Tax Planning

Coronavirus Economic Stimulus Package Highlights

In response to the COVID-19 pandemic, Congress passed a series of legislations including the “Coronavirus Aid, Relief, and Economic Security Act” or the “CARES Act”, which was signed into law by President Trump on March 27, 2020. The CARES Act is designed to provide economic relief for individuals and small businesses who have suffered economic hardships due to the coronavirus pandemic. The $2 trillion CARES package is the largest financial support package in U.S. history.

Overview

This article breaks down the CARES Act (hereinafter, “CARES”) by first analyzing the economic relief provided to individuals followed by small businesses.

The most commonly sought relief under CARES with regard to individuals includes the stimulus checks for people who fall within certain income thresholds, an increase in unemployment benefits, temporary student loan suspensions and modification of retirement plans.

In order to provide economic relief to small businesses, CARES grants the authority to the Small Business Administration (hereinafter, “SBA”) to allocate $377 billion to small businesses that have experienced economic disruptions due to COVID-19 through two loan programs: expansion of the Economic Injury Disaster Loan and creation of the Paycheck Protection Program.

Out of $377 billion amount, $349 billion is allocated to the Paycheck Protection Program. (There are currently discussions on adding $250 billion or more to the Paycheck Protection Program). Small businesses with 500 or less employees including nonprofits (even though small businesses with more than 500 employees may qualify provided that they satisfy the definition of a “small business concern” under section 3 of the Small Business Act, 15 U.S.C. 632), sole proprietors, and independent contractors are all potentially eligible for the Paycheck Protection Program loan.

Other forms of economic relief in response to the coronavirus pandemic include providing potential tax relief to employers affected by COVID-9 and temporary changes in net operating losses.

Economic Relief for Individuals

In a time of an economic crisis, payment of income taxes would most likely cause an additional burden for many people. From all apparent indication, this is why the filing of personal tax returns for the 2019 tax year has been extended to July 15, 2020. The same also holds true for California’s tax returns since the filing of California’s tax returns has also extended by the Franchise Tax Board. However, the taxpayer can still file on or before the April 15, 2020 deadline.

The July 15 extension is automatic as opposed to the filing of Form 4868 which otherwise would have been required but for these extraordinary circumstances. Note that the estimated taxes will not be extended as of now with the exception of Q1. Interestingly, Q2’s estimated taxes can potentially be paid before Q1 if the taxpayer exercises the option of extending Q1’s returns since Q2 traditionally falls on June 15, whereas Q1’s estimated taxes have been extended to July 15.

One of the biggest forms of economic relief provided to individual taxpayers are the stimulus checks. Assuming the taxpayer qualifies, the minimum amount of the stimulus check will be $1,200. Even though the taxpayer will receive capital based on the amount of the qualification, if any, the distribution will be characterized as a tax credit that will be applied towards the 2020 tax year.

If an individual’s Adjusted Gross Income (hereinafter, “AGI”) is under $75,000; married couple’s under $150,000; and head of household’s under $125,000, then they will all qualify for the full benefit based on their filing statuses. The amount of the benefit will be $1,200 for an individual and head of household, $2,400 for a married couple filings their taxes jointly, and an additional $500 for every child who is claimed as a dependent.

There is a $50 phase out for every $1,000 of AGI above their respective income thresholds. Thus, if Amy is single and she makes $125,000, the calculation will be as follows: $50 multiplied by 50 (representing the difference between $125,000 and $75,000), or $1,200. Therefore, if $1,200 (amount of the benefit) is subtracted from $1,200 (amount of the rebate phase out), Amy will not receive a check since her total amount of the benefit would amount to zero (0).

The increase in unemployment insurance is also another relief provided to individuals in response to COVID-19. Those who were receiving unemployment insurance or recently filed for unemployment are now eligible for a $600 per week increase in their unemployment benefits. The $600 increase will not affect the unemployment benefits that were already being received at the state level. Note that those who have been partially unemployed due to the diagnosis of COVID-19 may also potentially qualify for unemployment benefits. Self-employed individuals and independent contractors are also eligible for unemployment benefits.

