MORE on Wayfair

What does South Dakota v. Wayfair Really Mean – Impact For and Beyond Internet Sales

Introduction. 

IN a stunning reversal of prior constitutional precedent, the US Supreme Court held in the case of South Dakota v. Wayfair, et al., 585 US ___ (2018), that a state may require online retailers to collect and remit sales taxes.  Under the prior cases of National Bellas Hess, Inc. vs. Department of Revenue of Illinois, 386 US 753 (1967) and Quill Corp. v. North Dakota, 504 US 298 (1992), decided before the onset of massive internet selling, the Supreme Court held that a state cannot impose sales tax collection duties on an out of state retailer doing business via common carrier, absent some physical presence in the state such as property or employees.

The Wayfair decision will have the immediate effect of opening the floodgates for state sales taxation of interstate and international internet sales. This decision impacts sellers in a multitude of online market places such as Amazon, Jet.com, Walmart.com, EBay.com and other web-based selling environments. More ominously, the decision may well lead to other forms of state taxation and regulation.  Accordingly, e-commerce clients should review current sales and other activities in non-resident states, especially where there is more than a modicum of business, and determine if remedial action is required to avoid the imposition of unnecessary taxes, penalties and interest from those states, and perhaps other regulatory penalties.

Background.

Under the US Constitution, Congress is given the authority to regulate commerce among the states, Art. I, §8, commonly known as the “Commerce Clause” for short.  The purpose of the Commerce Clause is to avoid disputes in connection with interstate transactions. However, the Supreme Court has never held that Congress has the exclusive authority to regulate interstate commerce. Instead, the Court has held that states have concurrent jurisdiction and may require interstate commerce to pay its fair share of state taxes, so long as the states do not impose an undue burden on interstate commerce and thus interfere with the prerogative of Congress under, and the purpose of, the Commerce Clause.

Hence a given state may impose taxes on interstate commerce, so long as (1) the activity being taxed has a “substantial nexus” to the state, (2) the tax is fairly apportioned, (3) the tax does not discriminate against interstate commerce, and (4) the tax is fairly related to the services which the state provides, Complete Auto Transit v. Brady, 430 US 274 (1977).  If a given state tax fails one of the foregoing prongs of the Complete Auto Transit test, the tax will be held void in violation of Congress’ priority to regulate interstate commerce under the Commerce Clause.  This is called the, “dormant Commerce Clause” doctrine and applies where Congress has failed to enact a statute on a given state level tax or other regulation.

The sole issue before the Supreme Court in the Wayfair case was whether the first prong of the Complete Auto Transit test, i.e. “substantial nexus,” required the retailer to have a physical presence in the state as determined under the National Bellas Hess and Quill decisions.  The Supreme Court held that it did not, and thus from now on, retailers which make sales solely over the internet to customers in other states are now subject to the requirements of collection and remittance of sales taxes in those other states.  Most significantly, there may be other fallout from the decision, as discussed in the analysis section.

Analysis.

There are a couple of immediate concerns for our e-commerce clients:

  1. CLIENTS SHOULD ANTICIPATE THEY WILL BE REQUIRED TO COLLECT AND PAY SALES TAX IN ANY STATE IN WHICH A CUSTOMER RESIDES OR TO WHICH PRODUCT IS SHIPPED. States can be very aggressive in collecting taxes, sometimes even where modest amounts are involved. Even prior to the Wayfair decision, states were very creative in defining physical presence and finding substantial nexus under the Quill rule.  See, e.g., Overstock.com, Inc. v. New York State Department of Taxation and Finance, 987 NE 2d 621 (NY App. 2013) (internet retailer had sufficient physical presence where unrelated in-state vendors, i.e. contractors, assisted retailer with sales).

Indeed, some states went so far as to ignore or limit the Quill physical presence requirement in contexts other than sales taxes. See KFC Corp. v. Iowa Department of Revenue, 792 N.W.2d 308 (IA 2010) (no physical presence required for state income tax where franchisor licensed name and trademarks in state).   In that case, the Iowa Supreme Court took pains to note that the Quill physical presence test applied only to sales taxation, where compliance with numerous taxing jurisdictions and collections from third party customers would be a burden on interstate commerce, whereas state income taxation would not.

