider the following example. Shane is the sole shareholder of S Corp whose stock basis is $5,000. S Corp earned $5,000 in 2019. If a distribution is not made to Shane in 2020, his new basis in the stock will be $10,000. If Shane instead receives a distribution in the amount of $10,000, his basis will be reduced to zero since he would have a return of capital on his stock. The remaining $5,000 will be treated as a capital gain because Shane received an extra sum of money after his basis was reduced to zero.
Reasonable Compensation
Instead of making a distribution, an S corporation may provide salaries or wages to its employees. However, salaries and wages are subject to employment taxes whereas distributions are not. If the distributions are received by a shareholder-employee and he or she is not receiving reasonable compensation for the services provided to the corporation, the distributions may be reclassified as wages (in which case they may be subject to employment taxes). The IRS does not have any specific guidelines with regard to reasonable compensation. However, the factors that are considered include training and experience, dividend history, the amount that similar businesses pay for similar services, and compensation agreements.
Qualified Business Income
Since the GOP members of the Congress provided significant benefits to C corporations under TCJA by reducing the top rate from 35% to 21% and repealing the Alternate Minimum Tax for corporations, they also assumingly wanted to provide significant benefits to pass-through entities. Under TCJA, there is a new deduction available for pass-through entities under Section 199A of the Internal Revenue Code. For purposes of the new law, pass-through entities include S corporations, sole proprietorships, limited liability companies, partnerships, trusts, and estates. This deduction is known as Qualified Business Income (“QBI”).
Even though QBI is available for pass-through entities more broadly, the following analysis is based on the shareholder-employees of S corporations. Generally, the QBI deduction allows business owners of pass-through entities to potentially receive up to a 20% deduction on their business income. The two primary sources of income available to shareholder-employees generally boil down to two categories: compensation for services and business profits.
The portion of the income represented by the business profits is the amount that is available after the shareholder receives reasonable compensation for his or her services. Compensation for services comes in the form of W-2s and it is classified as wages. The portion of the income that qualifies as business profits (e.g., K-1) is the amount that exceeds the W-2s. It is this (business profits) portion of the shareholder-employee’s income that is potentially entitled to the QBI deduction.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect on the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
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Anatomy Of A Corporation
Corporations are treated as separate entities under the law. They generally have the capacity to perform the same types of functions that individuals perform including entering into contracts and promulgating or defending lawsuits. The primary incentive for forming a corporation is to grant limited liability to its owners.
One common misconception among the business community is that by merely filing proper documents with the state, the business owner has established a legally enforceable corporation. However, compliance with formalities is essential in order for the corporation to be granted with the status of limited liability and protect its owners from personal liability. Formalities are especially critical for corporations since they generally contain more rigorous standards than other business entities, such as LLCs.
WHAT STEPS ARE REQUIRED FOR ESTABLISHING A CORPORATION?
The first step required for establishing a corporation is filing an application for formation (e.g., Articles of Incorporation) with the state. It is generally recommended to establish the corporation in the state in which the business is going to operate. Of course, the corporation can do business in other states provided that the state allows the entity to operate in its state. However, a corporation will be required to file tax returns and pay taxes in any state that mandates state corporate income tax. In addition, different states have different requirements for other forms of compliance (e.g., Statement of Information).
After the state grants permission to the corporation to operate in its state, the next step is to conduct an organizational meeting. This is accomplished by the party that submitted the application for formation. The party that formed the corporation is known as the incorporator. During the organizational meeting, the incorporator appoints the Board of Directors (“Board”).
The next step is for the Board to adopt the Bylaws. The Bylaws are similar to Operating Agreements of LLCs. Bylaws are the heart of the corporation with respect to corporate formalities. They contain information about the annual shareholders meeting, the number of directors the shareholders may appoint, and quorum requirements for shareholder and director meetings. They may also include the various duties the officers may owe to the corporation and even the job descriptions of the officers.
After the Board adopts the Bylaws, the next step is for the Board to appoint the officers of the corporation. California requires for each corporation to have a President, Secretary, and Chief Financial Officer. However, one person may be appointed for all three positions.