Other highlights for individuals include temporary suspension of student loans and RMDs. Student loan payments have been suspended until September 30, 2020 with no accrual on interest.  Required Minimum Distributions have also been suspended for 2020. In addition, each person under a qualified plan may withdraw up to $100,000 without facing 10% early withdrawal penalty or having 20% automatic withholdings.

Economic Relief for Small Businesses

Some of the main vehicles designed to provide economic relief under CARES to small businesses include the SBA loans: Economic Injury Disaster Loan and Paycheck Protection Program Loan. Other forms of relief include the Employee Retention Credit and payroll tax deferment until 2021. Note that if a business takes a loan under the Paycheck Protection Program, it will not be eligible for the Employee Retention Credit or the payroll tax deferment.

The Economic Injury Disaster Loan, or EID has been available during many disasters in the past such as Hurricane Harvey. It was recently expanded by the SBA in response to the COVID-19 epidemic. The EID is designed to provide working capital loans to small businesses that are subject to federally designated disaster areas, which in the case of COVID-19 is the entire United States as of March 13, 2020. The Paycheck Protection Program, or PPP, which was also created by the SBA under the authority of CARES, is specifically tailored in response to COVID-19.

The EID loan is entirely funded through the SBA. It consists of an advance of $10,000 and a loan of up to $2 million at a 3.75% interest rate with a maturity period of 30 years. The $10,000 advance will be classified as a grant and no income will be recognized nor will that amount be required to be paid back to the SBA. The EID is a nonrecourse loan, meaning no personal guarantee will be mandated, and no collateral on the loan will be required so long as the loan amount does not exceed $200,000. The loan payments can be deferred for from six months up to one year even though interest will continue to accrue during the deferral period. 

The EID aims to provide for the sick leave of employees who are unable to work because of the coronavirus; for employers to maintain payroll during periods of business disruptions; and other expenses such as satisfying financial obligations that include rent or mortgage that cannot be satisfied due to loss in business revenue.

Nothing prevents the borrower from applying for both the EID loan and the Paycheck Protection Program loan. If the borrower already applied for the EID loan before April 3, 2020, she can refinance the EID loan under the Paycheck Protection Program loan at a much more favorable interest rate, but at a much shorter maturity period. Even though the borrower is not required to return the $10,000 advance under the EID loan, the total amount of the PPP loan may nevertheless be reduced by $10,000.  

The Paycheck Protection Program, or PPP, is guaranteed by the SBA, but it is not funded by the SBA unlike the EID loan. It is funded by private enterprises such as existing SBA lenders and federally insured depository institutions like banks. Unlike the EID loans which are processed by the SBA, PPP loans have to be approved by the private entities that are enrolled in this SBA program.

The PPP has similar intentions as the EID, but it is arguably broader and more restrictive than the EID. PPP’s aim is to provide various incentives to employers so they can maintain payroll during the COVID-19 pandemic and cover basic expenses. The means for reaching that aim is to provide funding to the employer for covered expenses that includes employee salaries, rent, utilities, costs related to insurance premiums, interest on debt that was incurred before February 15, 2020, and continuation of group healthcare benefits during periods of paid sick, medical, or family leave.

The borrower of a PPP loan can borrow up to $10 million at a 1% interest rate with a maturity period of two years (note that the SBA guidelines state that the maturity period can be as much as ten years). The initial payment for the loan can be deferred for six months, but the interest on the loan will accrue during the deferral period. Similar to the EID, no collateral, personal guarantees or borrower or lender fees payable to the SBA such as closing costs will be mandated for the PPP loan.

The distinguishing characteristic of a PPP loan is the potential forgiveness of the entire loan amount if the employers meet the covered expenses requirement and maintain the salary levels of their employees.

To calculate the loan amount, the borrower will use the average of the payroll expenses for the last one year before the loan is made increased by a factor of 2.5. For example, if the borrower’s monthly payroll expenses are $10,000, he will be entitled to receive $25,000 under the loan, which is 2 ½ times his monthly payroll expenses. Payroll expenses covered under PPP per SBA’s guidelines include not only salaries, wages, and commissions, but also group healthcare and retirement benefits, vacation payments and sick leave.