Accordingly, as a result of the removal of the physical presence test by the US Supreme Court, clients can expect increased state collection activity not only on sales taxes but on income and other taxes, as well as state regulation, even if business is only done remotely over the internet.

2. COMPLIANCE WILL BE A CHALLENGE AND AN INVESTMENT IN TAX MANAGEMENT SOFTWARE OR A QUALIFIED THIRD-PARTY RESOURCE WILL BE NEEDED. There are over 9,600 state and local taxing jurisdictions in the US, and hence national retailers must now invest in or create software to track sales in each and every one of those jurisdictions where sales take place. Compliance software and services are available, but not inexpensive and often the information needed to comply is hard to obtain from the online market place. While some online marketplaces will collect the tax for a seller, the reporting is usually left to the online seller. And mastering the details of these laws can be daunting. Retail clients can expect immediate increased compliance costs, and other clients will need to determine if their activities fall under state sales and use tax regimes as taxable retail sales for each state.  These will be expensive exercises.

  1. INTERNATIONAL SELLERS MAY FIND LIENS AND OTHER ASSESSMENT OF GOODS STORED IN THE US. It is unclear how this law will impact international sellers. Assuming the international seller has no nexus or contacts in the US but simply sells product through a marketplace such as Amazon.com, it is unclear how those businesses will be pursued. Most today are not collecting sales tax, however, if they enter into transactions to sell their business, they may find liens or other barriers in the transaction. Further, representations and warranties made to buyers in the transaction documents will likely require disclosure regarding compliance with tax laws such as these.

A few potential solutions:

  1. First, the court left open the possibility of challenges under other prongs of the Complete Auto Transit test. Hence a seller might successfully challenge a given tax if the tax is out of proportion to the benefits derived by the seller or otherwise discriminates against interstate commerce.
  2. Second, inasmuch as Wayfair is a Commerce Clause decision, Congress can enact overriding legislation preventing burdensome state taxation, and indeed there are pending bills addressing the matter. We’ll see if there is enough public outcry to force enactment of a statute.  If so, one hopes for the requirements of a uniform state sales (and perhaps income) tax rate enacted by each state, and de minimis sales exemptions, for ease of administration.
  3. Third, the Wayfair decision upheld the South Dakota law in question in part because the law imposes the tax only if a retailer makes more than a minimum level of sales, and because the tax was not retroactive. Hence if a state seeks to impose taxation on a single or a few isolated sales, perhaps an argument can be made that there is no substantial nexus. Any retroactive application might also be deemed unconstitutional.
  4. Fourth, Congress has already limited the ability of states to impose income taxes on certain sellers by federal statute, i.e. the statute commonly known as the “Interstate Income Act of 1959” or “PL 86-272” for sellers of tangible personal property. Clients can and should defend against such taxation as and when the statute is applicable.

Conclusion.

 Congress may well enact remedial legislation, but then again, 2018 is an election year.  In the meantime, clients should review outstate sales and activity and take remedial actions, including as applicable, obtaining appropriate sales tax licenses and collecting taxes, and reviewing potential income tax and other regulatory liability.  Clients should also expect more aggressive state collection activities in the ensuing months, even from states where client business activity is small.

AEGIS Law stands ready to help.  We will work with you and your accounting team to develop strategies for minimizing the impact of the Wayfair decision, and, if necessary, defend your business in court or via administrative appeal.

For more information, please contact your AEGIS attorney, Norman S. Newmark, head of the AEGIS Law tax department, at (314) 454-9100 x117 or nnewmark@aegislaw.com, or Rochelle Friedman Walk, the e-commerce practice, at (813) 999-0199 ext. 115 or rwalk@aegislaw.com.

About the authors:

Norman S. Newmark, JD, LLM, has over thirty-one years of experience in tax and tax-related matters, including state Commerce Clause cases, and is currently head of the AEGIS Law tax department.  He is licensed in Missouri and Oklahoma and admitted to practice before the United States Tax Court.

Rochelle Friedman Walk, JD, is AEGIS Law’s expert on e-commerce and an attorney who has a significant practice in representing e-commerce businesses and online sellers.  She is licensed in the states of Florida and Ohio.