WHO ARE THE OWNERS AND OPERATORS OF CORPORATIONS?
There are generally three categories of actors within corporations: shareholders, directors, and officers. The shareholders own the corporation, while the directors and officers operate it. Since people sometimes misconstrue the different roles of each of these key corporate actors, it is fundamental for anyone who has some form of a nexus with a corporation to understand the standards that apply to each actor based on the particular role.
Shareholders
Similar to living trusts and other business entities, a corporation must be funded or capitalized in order for it to become an enforceable legal entity. Capitalization may occur in the form of money, property, or services performed by a prospective shareholder in return for corporate stock. However, in no event can a shareholder own the corporate assets outright since the assets belong to the corporation. Therefore, the shareholder can only own stock in the corporation itself.
The most common form of capitalization is through a shareholder’s contribution of cash to the corporation. Generally, the Board sells the shares to a shareholder. The shareholder then becomes the owner of the corporation, which in turn grants the shareholder the right to receive dividends in the event the Board makes any distributions.
The Board has other powers besides making distributions to shareholders. The Board may determine not only whether to sell particular stock, but also what type of stock to sell. The type of stock a corporation may sell may vary. Typically, the corporation sells common stock, but in certain instances it may also sell preferred stock.
Common stock grants the same rights and privileges to all of its owners. Common stock grants its owners the right to vote during shareholders’ meetings. It may also grant the shareholders the right to receive dividends based on their pro rata share of ownership; the right to approve fundamental changes, including mergers and dissolutions; and preemptive rights that may prevent dilution of shares since the shareholder has the opportunity to purchase new shares that may allow him to sustain the same percentage of ownership prior to issuance of new shares.
On the other hand, preferred stock is generally a contractual relationship between the corporation and the shareholder. The owner of preferred stock generally has fewer risks than the owner of common stock. The owner of preferred stock may have a right to a specified amount of dividends per annum regardless of whether the Board makes distributions to the owners of common stock. The owner of preferred stock may also have preferential rights in the event of the corporation’s dissolution.
For those corporations that have considerably few shareholders, it is essential for the shareholders to consider forming Shareholders’ Agreements or Buy-Sell Agreements. Buy-Sell Agreements are formed for the specific purpose of determining the aftermath of the shareholder’s shares in the event she divests her interest in the corporation, becomes incapacitated, or dies. Even though both types of agreements are sometimes referred to each other interchangeably, Shareholders’ Agreements generally contain more terms than Buy-Sell Agreements.
These agreements between the shareholders are formed for many reasons; chief among them is to make certain that the shareholder who dies or becomes disabled does not deprive her family members from the right of having a financial stake in her shares. Thus, these agreements set forth the various conditions (e.g., disability and death) that may trigger a buy-out of the shareholder’s shares. If the specified condition occurs, the corporation itself may purchase the shares. In other instances, the shareholders may fund the agreement by purchasing life insurance policies on each other’s lives.
Board of Directors
The shareholders elect the directors at the annual shareholders meeting unless the voting occurs during a special meeting. In California, the Board must include at least three directors unless the corporation has less than three shareholders. If the corporation has two shareholders, only two directors are required. Similarly, if there is only one shareholder, only one director is required.
Directors generally owe fiduciary duties to the corporation, which include the Duty of Loyalty and Duty of Care. However, directors do not have to be in violation of these duties in order for the shareholders to remove them from the Board. The shareholders may potentially remove a director for any reason during a director’s term so long as they provide adequate notice of the special shareholder’s meeting where the removal is contemplated to take place.
There are generally two categories of directors: Inside Directors and Outside Directors. Inside Directors are also usually officers or employees of the corporation. Outside Directors are generally not involved with the operations or executive management of the corporation. Their contribution is strictly limited to their duties as directors or advisors of the corporation.
Directors are accountable for all of the consequential decisions of the corporation. Consequential decisions are those decisions that are likely to have a substantial impact on the corporation. For other types of decisions, the Board may nominate a committee. The committees nominated by the Board can be formed for litigation purposes or when the Board is considering of undertaking major actions, such as large investments. The committees can also be formed for the purpose of complying with an audit or determining the compensation of directors and officers.