Note that there are salary limitations with respect to the calculation of payroll expenses. The maximum amount of the employee’s wages the employer is entitled to include in the final calculation of the total loan amount is $100,000 per annum. As such, if Avo, who may be one of the borrower’s employees or the borrower himself, makes $120,000 a year or $10,000 per month, Avo will only be entitled to $8,333 per month instead of his full $10,000 monthly salary.

The full loan amount or a portion thereof may be forgiven if the funds are spent on covered expenses for the first eight-week period from the date of the loan disbursement and if no more than 25% of the forgiven amount is used for non-payroll expenses. In other words, 75% of the loan amount must be allocated towards payroll expenses within the meaning of the SBA’s guidelines. For tax purposes, the forgiven portion will be classified as a grant and it will not count as income on the borrower’s tax returns as earned income or forgiveness of debt.

To illustrate the loan forgiveness requirements, suppose that Avo’s loan amount is $25,000. He ends up using $20,000 for the first eight weeks from the date of the loan disbursement on covered expenses. The remaining $5,000 will not be forgiven, but nothing prevents Avo from closing out the loan before interest kicks in since there are no prepayment penalties or fees. However, Avo could not have used more than 25% of the $20,000 forgiven amount, which in this case is $5,000, on non-payroll expenses such as rent and utilities.

Even if the forgiveness requirements are met, the portion of the forgiveness amount may nevertheless be reduced if the business has less employees during the eight-week period after the loan is issued compared to the prior period. However, if the business rehires those employees that were let go within a 30-day period after firing them, the business will be exempt from this rule. There are two formulas used to determine the reduction amount of the forgiveness portion of the loan and the borrower has the luxury of applying the formula that is more favorable to him.

The first formula (“Formula 1”) factors in the average full-time employees the borrower had on a monthly basis between February 15, 2019 and June 30, 2019. The second formula (“Formula 2”) factors in the average full-time employees the borrower had on a monthly basis between January 1, 2020 and February 29, 2020.

Let’s assume that Avo’s potential forgivable loan amount is $20,000 and that he had 20 employees during the time period specified under Formula 1 and 18 employees during the covered period. Formula 1 is calculated as follows: $20,000 x (18/20) or 0.9, which equals $18,000. Therefore, the forgiven portion of Avo’s loan amount would be $18,000 under Formula 1.

Let’s assume that Avo’s potential forgivable loan amount is still $20,000, but he had 18 employees during the time period specified under Formula 2 and 18 employees during the covered period. Formula 2 is calculated as follows: $20,000 x (18/18 ) or 1, which equals $20,000. Therefore, Avo could apply the more favorable Formula 2 and the forgiven portion of his loan would be the full $20,000.

The forgiveness amount, which in the example above may be as much as $20,000, may also be reduced if the employee’s salary is reduced by more than 25% compared to the previous quarter. However, if the reduction is reversed within 30 days, this rule will not apply.

For business owners who do not participate in either of the loan programs (EID and/or PPP), they can utilize the Employee Retention Credit, which in effect is a credit against payroll taxes for the employer; calculated by 50% of the qualified wages of the employee(s) capped at $10,000 per employee with a maximum tax credit of $5,000 per employee.

Another option is to defer the payroll taxes for the 2020 tax year. For payroll taxes that are due for the 2020 tax year, they can now be paid with the following schedule: 50% have to be paid by December 31, 2021, and the remaining balance by December 31, 2022. However, the taxpayer should consider whether to use a payroll company for the 2021 and 2022 tax years, and instead consider placing the funds into a separate account that is accessible by the business owner, since there is a likelihood that the payroll company may go out of business and the deferred amount may be lost, yet the taxes on them will nevertheless be due.

There are also tax credits available for the employer’s portion of the Federal Insurance Contributions Act (“FICA”) contributions if the employee is required to be quarantined due to the coronavirus or take care of a family member who has coronavirus or a child who is not going to school because of school closing. If the employee is required to miss work because she is infected by the coronavirus, the amount of the eligible tax credit for the employer will be $200 per day for a maximum of 10 days. The amount of the credit is limited by the lesser of wages plus healthcare costs the employer provides or $511 per day. If the employee is required to miss employment due to family leave, the amount of the eligible tax credit for the employer will be $200 per day capped at $10,000.