©2018 AEGIS Law All Rights Reserved.

 

Will the US Supreme Court Require Online Sellers to Collect Sales Tax without Nexus?

SOUTH DAKOTA V. WAYFAIR – WILL THE SUPREME COURT BE FAIR TO SMALL BUSINESS?

Our firm and many of our clients are closely watching the US Supreme Court as it hears oral arguments on tomorrow, April 17, 2018 (the day after tax day) and considers the  South Dakota v. WayfairConsidering it was determined years ago that a business has to be, in layman’s terms, present in a jurisdiction before it was obligated to collect sales tax, it is not surprising that sellers on Amazon.com, Wayfair.com, Ebay.com, Jet.com, Walmart.com and the like have not considered collecting sales tax in those jurisdictions where they had no physical presence. Major retailers have always shipped into states in which they had no stores and charged no sales tax.

The Dilemma: revenue lost by states due to online selling

The states have a problem. About 50% of Holiday sales in 2017 were made online. Sales tax revenue is one of the ways state and local governments survive. States are facing a deficit due to the decline in sales collected as a result of online sales.

The Dilemma: the burden on smaller enterprises

The real dilemma is both one of competition and one of of desperate impact on small online sellers. Today, few international sellers collect sales tax. US-based online sellers are then at a pricing disadvantage if they collect sales tax when their competition does not.

Sellers do not have accurate or complete information from the marketplaces to be able to timely and correctly file in each state and local jurisdiction. Amazon and other marketplaces move inventory as they deem necessary to meet customer needs and sales data and customer names and detail data are not comprehensively and consistently provided to the online sellers. The inventory is sold anywhere that the market place, such as Amazon, chooses to let consumers purchase.  The burden of reporting to all of the states and local jurisdictions is onerous. The cost of compliance and the risk of failure to comply with states and all of the local jurisdictions within those states may cause many online retailers to close their doors.

Conclusion

At the Walk Law Firm, we represent many online e-tailers particularly in buying or selling brands or in funding their companies. Our clients are very entrepreneurial and look at this issue as a way in which governments make it harder for small business to succeed. It adds confusion and complexity to already heavily negotiated disclosure in merger and acquisition transactions.

CNN reported on April 15, 2018, their view of the upcoming oral arguments. I agree with the concerns raised and am hopeful that our Supreme Court does not put the onus on small business and online retailers. If it deems it is necessary or appropriate to permit state and local governments to require online sellers to collect, report and pay sales tax in jurisdictions in which they have nexus only as a result of selling in a market place, then it is our view that the various market places should be responsible for collecting, reporting and paying the tax to the states and local jurisdictions.

Let’s hope our Supreme Court appreciates the need to continue to grow small business in the US.

Can You Really Replace Your Lawyer with Artificial Intelligence and Internet Forms ?

Some months ago, I sat in a monthly CEO round table discussion regarding artificial intelligence (AI) and how it does and may, in the future, impact each of our businesses. One of the CEO’s astutely said he imagines in the not so distant future he won’t be needing me for much. He thinks he will be able to get all of his business deals done through Siri, Google or Alexa. After we all chuckled for a minute, I thought about whether that is true. If not, why not? If so, what do we need to do to differentiate ourselves from AI lawyers and law firms.

In considering the options, I came to the conclusion that he is partially right, and at the same time, very wrong.

He is right because so much information is available on the internet and finding forms that look pretty good or on point is not too hard today. With AI, finding the right form and information should be even easier. On the very wrong side of the equation, there is actually some art to what we do. Some of the clients who need us the most have tried to save money by drafting for themselves only to find themselves in a messy situation. Often, the drafts are inconsistent, lack key provisions, have language that is hard to interpret and create unintended consequences. Form agreements do not reflect orally agreed terms.

AI will get better.

With AI, it’s conceivable that some of the problems described above will dissipate. I still believe, the best business lawyers will continue to distinguish themselves from other lawyers with practical counsel based on experience.

AI will not compete with great legal minds.