Officers
The directors appoint the officers. The officers carry out the decisions that are made by the Board. Typically, positions held by officers may include: President, Vice President, Chief Executive Officer, Chief Financial Officer, Treasurer, and Secretary.
The scope of authority of officers who are in charge of the day-to-day operations of the corporation is limited to the authority provided in the Bylaws and the Board’s potential expansion of the authority so long as there is neither a violation of the Bylaws provisions nor state law. The officer’s scope of authority should also be included in a provision in a contract between the officer and the corporation where the officer’s role is clearly delineated.
WHAT STRUCTURES ARE AVAILABLE TO CORPORATIONS?
There are various types of corporations (e.g., Non-Profit Corporations) available to entities that are looking to establish a particular type of corporation. However, this section focuses on analyzing the following types of corporations: closely held corporations, public corporations, and professional corporations. The alternative to these structures is to operate as an ordinary corporation without being subject to the standards that apply to the particular type of corporation.
Closely Held Corporations
Closely held corporations (“Close Corporations”) are those entities that have few shareholders. There is no public market for the stock of a Close Corporation. In fact, a Close Corporation may have limitations on transfers of its corporate stock from its shareholders to third parties.
California does not permit Close Corporations from having more than 35 shareholders. In order for an entity to qualify as a Close Corporation for IRS purposes, it cannot be a personal services corporation and it cannot have more than five individuals who own 50% or more of the value of its outstanding stock. Certain types of trusts and private foundations may qualify as individuals.
Close Corporations are usually formed in order for the family business to be operated by the family members. Most of the key operational matters of Close Corporations are set forth in the Shareholders’ Agreement. Furthermore, the day-to-day managers and shareholders are generally the same individuals.
The major advantage for forming a Close Corporation is that the formalities that are required for Close Corporations are not as heightened as they are for ordinary corporations. Close Corporations grant the shareholders the ability to operate their business within the terms of the Shareholders’ Agreement in a decentralized fashion. The shareholders may even agree to waive certain formalities such as annual shareholder or director meetings. However, with the advent of LLCs, there is no longer a particular incentive for establishing Close Corporations since LLCs can also provide limited liability and decentralized management structures without being subject to more rigorous formalities.
Public Corporations
A Public Corporation is a corporation which has many shareholders. A corporation will be deemed a Public Corporation within the purview of the Securities and Exchange Commission (“SEC”) if it has more than 750 record shareholders and more than $10 million in assets. While Public Corporations may potentially attract more investors than other types of corporations, the major downside for Public Corporations that are subject to SEC scrutiny is that a corporation’s compliance with SEC regulations is costly. Some examples of compliance include being subject to annual audits and filing quarterly and annual reports.
Professional Corporations
Professional Corporations (“APC”) are corporations that are formed under the laws of a particular state. APCs are formed for the purpose of providing professional services to their customers, patients, or clients. In California, entities that are seeking to qualify as APCs must be comprised of licensed professionals, such as lawyers, dentists, doctors, veterinarians, and certified public accountants. The analogous classification of an APC for IRS purposes is a Personal Service Corporation (“PSC”). The types of entities that may be deemed by the IRS as PSCs are those corporations that provide personal services in specified fields, such as law, accounting, health, or actuarial science.
Similar to non-professionals and other business entities, the primary reason professionals form corporations is limited liability. Professionals, who are also business owners, are subject to the risk of having their personal assets exposed if a lawsuit is promulgated for actions or inactions that occurred during their ordinary course of practice. While malpractice insurance may be a great asset protection tool for mistakes that are made during a professional’s ordinary course of practice, it may not necessarily safeguard the professional’s personal assets if a customer brings a lawsuit after being injured on the premises in which the professional’s business is operated.
Finally, under TCJA, the same entity that is an APC (formed in California) and PSC (deemed by the IRS), with a subchapter C status, must pay a 21% flat tax on its corporate earnings in addition to the $800 annual fee required by the California Franchise Tax Board. Additionally, the dividends may be subject to a 23.8% capital gain tax for non-corporate taxpayers. However, the corporation may instead make a subchapter S election, in which case it will be treated as a pass-through entity and the flat tax will generally not apply at the corporate level.