The FICA refunds may be claimed when filing quarterly returns, which are typically due on April 30th, July 31st, Oct 31st, and January 31st. If the tax credit taken was less than the quarterly taxes that were paid in the previous quarter, the taxpayer would have to wait until the following quarter to apply the credit. For example, if the FICA contribution during the last quarter was $500, but the tax credit for the current quarter is $1,000, the taxpayer would not have the $500 difference returned and would instead apply the credit on the following quarter’s return.

One final development that may be of great importance to business owners pertains to net operating losses. Carryback losses were temporarily brought back ever since they were largely eliminated under the GOP Tax Cuts and Jobs Act. For the 2018, 2019 and 2020 tax years, a business can carryback its net operating losses for 5 years and the 80% threshold will no longer apply. Therefore, a business may carryback its net operating losses for those years on 100% of the taxable income to the preceding five years.

Important Note: This article is published for informational purposes only and it is not meant to provide legal, financial, or tax advice. The law and guidance in this area are changing virtually on a daily basis. The information presented above is our understanding of the three complex sets of legislations passed in response to the coronavirus pandemic including the CARES Act. Please consult with your advisors to determine which of the relief efforts mentioned in the article, if any, are applicable to your circumstances.  

New Deduction For Pass-Through Entities

Under the new tax laws (“TCJA”), there is a new deduction available to owners of pass-through entities. Section 199A of the Internal Revenue Code allows owners of pass-through entities to deduct up to 20% of their business income from their income taxes. The first portion of this article provides an overview on the various types of pass-through entities that are included under Section 199A. The second portion of the article provides an analysis on the conditions that the owners of pass-through entities must satisfy in order to qualify for the 199A deduction.

PASS-THROUGH ENTITIES

For purposes of Section 199A, the following entities are entitled to the deduction: sole proprietorships, partnerships, limited liability companies, S corporations, trusts, and estates. The most distinguishing characteristic of pass-through entities is that the entities themselves generally do not pay tax. Instead, all of the earnings and expenses are passed through to the owners who pay the taxes on their individual tax returns. The sections below provide an overview on the general characteristics of each type of pass-through entity.

Sole Proprietorships

A sole proprietorship is not a separate entity from the business owner. It is operated by a specific individual. All benefits and obligations alike are limited to only the business owner. It cannot be passed to a different person unless the new owner creates a different sole proprietorship or a different type of business entity. Even if the business has employees, the risks and liabilities of the business are assumed only by the single individual.

Sole proprietors often receive Forms 1099-MISC during the course of their business dealings, which they must report along with their other income. The income and expenses pass through to the business owner and they are reported on the individual’s personal tax return on Schedule C (or Schedule C-EZ) of Form 1040. If the sole proprietor accumulates net earnings of $400 or more from his self-employment, he must pay self-employment tax by filing Schedule SE with his Form 1040.

Partnerships

A partnership is generally a business venture between two or more persons who agree to carry on a trade or business. In essence, it is a contractual relationship, which can be written or oral. Each partner contributes money, property, or labor in return for a share in the profits and losses of the business. The rights and responsibilities of the partners are generally included in the Partnership Agreement.

Partners owe fiduciary duties to each other and to the partnership. These duties include the duty of loyalty, care, and the duty to act in good faith. A partner may legally bind the partnership provided that she has authority to engage in a particular course of conduct on behalf of the partnership. Authority is generally presumed if the transaction was part of the usual and ordinary course of the partnership’s business operations.

For federal tax compliance purposes, a partnership must report the income, deductions, gains, and losses from its business operations on Form 1065, but the partnership itself generally does not pay tax on its income. However, the partnership must issue Schedule K-1 to each partner. The partner’s share of partnership income is reported on Schedule E.