When we hire young lawyers, I look for great minds with personalities that can communicate. Law school does not teach you to perform the tasks of a lawyer, but rather how to think like a lawyer. How to assess risk and pursue results. As business lawyers, we need to do even more. By learning from our clients about their business, we anticipate the future of business dealings and changes to law. Then, we design business structures that can grow with the business itself. So for our business clients, AI will need to be more than a system that pumps out forms to effectively compete with us.

Practical business advice will be difficult to convey.

We look at each client situation both from the practical business situation as well as the legal and risk management side. Our clients are small to mid-size businesses that are accelerating. We respond quickly, effectively and with an eye on the budget. We offer practical advice that is supported by quality legal work. Often, our clients’ businesses will need cash infusions or loans. We endeavor to ensure the business is being run and documented in a way that enables investors to invest without adding undue burden to the business owner. We need to be good at business – not just good lawyers.

Culling the information is an art.

As good as AI may be, the quantity of information will be daunting. Clients will be challenged to discern the practical solution. Culling forms and knowing what various types of investors need, what the IRS requires and balancing have to have, with nice to have, with not really needed, is an art form. It is learned from the number of deals we have done and from the experience of listening to the voice and tone of the client and other parties. The work changes with outside factors as emotions and desires of all of the parties fluctuate.

So at least until proven otherwise, I would be willing to put up my team and experience at the Walk Law Firm, PA up against the advice of Siri, Google and Alexa as practical business lawyers for small to midsize and accelerating businesses. We may create less forms in the future, but I am confident we will still be needed for our practical business and legal counsel.

WALK LAW FIRM, PA Named a 2017 Law Firm 500 Honoree for Fastest Growing Law Firms in the United States

We are very proud of the growth our firm has experienced over the last 3-years, but our record only stands because of our tremendous clients, dedicated team and passion for providing practical and timely legal counsel for businesses and their owners.

“Although we have grown quickly, we have worked hard to be measured by  results for our clients, not growth for growth’s sake,” commented Rochelle Friedman Walk, Esq., President of the Walk Law Firm, PA. “Our team has been dedicated to providing excellence in customer service resulting in many happy clients. In doing so, our commitment and focus has taken us on a fabulous journey of growth – both personally and for our business,” she continued.

We are pleased to announce that our law firm has been named a 2017 Law Firm 500 Honoree awarded to the fastest growing law firms in the US. It began earlier this year when we were nominated for our growth, operational excellence and commitment to client service. To our surprise, we were ranked 74th, which was stunning for a firm of 3 lawyers.

A significant area of growth for us has been in advising buyers and sellers of e-commerce businesses, especially Amazon.com, Jet.com, Ebay.com and other well known online retail. We strive to understand the current state of the art and the best methods for transferring, funding and managing the sale of these types of accounts and businesses.

We believe our focus on what we do best has enabled clients and referral sources to stick with us and rely on us. We exclusively represent businesses and their owners with a passion for quality, practical counsel. Whether the project is an acquisition of a new business, the sale of equipment, company agreements, partnership and shareholder agreements or simply practical counsel on how to handle a sticky situation, employment matter or intellectual property license, we are ready and willing to jump in and help.

The Law Firm 500 Award is an honor for our firm to receive and a tribute to our team. We are proud to serve our clients and delighted to be including in this list of growing and dedicated law firms.

As we continue to grow we encourage you to follow our progress, and stay in touch! You can view the full list of Law Firm 500 Honoree firms here: https://lawfirm500.com/award-honorees/

 

Selling Your Online Business, Part 3 – Who else is involved?

You’ve engaged a broker to help sell your business. Who else should be on your team, and who else is involved in the sale process?

Obviously, it is in your interest to find good legal representation that specializes in providing legal counsel to businesses, particularly in the area of mergers and acquisitions of online businesses. That is where we come it.

It is also in your interest to get your CPA involved for the business appraisal process. Although it might seem time consuming and costly to have a business appraisal done, we highly recommend that you have an appraisal conducted by a professional experienced in business appraisal techniques; a professional with experience in your particular industry is ideal.

An accurate business appraisal has several benefits. If your asking price is too high, you might scare away potential buyers. If your asking price is too low, you risk leaving money on the table. Also, having an appraisal conducted adds credibility to your ask. It shows where your figures are coming from.

It is important that your financials are in good shape in order to have an accurate appraisal.