WHAT CLASSIFICATIONS ARE AVAILABLE TO CORPORATIONS FOR TAX PURPOSES?
By default, a corporation is treated as a subchapter C corporation by the IRS. The primary difference between a C corporation and a subchapter S corporation is that a C corporation is taxed on its earnings twice, whereas an S corporation is generally taxed on its earnings once. Subject to certain limitations, any corporation may potentially make an “S” election and be taxed as an S corporation.
C Corporations
The earnings of C corporations are taxed to both the corporation and the shareholder. When the C corporation earns its profits, the profits are taxed on the corporate income. If the corporation makes distributions, the shareholders are also taxed on the profits. This concept is otherwise known as “double-taxation.”
To illustrate how double-taxation works in practice, suppose that the corporation earns $100,000 from selling skin products. First, the corporation pays 21% tax on the $100,000 amount, which nets the corporation in the amount of $79,000. If the corporation makes a distribution of the entire amount to the shareholder who owns 100% of its stock, the shareholder may also pay 23.8% capital gain tax on the $79,000 amount, which amounts to $18,802. In essence, $39,802 ($21,000+$18,802) of the $100,000 amount of the corporate earnings may potentially belong to the federal government.
S Corporations
Similar to partnerships and sole proprietorships, S corporations are pass-through entities. Unlike C corporations, S corporations are not taxed on their corporate earnings. Instead, the earnings and expenses pass through to each shareholder and each shareholder is taxed based on the pro rata share of ownership in the corporation.
Suppose that the same corporation which sells skin products makes a timely election and it is now taxed as an S corporation. The shareholder of the corporation still owns 100% of its corporate stock. The shareholder’s effective tax rate is 18.29%. Since it is an S corporation, the $100,000 amount of the corporate earnings are not taxed at the corporate level. Instead, the income will pass through to the shareholder who may pay 18.29% tax, which amounts to $18,290. Compare $18,290 with the $39,802 amount of tax the same shareholder would ultimately pay if the corporation had not made the S election.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect on the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
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Five Fundamentals Of LLCs
A Limited Liability Company (“LLC”) is a hybrid business entity which contains elements of a partnership and a corporation. LLCs consist of members and managers. An LLC may provide tremendous benefits for its members, which include asset protection, intergenerational transfers, tax saving strategies, wealth preservation, flexible management structures, and clarity on the roles of all essential parties involved in the company as set out in the Operating Agreement.
The following five concepts are fundamental for establishing an LLC: Asset Protection, Intergenerational Transfers, Tax Saving Strategies, Management, and Funding.
Asset Protection
Generally, the more assets a person owns in one’s name, the more likely it is that he or she will be a target mark for creditors. This is why it’s good practice to own as little as possible in your own name. In order to accomplish this goal, it’s important to evaluate the types of asset protections tools that are available to you. An LLC is one such tool that is effective for asset protection purposes.
For creditors of the LLC itself, a member’s personal liability will generally be limited to the amount of the member’s investment in the LLC unless the member personally guarantees the transaction in question.
For creditors of the member of the LLC, a creditor is generally precluded from acquiring an interest in the debtor-member’s interest in the LLC if the judgment was entered after the LLC was formed. However, most states allow for a judgment creditor to levy on assets after distributions have been made to the debtor-member by the LLC.
As a general rule, a creditor has no right to become a member, compel a distribution, or demand company assets. If such rights were given to a creditor, then the other members of the company would suffer from an action or inaction of a particular member. This would inevitably lead to an unjust result for the remainder of the group. Therefore, the creditor must wait until distributions are made to the member before any potential recovery can be pursued.
Another limitation on a creditor’s pursuit on a claim against the debtor-member is that an Operating Agreement has the power to prevent non-members from acquiring an interest in the company. This is especially important in the case of failed marriages and judgment creditors because courts may at times issue overreaching rulings in order to accomplish an equitable outcome in the event of divorces or other circumstances. An LLC can also provide the means for family members or ex-family members who are in dispute to not be compelled to communicate at the time their interest is being transferred from their donors to them.