In a General Partnership (“GP”), all partners are jointly and severally liable for the debts and obligations of the partnerships. For example, if a partnership has two partners and it defaults on a loan, each partner may be personally obligated to satisfy the balance on the loan. Similar to sole proprietorships, this factor is problematic from asset protection standpoint because it does not protect the business owner’s assets from the risks that may arise during the course of business operations.

A Limited Partnership (“LP”) is a two-tiered partnership entity with at least one general partner and one limited partner. In California, the Partnership Agreement must be in writing and the Certificate of Limited Partnership must be filed with the Secretary of State of California. The general partner legally binds the partnership for any decision she may make throughout the duration of the partnership. She is also liable for all the debts of the LP. On the other hand, a limited partner will generally not be subject to liability unless he loses the protection of limited liability for various reasons, such as when he actively participates in the management of the partnership.

In California, a Limited Liability Partnership (“LLP”) is restricted to only certain class of professionals such as lawyers and accountants. The underlying purpose of an LLP is to avoid liability on the members of the partnership for the malpractice of their partners. For instance, if the law firm is an LP instead of an LLP, all of the attorneys who participate in the management of the law firm may be jointly and severally liable for the malpractice of their partners. Since California forbids law firms from forming LLCs, the law firm may in the alternative incorporate. However, corporate formalities can be much more complex than the management of a partnership under a Partnership Agreement.

Limited Liability Companies

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, and flexible management structures.

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 the LLC. In manager-managed LLCs, members may appoint one or more managers to conduct the business activities that fall within the scope authorized by the company’s members.

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 (i.e., disregarded entity). Under such classification, the member is considered self-employed and is consequently responsible for self-employment taxes. If the LLC is not taxed as a C corporation, then it will be taxed as a pass-through entity. The earnings and expenses will pass through to the member’s personal tax returns. Under a pass-through scenario, the LLC itself will file Form 1065, but it will not pay the income taxes on the LLC’s profits.

Five Fundamentals of LLCs

S Corporations

There are generally two types of tax treatments available to corporations under the federal rules. By default, a corporation is taxed under Subchapter C of the Internal Revenue Code. However, a corporation may elect to be taxed under Subchapter S of the Internal Revenue Code.

In order to qualify as an S corporation, (1) the entity 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).

The shareholders of S corporations 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. The shareholders must pay taxes on their share of the corporate income regardless of whether distributions are made.

Anatomy Of A Corporation

Trusts

Trusts are created and operated under the laws of the state in which they are formed. A typical trust generally consists of a Trustor, Trustee and Beneficiary. The Trustor (a.k.a., Grantor, Settlor) is the original owner of the property. The Trustee is the fiduciary party that manages the trust assets. The Beneficiary is the designated party that is entitled to receive the trust income or assets.

A trust may be created during an individual’s life or after death under an individual’s will. A trust may also be a grantor trust or a non-grantor trust. If it is a grantor trust, then it is not recognized as a separate entity for federal income tax purposes. The most common types of grantor trusts are Revocable Living Trusts, which allow the Trustor (i.e., Grantor) to make changes or end the trust during his lifetime. Many people use Revocable Living Trusts as alternatives or supplemental to wills.

A non-grantor trust is any trust where the assets are not held by the grantor either directly or indirectly. A non-grantor trust is considered a separate legal entity. The most common of these trusts are irrevocable trusts, where the trust cannot be revoked once it is created. The transfer of the asset is deemed a complete gift with gift tax implications. The income and deductions of non-grantor trusts are reported on Form 1041 (Income Tax Return for Estates and Trusts).

Estate Planning In A Nutshell

Estates

An estate is created when a person dies. Upon the distribution of all assets and satisfaction of all liabilities, both estates and trusts generally cease to exist. The assets of the estate must generally be treated on the beneficiary’s return in the same manner as they are treated on the estate’s return. In addition, the estate’s gross income, deductions and credits are calculated in the same manner as that of an individual. However, they are reported on Form 1041 only if the estate’s annual gross income exceeds $600.

The beneficiary who inherits the property is generally not taxed on the transfer. However, until the distribution is made, the beneficiary may be subject to income tax if she is receiving distributions before the final distribution of the estate (e.g., during the course of a litigation dispute). Any distributions made to a beneficiary are reported on Schedule K-1.