Who else is involved in the process? The potential buyers and their respective counsel. A potential buyer could be an individual or perhaps a private equity group, each having its own benefits and detriments. A potential buyer may also have financial experts involved in the due diligence process. A potential buyer may have a lender involved that could impact the transaction and the relationship between you, the Seller, and the buyer. For example, if there is a seller finance component with a security interest, the Buyer’s lender may require you to subordinate your lien, and may place other restrictions on repayment of the seller loan.

We can help. The attorneys at Walk Law Firm, PA are experienced in assisting clients with navigating these various relationships. We understand the sale process and can guide clients throughout the transaction. Please feel free to call one of our attorneys at (813) 999-0199, or contact us via our website at www.WalkLawFirm.com.

© 2017 Matt Welker – This article is for general information only. Nothing contained in this article should be construed as legal advice or the formation of a lawyer/client relationship.


Selling Your Online Business, Part 2 – Who is this broker?

So, you have decided to sell this thing you’ve built from a hobby in your garage or a side-business to a multi-million-dollar online business. What happens now?

Many online business sellers engage a business broker. You could engage a general business broker or a broker that specializes in the brokerage of online businesses. We’ve found that the brokers that specialize in online businesses are more familiar with the nuances of online businesses and the different challenges that online business sellers face when selling their businesses. Obviously, there is a cost to engaging the services of a business broker. And any good business broker will require you to execute a contract that at the very least addresses their commission. It might be called a broker agreement or an engagement agreement, but it is generally a one-sided agreement in favor of the broker. We highly recommend you engage legal counsel to have this agreement reviewed before signing.

Don’t be fooled. The broker is a salesman and hopefully, for your sake, a good one, but keep in mind that he is selling you too. He is in this for the commission. Generally, the broker’s commission is based on a percentage of the overall purchase and sale price, or some percentage scale formulae (e.g., Lehman Formula, Double Lehman, Reverse Lehman, or some alternative or progressive fee schedule, which each warrant a separate blog article unto themselves). It may or may not have floor – i.e., it includes a proviso that the commission will not be less than a certain amount. A lot of online business sales include seller promissory notes, consulting agreements, earn-outs, and other methods putting value on the purchase and sale of the business. Many brokers will insist that their commissions be based on the entire purchase price, including any amount due under a seller note, consulting fee, earn out payment, etc. Keep in mind, the brokers agreement is a negotiable document, and you can structure it in such a way that it makes sense for you and your business.

We can help. The attorneys at Walk Law Firm, PA are experienced in assisting clients with the review and negotiation of brokers agreement when clients are seller their businesses. We understand what brokers expectations are regarding these agreements and we will balance these expectations with our client’s best interest in the sale process. Please feel free to call one of our attorneys at (813) 999-0199, or contact us via our website at www.WalkLawFirm.com.

© 2017 Matt Welker – This article is for general information purposes only. Nothing contained in this article should be construed as legal advice or the formation of an attorney-client relationship.


Selling Your Online Business, Part 1 – Selling Your Baby

You’ve birthed this awesome online business. For whatever reason (hopefully because you’re going to make a boatload of cash), you’ve deemed it to be in the best interest of the company (and in your best interest) to sell. It is important to have a general understanding of the sales process in order to: (i) simplify the overall selling process; (ii) make yourself, your company, and your advisors more efficient during the process; and (iii) to ensure a successful business closing.

This blog series on the legal considerations for selling your online business will provide an overview of the business sales process. Further, the series will touch on various phases (in relatively sequential order) of the selling process, including: engaging a broker; engaging a financial advisor or valuation expert (or both); negotiating the letter of intent; the due diligence process; negotiating a definitive sales agreement (and ancillary transaction documents); the closing process; and post-closing matters, including restrictive covenant arrangements.

The attorneys at Walk Law Firm, PA are experienced in assisting clients sell their online businesses. Please feel free to call one of our attorneys at (813) 999-0199, or contact us via our website at www.WalkLawFirm.com.

© 2017 Matt Welker – This article is for general information purposes only. Nothing contained in this article should be construed as legal advice or the formation of an attorney-client relationship.


New DOL Overtime Rules

By: Frank N. Lago, Esq.