There is another layer of asset protection that deals particularly with the recipients of the LLC interest. It’s standard practice for owner-members to make gifts to their heirs throughout their lives. Several problems are immediately surfaced when gifts of substantial value such as property or a significant amount of cash are transferred to their heirs. Without a proper plan in place, the recipients are likely to subject these assets to waste or relinquish them to creditors or former spouses. However, the transfer of an interest in the LLC can protect these assets from loss or waste by the recipient-members.
Keep in mind that the asset protection planning must be done well in advance of any anticipation to a claim. That’s because fraudulent transfers are broadly construed. Intent is generally presumed if a transfer is found to have been made before or after the claim arose with the intent to defraud, hinder, or delay a known creditor. If the transfer is deemed fraudulent by the court, the court may set aside the transfer, which may also lead to criminal consequences.
An LLC is the preferred homeplace for many types of properties, including real estate. Real estate held for the purpose of investment is a ubiquitous phenomenon. Yet in practice, it is widespread to see title to its ownership being held in an individual’s name. In fact, if an investor owns multiple income-producing properties, it’s recommended (subject to some exceptions) to form and operate a separate LLC for each piece of property. In the case of a primary residence, transferring title to a living trust is the preferred method primarily due to tax advantages and the homestead exemption.
One of the reasons for forming a separate LLC for an income-producing real estate is that an injury on its premises can be costly even if the insurance policy satisfies a portion of the claim. Thus, if an entity only owns one piece of real estate, the claims will only be limited to that piece of property. If, however, the entity owns other assets, all such assets are at the risk of being exposed to the creditor.
Let’s also not forget one crucial point in the context of asset protection. By merely establishing an LLC, it will not be enough to be sheltered from personal liability. Formalities must be followed to embolden the shield of limited liability (just like for corporations or other types of entities that are subject to limited liability). If formalities are not adequately followed or there is a personal guarantee against the particular risk in question, the member’s personal assets will likely be exposed to the creditor.
It’s also equally important to make sure that the business is never conducted in the individual member’s capacity, but only in business capacity. For example, as “Manager” or “Member.” In the context of distributions, the accounting must continuously be updated as the distributions are being made to the members. The lack of formalities will give more weight to the argument that the LLC had no business purpose and should be disregarded as a separate legal entity.
Despite all the asset protection tools, a creditor has a few recourses (some of which go beyond the scope of this article). The one recourse that is generally available to a creditor is commonly referred to as a “charging order.” A charging order permits a creditor to seize only those assets that have been actually distributed, but not the assets that the debtor-member may potentially be entitled to receive under his or her ownership interest in the LLC.
Charging orders are better known as “phantom income” for a reason. The IRS requires for the members of the LLC to pay income tax even if they do not receive any distributions. In the case of charging orders, the creditor would be required to pay income tax on the debtor-member’s interest in the LLC even if the creditor does not receive any actual distributions. This is perhaps the most deterring factor on a creditor’s pursuit in recovering from an LLC because a creditor generally ends up in a worse position than before his pursuit of the charging order. Additionally, a creditor’s tax bracket may also increase as a result of the charging order.
Intergenerational Transfers
An LLC can be structured in such a way to protect the assets of a family for generations. These are otherwise known as Family Limited Liability Companies (“FLLC”). Even though such entities are structured and operated just like typical LLCs, most, if not all of the assets, are owned by the family in FLLCs.
In general, LLCs have some of the same benefits as living trusts when it comes to intergenerational transfers. An LLC can provide for a smoother transfer of wealth upon the death of an owner by avoiding probate. It can further prevent assets from going through probate in the event of a member’s disability and even in guardianship or conservatorship proceedings.
Another similarity with a living trust is that the nature and character of the underlying assets of the company are private. In other words, details as to what assets the LLC owns will generally be outside the scope of the public domain. As opposed to probate, where the circumstances surrounding the transfers of the decedent’s assets are a matter of public record, transfers of LLC assets are generally accomplished under private circumstances.