NEW DEDUCTION UNDER TCJA

The Section 199A deduction is only available to owners of pass-through entities. It will take effect from the 2018 tax year and it is set to expire after December 31, 2025 unless otherwise extended by Congress. The maximum potential amount of the deduction is 20% of the Qualified Business Income (“QBI”) from each business the taxpayer owns. For active business owners, the portion of the business income is generally the remaining portion after a business owner receives reasonable compensation (e.g., W-2s).

The eligibility for the QBI deduction is first determined by the taxpayer’s total taxable income (e.g., business and investment income) minus adjustments (e.g., deductions). The second inquiry is how much the taxpayer is entitled to deduct. There is generally an “overall limitation” which is determined by the lesser of the combined net business income or 20% of the total taxable income (in excess of any net capital gain). For taxpayers who only receive business income from passive avenues (e.g., rental real estate), the overall limitation is generally sufficient to determine the QBI deduction. It gets more complicated for taxpayers who operate active businesses.

The analysis below focuses on owners of active businesses, such as professionals or entrepreneurs who own and also operate their businesses. Besides the overall limitation test, there are primarily two overarching tests that are used to determine the amount the taxpayer may deduct: the type of business the taxpayer operates and the taxpayer’s total taxable income.

Type of Business Test

Whether the taxpayer provides services in a Specified Service Trade or Business (“SSTB”) within the meaning Section 199A is a significant factor in determining how much the taxpayer is entitled to deduct. If the taxpayer falls in any of the enumerated classifications as outlined in Section 199A, her deduction may either be reduced or she may not be entitled to any deduction. If the taxpayer provides services in a SSTB, she may not be entitled to any deduction beyond a certain threshold, even though a similarly situated taxpayer may otherwise be entitled to receive a deduction.

There are two classifications of SSTBs within the meaning of Section 199A. The first classification defines SSTB as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services” (architects and engineers are expressly excluded under 199A). The second classification involves the performance of services in the areas of investing and investment management, trading or dealing in securities, partnership interests, and commodities.

The first classification also includes a catch-all category of “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Even though the term “trade or business” is not defined by statute, the factors that may be considered include the profit motive of the business owner and the continuous and regular activity of the business. The proposed regulations limit the definition of “reputation or skill” to (1) income from endorsing products or services, (2) licensing or receiving income for the use of an individual’s likeness, or (3) receiving appearance fees from various media platforms such as television.

Total Taxable Income Test

The key factor for determining the QBI deduction is the taxpayer’s total taxable income. If the total taxable income falls in Tier 1, regardless of whether the taxpayer’s business meets the SSTB test, the taxpayer may be entitled to the maximum deduction. If the taxable income falls in Tier 2, the amount of the QBI deduction is generally reduced. If Tier 3, depending on whether it is SSTB, the QBI deduction is either limited or the taxpayer is not entitled to any deduction.

The threshold of the total taxable income for Tier 1 is $157,500 ($315,000 if filing a joint return), Tier 2 is $207,500 ($415,000 if filing a joint return), Tier 3 is any amount that is in excess of $207,500 ($415,000 if filing a joint return).

Assuming the taxpayer falls in Tier 1, the maximum the taxpayer may deduct is 20% of his combined net business income. This means that the taxpayer who earns $100,000 on his QBI may pay tax only on $80,000. If we assume that the taxpayer falls in the 24% tax bracket, the taxpayer would pay 24% tax on the $80,000 portion (as opposed to the full $100,000). Therefore, the taxpayer would pay only $19,200 on the QBI portion (instead of $24,000).

If the taxpayer falls in Tier 2 or Tier 3, there is a wage and capital (i.e., Qualified Property) limitation. Qualified property is any tangible property that is subject to depreciation and is available for use during the tax year. The depreciation period is determined by the later of the regular depreciation period that would apply to the particular property or 10 years. The 2.5% calculation in the formula is determined by the unadjusted basis of the property, meaning, the basis of the property immediately after its acquisition.