The Fair Labor Standards Act (FLSA) guarantees a minimum wage for all hours worked during the workweek and overtime pay of 1.5 times the employee’s regular rate of pay for hours worked over 40 in a workweek. The DOL has revised the rules that apply to executive, administrative, professional, and computer employees, generally known as “white-collar” workers. These new rules do not apply to employees who are exempt from over-time pay under Section 7(i) of the FLSA. Those employees typically earn more than 50% of their pay from commissions. To determine if an employee is exempt from having to be paid over-time, the employer must apply two test, the threshold test and the duties test.

The Threshold Test. If the white-collar employee earns less than $913 a week, which is $47,476 a year, the employee is entitled to overtime pay for hours worked over 40, regardless of their job duties and responsibilities. If they make more than this amount, they will qualify for overtime only if they meet the standard duties test, discussed below. This is an increase from the previous amount established in 2004 of $455 per week. The threshold will be adjusted every three years, and adjusted to the salary level of the 40th percentile of weekly earnings of full time salaried workers in the lowest-wage census region according to the BLS. White-collar workers who earn less than the $913 per week will be eligible for overtime.

When calculating the salary of an individual, nondiscretionary bonuses and incentive payments, including commissions, can satisfy up to 10% of the standard weekly salary, but the remaining 90% needs to be paid on a regular basis, provided the bonuses are paid at least quarterly. Additionally, if at the end of a quarter, the employee’s salary is less than the $913 per week, the employer will have one week to make a catch-up payment to bring that employee to the threshold limit, so long as the shortfall is only 10% of the salary level.

Here is the example from the final rule. “In January, February, and March, Employee A must receive $821.70 per week in salary (90 percent of $913), and the remaining $91.30 in nondiscretionary bonuses and incentive payments (including commissions) must be $131 paid at least quarterly. If at the end of the quarter the employee has not received the equivalent of $91.30 per week in such bonuses, the employer has one additional pay period to pay the employee a lump sum (no greater than 10 percent of the salary level) to raise the employee’s earnings for the quarter equal to the standard salary level.”

The Duties Test. If the employees “primary duty” is as an “executive,” “administrative,” or “professional” employee, they are exempt from earning overtime pay.  An executive is someone: whose primary duty in management of the business; who customarily and regularly directs work; and who has the authority to hire or fire other employees or advise on their status.

An “Administrative” employees is an employee: whose primary duty is the performance of office or non-manual work directly related to the management or general business operations; and whose primary duty includes the exercise of discretion and independent judgment with respect to matters of significance. “Matters of significance” refers to the level of importance or consequence of the work performed.

A “professional employee” is an employee: whose primary duty is the performance of work that requires knowledge of an advanced type in a field of science or learning customarily acquired by a prolonged course of specialized intellectual instruction or requires invention, imagination, originality or talent in a recognized field of artistic or creative endeavor.

Highly Compensated Employees. If the employee earns more than $134,000, regardless of duties, they are exempt from overtime pay.

We can help. The attorneys at Walk Law Firm, PA is experienced in assisting its clients with FLSA audits, overtime, timekeeping, and pay practices and policies.  We understand how you have to comply with the legal requirements while growing and advancing your business.  Please feel free to call one of our attorneys at (813) 999-0199, or contact us via our website at www.WalkLawFirm.com Please note the above example is a simple scenario that does not involve bonuses, salary deductions, or any other factor that could affect how the effective hourly rate, overtime rate, and overtime pay are calculated.  While FLSA appears simple, there are a myriad of rules involving its applications and possible misapplications by businesses.

Violation of Bank Secrecy Act leads to $200,000 fine for Gold Buyer.

In December 2015, the Financial Crimes Enforcement Network (FinCen) fined a precious metal dealer for violating the Bank Secrecy Act (BSA) anti money laundering (AML) requirements, $200,000, in addition to forcing them to hire an auditor and provide comprehensive financials to FinCen. The gold buyer failed to secure the necessary customer information when buying and selling precious metals. And to think, the fine and penalties could have all been easily avoided.