The effective planning techniques involve not only how the assets will be transferred when the owner of those assets dies, but to also employ techniques that will allow the transfer of assets during the donor’s life. In the context of FLLCs, there is a planning method available through gifting which allows for senior family members to periodically gift a portion of their assets to their younger family members.
There are some assets, however, that by their nature make it difficult to gift in fractions. Transferring portions of real estate, farm, or other assets are difficult to calculate especially when their value can fluctuate on a daily basis. There are some factors that may make the particular asset periodically more or less valuable: external market conditions and the overall condition of the asset. However, the gifting of an interest in an LLC avoids the trouble of transferring a fraction of a particular asset.
Regardless of the type of asset being transferred, there are incentives in place for transferring wealth during a donor’s life. These incentives can range from reducing the donor’s taxable estate to providing for the living expenses of the donor’s children. As such, the implementation of an annual gifting method may play a significant role in the periodic transfer of wealth from the older family members to the younger ones.
In 2018, the annual exclusion amount is $15,000 for individual taxpayers. Under the taxation rule of gift-splitting, a married couple can transfer $30,000 to any individual without being required to pay a Gift Tax or having to file a Gift Tax Return. To illustrate the significance of annual gifting, suppose that a married couple has four children. The couple can potentially remove $120,000 per annum from their estate without the Gift Tax consequences.
An LLC can also provide an excellent tool for gifting an interest during the donor’s life without commingling the gifted portion of the assets with the recipient’s other assets that have been accumulated during his or her marriage. After the membership interest is directly transferred to the recipient or in a separate property trust that has been specifically established for the recipient, the “paper trail” can show that a particular asset (whether in the form of cash or other property interest) is in fact the separate property of the recipient-member.
In the context of LLC ownership transfers, it is the member’s interest – not the actual asset – being transferred. Thus, the interest is adjusted in value due to lack of marketability. That’s because the assets that are subject to the LLC generally have limitations. Such limitations may include the right of first refusal, the inability to demand a distribution, order a dissolution, or participate in the management of the LLC.
The fundamental reason for the lack of marketability is that the membership interest is not a liquid asset and generally cannot be freely assigned. In other words, if the buyer cannot indeed purchase the piece of a parcel, but instead he or she can only purchase a potential ownership interest in the parcel (e.g., by owning X% in the LLC) with some of the previously mentioned limitations, the value of the membership interest will be discounted in accordance with the limitations.
The discounting aspect for lack of marketability is especially useful in the context of gifting. For instance, if a member’s interest is discounted by 1/3 due to lack of marketability, a gift of $10,000 in the form of an LLC interest is equivalent to a gift of $15,000 in the underlying assets of the LLC ($15,000 x 2/3 =$10,000).
Upon the death of the owner-member, value adjustments may also apply to the remaining portion of the deceased member’s interest in the LLC based on lack of marketability. A general formula for calculating the taxable value of the estate of the deceased-member’s interest is the following:
% of ownership x FMV (1 – discount) = Estate Tax Value
Tax Saving Strategies
An LLC can be taxed as a disregarded entity, partnership, cooperative, or corporation. By default, a multi-member LLC is taxed as a partnership. By default, a single-member LLC is taxed as a sole proprietorship. Under such a classification, the member is considered self-employed and is consequently responsible for self-employment taxes (Social Security and Medicare).
For income tax purposes, sole proprietorships, partnerships, and S-corporations are classified as pass-through entities. This means that the income and expense will pass through to the owner’s personal tax returns. Under a pass-through scenario, the LLC itself will file a Form 1065 tax return, but it will not pay the income taxes on the LLC’s profits.
One strategy for lowering a member’s taxable income is to not have them actively participate in the management of the LLC. Members who do not participate in the management of the company will generally be exempt from paying the self-employment tax. Therefore, their overall income tax may be reduced since they will not pay the self-employment tax on the LLC portion of their income.
Another way to reduce the overall income taxes during the members’ life is by spreading them among members who happen to fall in lower tax brackets than the owners. This is especially useful in the context of FLLCs since younger family members may not necessarily earn as high of an income as their elder counterparts.