Taxpayers who fall in Tier 2 are subject to a phase-in of the W-2 and Qualified Property limitation. This is true regardless of whether the taxpayer operates an SSTB. However, there are differences between owners of SSTBs versus owners of non-SSTBs when calculating the QBI deduction for Tier 2.

Generally, the formula used to calculate the QBI deduction for taxpayers who fall in Tier 2 is determined by the portion of the taxpayer’s total taxable income that is in excess of the Tier 1 threshold yet below the Tier 3 threshold. The difference is then divided by $50,000 ($100,000 for joint filers). For MFJ taxpayers who operate SSTBs, the formula for the QBI deduction is [1 – (taxable income – $315,000) / $100,000)] x (QBI x 20%).

To illustrate the application of the SSTB formula for Tier 2, let’s assume that Larry and his wife operate a law firm (SSTB), which is taxed as an S corporation. In 2018, the couple’s taxable income is $345,000 and QBI is $95,000. If we apply the formula above, their QBI deduction for 2018 is $13,300 based on [1 – ($345,000 – $315,000) / $100,000)] x ($95,000 x 20%).

If the taxpayer’s taxable income falls in Tier 3, the next inquiry is whether the taxpayer’s business falls within the realm of SSTB. If it is SSTB, the inquiry ends here and the taxpayer is not entitled to any QBI deduction. If it is not SSTB, then the deduction is equal to the lesser of: (a) 20% of net business income or (b) greater of (i) W-2 x 50% or (ii) W-2 x 25% + 2.5% of Qualified Property.

In order to understand the application of the formula for Tier 3, assume that Ronald owns and operates a golf course (not SSTB). In 2018, Ronald’s total taxable income is $400,000. His entire income is from the operation of the golf course. Ronald also purchased $1,000,000 worth of golf clubs and other Qualified Property that have not fully depreciated. Since Ronald operates as a sole proprietor, he cannot receive W-2s. Thus, his QBI deduction is $25,000 because $25,000 is the lesser of: (a) $80,000 (20% x $400,000) or (b) greater of (i) 0 (zero W-2 x 50%) or (ii) $25,000 [0 (zero W-2 x 25%)] + [$25,000 ($1,000,0000 x 2.5%)].

Assume the same facts as in the example above, except that Ronald is a shareholder-employee of an S corporation and received $100,000 in W-2s. He does not have any Qualified Property (e.g., golf clubs). His QBI deduction is $50,000 because $50,000 is the lesser of: (a) $80,000 (20% x $400,000) or (b) greater of (i) 50,000 ($100,000 W-2 x 50%) or (ii) $25,000 [$25,000 ($100,000 W-2 x 25%) + 0 (zero x 25%)].

Planning Techniques

Since the taxpayer’s total taxable income is arguably the biggest factor in determining eligibility for the QBI deduction, one technique is to reduce the taxable income to the extent possible. There are various ways to achieve that end. One way is to implement defined benefit or defined contribution plans. If done correctly, these plans may reduce the taxable income, provide asset protection, and secure a peace of mind for the latter years of a person’s life.

Another technique is to restructure the business entity. For shareholder-employees of C corporations, it may be better to restructure as a S corporation since 199A is available only to pass-through entities. For sole proprietors and partners of partnerships who fall in Tier 2 or Tier 3, they are generally not entitled to the deduction because they cannot receive W-2s. However, if there is Qualified Property, they may be entitled to the deduction. In any event, converting to a S corporation is not only beneficial for asset protection purposes and reducing the AGI, but it may now also be beneficial for the QBI deduction.

To illustrate the significance of the impact of entity structures, let’s assume that Tommy and Dolly (a married couple) operate an online shopping business. The business has no Qualified Property, but in 2018, it generated $500,000 of QBI and $550,000 of taxable income. If the business is treated as a sole proprietorship or partnership, the couple will not be entitled to any QBI deduction. If it is treated as an S corporation, they may be entitled to a deduction in the amount of $50,000 assuming that they pay themselves $100,000 in W-2s.

Taxation Of Corporations

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 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.

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.

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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.

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.

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.