The Bank Secrecy Act makes “dealers” of “covered goods” create and enforce an Anti-Money Laundering program. “Covered goods” are jewels, precious metals, precious stones, and finished goods (including jewelry. A “dealer” is a person, or entity that has purchased AND sold $50,000 of covered goods. Most businesses that buy and sell gold, fall under this definition.

If the business entity is a dealer of covered goods under the BSA, they must have an anti-money laundering program. The Bank Secrecy Act, Anti-Money Laundering Examination Manual mandates that the program have: “a system of internal controls to ensure ongoing compliance, independent testing of BSA/AML compliance, designate an individual or individuals responsible for managing BSA compliance (BSA compliance officer), and training for appropriate personnel.” The program is intended to identify large cash transactions of potential money launders. Pinellas, Hillsborough, and Paso counties are High Drug Trafficking Areas, so the need to launder money is great. Next time you have a large dollar transaction, think about your AML program.

Next Blog: The necessary elements of an AML Program.

 

The Walk Law Firm can help you become compliant with the BSA/AML statutes. Contact Frank Lago if you have questions or concerns about your BSA/AML compliance.

Understanding Limited Liability Company (LLC) Taxation

Once you’ve decided to form a limited liability company (LLC), your next decision is most likely going to be “how am I going to be taxed?” An LLC is not a tax entity. Instead, the IRS considers the LLC “disregarded” and applies tax laws that apply to sole proprietorships, corporations, and partnerships to the LLC. But, to avoid an esoteric discussion of tax law, I hope I can give you enough information in this article to help you in determining which tax entity is best for you.

If your LLC has one owner, it may elect to be a C corporation or S corporation, otherwise it will be a Disregarded Entity.  “Disregarded Entity” means the IRS ignores there is a legal entity between you and the income, losses, assets, etc. for tax purposes. A single owner disregarded entity will be treated as a sole proprietorship. If your LLC has multiple owners, it may elect to be a C corporation or S corporation, otherwise it will be a Disregarded Entity. A multi-owner disregarded entity will be taxed as a partnership.

To be or not to be… Disregarded

          Sole Proprietorships

The single member LLC, when disregarded, is analogous to a sole proprietorship. That is to say, you are your business and your business is you. Per the IRS, as a consequence of not making an election you will report your income and deductions, from your LLC, on a Schedule C, on your Form 1040. This is the simplest form of taxation and provides for single-level taxation. “Single” or “Double” taxation, as you’ll read later, refers to how many times the federal government gets to tax your “income.” With a sole proprietorship the only income tax that applies would be your individual income tax. But, the drawback of the sole proprietorships is that you have to pay Self-Employment Tax on all the income you make from the business. So keeping that in mind, you are going to pay income and self-employment tax on the profit you’ve made.

How much is self-employment tax? Generally it’s 15.3% on the first $117,000. Anything above $117,000 is subject to a 2.9% Medicare tax. There is an Additional Medicare Tax 0.9% tax for income over a threshold amount. The threshold amounts vary by filing status, but if you’re married filing jointly it is $250,000.

So in addition to your self-employment tax of 15.3%, you’re going to pay personal income tax. Assuming a 20% effective personal income tax rate, that’s a whopping 35.3%. Keep in mind that personal tax rates range from 0% to 39.6%, and possibly higher with the investment tax. As my good friend George says, the IRS is not my business partner, and luckily for him and for you there is a tax planning opportunity here.

C and S Corporations

The IRS allows for single members LLCs to elect, according to the check the box rules, to be taxed as a corporation. When you elect to be taxed as a corporation you are electing to be taxed under subchapter C of the internal revenue code, hence the nomenclature “C Corporation.” C corporations pay income tax on their income, though at preferential graduate tax rates. That means the overall tax brackets are lower than individual brackets. The profits stay in the company until there is a distribution. Typically, you’re going to distribute money from the corporation in the form of a dividend. Dividends are taxed at different rates than your income is taxed, typically much lower, at “capital gain” rates of 15-20%. But, you’re paying tax twice. Which is why this generally isn’t used as a tax structure, but the C Corporation’s brother, the S corporation is much more useful in reducing federal taxes.