Another benefit of an LLC is that a transfer of an asset by an individual to the LLC is normally not a taxable event unless otherwise excepted. Similarly, transfers upon the dissolution of the LLC are also not taxable since they are deemed a return of capital. Of course, gain may be recognized if the asset is sold by the individual after the asset has been transferred from the LLC.
The general tax consequence on transfers (to and from) an LLC is especially significant when considering that virtually any transfer from one entity to another can either be accomplished by sale or gift. If it’s a sale, then the transferor must generally pay capital gain taxes if the asset has appreciated in value since its purchase. If it’s a gift, there may be gift tax consequences. In this case, we have the owner being a separate entity, transferring to the LLC (also a separate entity). Nonetheless, these transfers generally do not qualify as taxable events for IRS purposes.
In the context of FLLCs, calculating the basis of assets or membership interests can be problematic, especially if such assets are sold generations after their purchase. This will inevitably affect the basis adjustments of those assets. The basis of an asset is what the original owner paid for its purchase. Several factors may affect the adjustment of the basis by either increasing the original basis (e.g., capital improvements) or by decreasing the original basis (e.g., depreciation deductions).
The similar concepts on basis adjustments apply to a member’s interest in the LLC because these interests also have their own basis. If there are many assets with different basis inside the LLC, it can become a logistical nightmare for accountants and administrators to calculate each member’s separate basis in the LLC. Thus, mixing different assets in the same LLC can be problematic especially in the context of multi-generational entities (e.g., FLLCs). Instead of being limited to one LLC, it is recommended to consider additional or subordinate LLCs especially for preventing such problems down the road.
The last point with regard to tax consequences of LLCs pertains to state law. When forming an LLC, it’s essential to consider all of the laws that the state provides on the formation and governance of LLCs. Some states have favorable laws with regard to LLCs versus other business types of entities; other states tend to be less favorable.
Management of an LLC
LLCs consist of members and managers. If we can make an analogy with corporations, members would be equivalent to the shareholders of a corporation; whereas managers can be a hybrid between Board of Directors and senior officers of a corporation (depending on the scope of authority provided by the members and the Operating Agreement).
There are two types of structures in which LLCs operate. There are member-managed and manager-managed LLCs. In member-managed LLCs, the members of the company manage the company by voting in accordance with each member’s interest. In manager-managed LLCs, members appoint one or more managers to conduct business activities that fall within the scope authorized by the company’s members.
There is no requirement for a manager to be a member of the LLC. Even in a member-managed LLC, the members may appoint a manager to be responsible for the daily business operations, but nevertheless be prevented from exercising any decision-making management authority.
A managing entity is recommended for a variety of reasons. First, as opposed to an individual, a managing entity does not have the same limitations as a human being might have, including disability and death. Since managers generally answer to members, the level of control over investment decisions can be set by the members in accordance with the manager’s fiduciary duty to the LLC. The level of control may vary from how much income to distribute or reinvest to being limited to only managing simple day-to-day operations.
An LLC formed in California must have an Operating Agreement. The Operating Agreement sets forth the scope of authority of members and managers. It can also provide restrictions on the transferability of membership interests and determine the form of compensation of its managers. A membership interest can be in the form of percentage or membership units. Membership units are analogous to owning shares in a corporation.
There are generally four ways members can receive compensation from the LLC. First, the General Members can receive management fees for managing the company. Such compensation can even be in the form of “preferred equity interest,” whereby a certain percentage of income is paid to the individual or entity holding that interest.
The second way is for the LLC to make distributions to the members. In such a scenario, the limited members will generally be entitled to a pro rata share from the distributions. The third way is for the LLC to make loans to the members. This strategy should be implemented with extreme caution. The fourth way provides an option to the limited members to potentially purchase a more significant share in the LLC from the owners, thereby resulting in more direct income for the owners.
Funding the LLC
Funding is the process of transferring assets to the LLC. Funding is an essential step in order for the LLC to be legally enforceable. An LLC must have a business purpose. If the LLC does not have any assets or is not otherwise funded, it follows that it does not have a business purpose.
The similar concept of funding applies to revocable living trusts. If a revocable living trust does not have any assets, it can be the most potent trust instrument ever written, but it will generally have no legal effect. Therefore, an LLC must also be properly funded, for among other things, to potentially grant limited liability to its members.
The means for funding the LLC may vary from asset to asset. For example, different standards apply when real estate is transferred onto the LLC as opposed to a publicly traded security company. As a baseline rule, the transfer of an asset to the LLC must happen in the same manner in which title to the particular type of property is held. In case of real estate, such transfers may only be effectuated by deeds, regardless of whether the transfer is from person to person, or from (or to) an LLC.
Notwithstanding the type of asset being transferred, the value of the asset must be determined at the time of transfer. Determining the valuation of real estate and business interests in firmly held companies or LLCs is not an exact science. Consequently, such assets may be required to be appraised by a qualified appraiser (someone with an excellent reputation in the field of appraisals and a successful track record for audits). To justify any valuation discounts in the event of litigation or potential challenges by taxing authorities, qualified appraisals should also value the interest in the LLC at the time the member’s interest is either sold or gifted or when one of the members dies.
The transfer of stocks, bonds, and other securities to an LLC is accomplished by a stockbroker, the issuing company, or a third party agent. If a stockbroker is used to facilitate the transfer, it’s recommended for the stocks to be held in a “nominee securities” account. In other words, the brokerage account will be in the name of the LLC, however, the actual stocks will be held in the brokerage company’s name.
One final point concerning funding to keep in mind when it comes to stocks and investment assets are the “anti-diversification rules.” Generally, the transfer of an asset to the LLC is not a taxable event unless the transfer triggers an immediate tax consequence within the meaning of diversification of securities.
Several standards are used to determine issues related to diversification. First, “The 80% Rule” states that if 80% or more of the assets of the LLC are marketable securities, the LLC can be classified as an “investment company.” As a result, the anti-diversification rules may apply and tax may be due on the transfer. Therefore, if 20% or more of the assets are made up of real estate, the anti-diversification rules will not be triggered and no tax would be due on the transfer provided that real estate assets remain at 20% or more in the LLC after the transfer.
Second, “The Non-Identical Assets Rule” applies in a scenario where one person contributes one type of stock and another person contributes another type of stock, the anti-diversification rule may be triggered. However, if the same two people were to contribute two of the same stock or if one person contributes all of the assets (even if they are not identical), the anti-diversification rules will generally not be triggered.
Third, “The 25% Test and 50% Test” states that no diversification can occur when the transferor transfers a diversified portfolio of securities to the LLC which contains no more than 25% of the value of all securities from one issuer and no more than 50% of the value of all securities from five or fewer issuers. In this instance, the portfolio itself is considered diversified since it does not contain any one issuer which represents more than 25% of the value of the total securities nor five or fewer issuers which represent more than 50% of the securities in the same portfolio. Similar to mutual funds, diversification rules generally do not apply to a portfolio that is being contributed to the LLC that is already diversified.
The crux of the matter regarding the anti-diversification rules is that if an LLC owns securities and the LLC itself is in fact performing the functions of an investment company within the context of securities, then any asset being transferred (including cash) to the LLC may be subject to tax. The application of these rules can be pernicious and planning around them must be done with extreme caution to minimize the likelihood of a tax being due on a transfer.
Final Thoughts
The rigorous legal standards surrounding LLCs increase the likelihood for the LLC to lose its asset protection status against creditors or to be successfully challenged by taxing authorities. The LLC provides tremendous benefits to its members: asset protection, intergenerational transfers, tax saving strategies, flexible management structures, and wealth preservation. In order to enjoy all the benefits that an LLC has to offer, it’s important to be in constant contact with qualified advisors, including attorneys, CPAs, tax specialists, and financial advisors to make sure that all applicable legal matters are properly addressed in advance.
Remember that an LLC is a business, it must have a business purpose, and it must be operated as a business. Problems are bound to occur when the owners of LLCs deviate from these standards and become overconfident in the notion that their LLC is an enforceable legal entity that is unequivocally protected against creditors and taxing authorities by virtue of its existence.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect on the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
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