Subchapter S corporations give the benefit single taxation at the individual level, while relieving some of the self-employment tax. Thus, instead of paying a corporate income tax, the S corporation pays nothing. In exchange, all of the income is deemed to have been distributed to the shareholders, unlike a C corporation, which only taxes its distributions when actually distributed. This is known as “phantom income.” The S corporation shareholders, whether or not they received the distributions, will pay taxes on that amount. One major benefit is that the shareholders do not pay self-employment tax on the income that is considered a distribution. This has the potential to greatly lower your tax bill. But, you have to approach this structure with caution. An S corp. does have to employ someone to do work. So if you’re doing all the work, you do have to pay yourself a “reasonable salary,” and you and the corporation will share the self-employment tax on your amount of compensation and file employment tax returns, Forms 941/944 and Form 940. Individuals get in trouble when they pay themselves too little and all the income as distribution. As in the case of Mr. Watson who found himself in court after paying himself $24,000 in wages and taking $203,651 in distribution.  While paying yourself a less than reasonable salary will lower your tax bill, it places you at risk. Nonetheless, any amount of money on which you do not have to pay employment tax, will reduce your taxes. Here’s an oversimplified example:

You’ve taxable income is $150,000 as an individual and you’re married. As a sole-proprietorship, you pay $39,528 in federal income tax plus $17,901 self-employment tax for a whopping $57,435. You keep $92,565.

If you were operating as an S corporation, let’s assume you pay yourself as a wage $75,000 and receive $75,000 in distributions. First, you’d pay self-employment tax on your wages of $75,000, which is $11,475. Reducing your distribution by that amount leaves you with $69,262 (75k for tax purposes) in compensation in your pocket and $69,262 available for distribution. Your income tax will be $35,928 plus 36% over 140,000. The product being $1,534 plus $35,928, totaling $37,426 in taxes. From $150,000 less self-employment taxes paid, take home $101,099 versus $92,565 as a sole proprietorship. A savings of $8,534 in taxes.

One caveat to keep in mind is that an S corporation generally cannot deduct health insurance and term life premiums while a C corporation can deduct up to $50,000 per employee. If you really wanted to make these amounts deductible, you could actually setup two separate entities and get the best of both worlds, primarily using a management contact.

S corporations also cannot make distributions unevenly, this is known as the “single class of stock” rule and have restrictions on ownership, unlike C corporations.

Partnerships

LLCs, with two or more members, who do not elect to be taxed as a corporation, will be taxed as a partnership. Partnerships, like S corporations, are a pass through tax entity. Meaning, the income is passed directly from the partnership to its Partners. Partnerships do not pay separate income taxes like C corporations. Partners of a partnership are not employees and should not receive a salary. There is a rich, legal history in understanding the employment status of partners in partnerships. Here is a detailed history. Otherwise, understand that a partner will pay self-employment tax on all of his income that flows from the partnership. A partnership can make “guaranteed payments,” which look like a salary to the partner. But, the partner will still need to pay self-employment tax on this income. There are several reasons to avoid the self-employment tax, but there are several reasons why you might choose to be taxed as a partnership.

Partnerships offer the most flexibility with a pass-through tax entity. A partnership will undoubtedly need a partnership agreement, or in the case of an LLC, an operating agreement. Both are contracts that govern the relationship between the entity and its members (LLC) or partners. With a partnership you can get creative in how cash will be distributed, who will be allocated income and losses, foreign or domestic, how debts are repaid, etc. For this reason, when there are multiple members who are not even partners, they often choose to be taxed as a partnership. But, to the extent that your entity doesn’t need a complicated structure of distributions or allocations, it is usually advisable not to be taxed as a partnership.

 A Note on Liability

As a general rule, LLC members are not liable for the debts of the LLC. But, in Florida, in accordance with the Olmstead case, the single member or a single member LLC, may become liable for the debts of the LLC, after the creditor secures a charging order. This is not the case for a multi-member LLC. If you are considering a single member LLC, you may consider a Florida Corporation with an S Corporation election, because you will get the limited liability you are searching for and the benefits of pass through taxation.

Need more help?
If you have more questions or need help establishing your entity please call our offices at (813) 999-0199, www.WalkLawFirm.com.

Frank Lago is an attorney at the Walk Law Firm, PA. HE is a graduate of Stetson University School of Law and holds an LLM in Taxation from Georegetown University.