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.

Sweat Equity v. Money Investors: Who Makes the Rules? [The Golden Rule of Business]

Many years ago, while working as the General Counsel to a large public company going through a Chapter 11 Bankruptcy, I learned that the Golden Rule as we all learned it in kindergarten [do unto others as you would have other do unto you] is not the only Golden Rule when it comes to business. I certainly support and believe in the Golden Rule we learned in kindergarten and try my best to adhere to it, but when it comes to money and business, I have learned that the Golden Rule really is: the person with the gold makes the rules.

In business large and small, there is often reward and equity for those who have a great idea or are the work horses driving success (the “Sweat Equity Owner”). Typically, however, the greatest percentage of equity and, hence, the greatest return in pure dollars, goes to the person who put up the money in the first place (the “Cash Equity Owner”). Once the business gets going, this often leads to resentment of the Sweat Equity Owner and frustration of the Cash Equity Owner.

Not surprisingly, the Sweat Equity Owner often feels like he has worked harder and should be compensated for the hard work and ideas. In addition, the family of the Sweat Equity Owner has started to feel the pain of long hours and missed meals and events, resenting the Cash Equity Owner whose life and lifestyle has not changed at all.

The Cash Equity Owner is frustrated because the project is taking longer than expected to show a return and the Sweat Equity Owner continues to ask for cash, primarily to meet living expenses in the form of  salaries for business personnel. The Cash Equity Owner usually has other investments or businesses and more business experience and wants the Sweat Equity Owner to work differently and take his advice on how to get the work done more quickly so that product can get to market faster. His family (or fund investors) wants to know when they will see a return on investment.

Not to sound like a broken record on the reasons for Business Divorce, but there are some things that can be done at the onset of a relationship to avoid these dilemmas. Too often, when the relationship is formed, there is no substantive discussion of duties, timing for deliverables and exit strategy for the Cash Equity Owner. The conversations are very high level and never transcribed into a detailed agreement. One party calls cash loans while the other considers it equity.

In the last 12 months, I have encountered among other missteps: companies in which the equity was never issued despite cash being infused; standard Bylaws from companies like Legal Zoom were used, but no one ever read or understood what they meant; Articles were filed on www.Sunbiz.org indicating the names of managers, managing members, officers, owners … who were not in fact in the positions indicated and who had no authority to act on behalf of the business; domain names and other intellectual property placed in the name of one owner instead of the business …. This list is hardly exhaustive, but all have led to expensive legal battles between business partners on break-up.

When I get the call, whether as an attorney or mediator, that business partners are seeking to terminate their business relationship, the first step in my analysis is to look at the agreements between the partners.  These documents become the guide on how to proceed. If they have been carefully crafted and reflect the partners intent, often the cost to the business as well as the individuals for navigating the business divorce is emotionally and financially insignificant —- Owners typically know what to expect and time is spent implementing already agreed plans. Without these written agreements or mutual acknowledgment of intent of unwritten agreements by the Owners, the cost in the first days of efforts to separate can be thousands, and at times, tens of thousands, of dollars.

At this point you are probably thinking that I am exaggerating, but in fact, if a lawsuit needs to be filed  in order to keep the business running and make it clear who has authority to act, the effort is significant and lawyer time and cost is high. We start by preparing a complaint seeking injunctive relief and serve it with requests for admissions, production of documents and interrogatories. At times, we demand a receiver be appointed if we are representing the Cash Equity Owner and our client is not ready or able to step in and run the business. We seek emergency hearings to ensure if our client in good faith believes irreparable harm to, or waste of, business assets will occur if action is not immediate.  We often need to include third parties such as the domain hosts or banks to require them to turn over account codes and keys or to freeze assets.

Courts do not like to get involved in daily business activities and if the situation  lacks clarity, the court may appoint a receiver on its own. Domains and intellectual property will need to be be place in escrow; bank accounts will need to be frozen or unfrozen; payroll companies, customers, vendors, employees will all need to be notified as to who has authority to direct activities just to keep the business operating  and attorneys will be stepping into conversations with domain hosts, bankers, customers, vendors and employees…. all while on the clock. By the way, the Receiver will hire an attorney as well and both the receiver and attorney will also be on the clock.

Back to the Golden Rule — needless to say, the Cash Equity Owner often has the gold necessary to stay afloat while the Sweat Equity Owner does not.

Although good friends and family members make great investors because they are trustworthy, life changes and needs change over time. By having a frank conversation up-front and documenting the deal, before money is invested, much of the financial and emotional cost can be minimized on business divorce and friendships and family relations can remain favorably intact. Like a good pre-nuptial, shareholder agreements, operating agreements, and buy-sell agreements, can minimize cost in the future and avoid undue emotional harm. To me, it is well worth spending a couple hours in frank discussion and a couple thousand dollars up-front when investing in a business to avoid a later fight at ten times that expense.

At the Walk Law Firm, we regularly advise clients on these matters and encourage open discussion between owners. We can work as company counsel or as counsel to a business owner in helping businesses sort through these issues.

Five Questions to Ask When Hiring a Lawyer for Your Business

As a General Counsel, I spent a significant amount of time researching and interviewing attorneys and other professionals to represent my company’s interest in litigation and business negotiations. The selection of counsel is a significant investment for a business and is more than a cost. As a matter of fact, selecting the wrong counsel or failing to engage counsel may be the most costly decision a business may ever make.

Business lawyers are not a dime a dozen and all lawyers are not created equally. Experience in business and with specific transactions helps clients set strategy and successfully navigate the most difficult transactions from financing arrangements to large acquisitions of property and negotiations with key employees and contractors. Often, business lawyers are sounding boards to business owners contemplating  confidential business transactions.

With the advent of the internet, it is easy to find lawyers and there are plenty of bidding sites like Elance.com and Guru.com where you can get a flat fee or a cheap quote. As tempting as it is to hire the cheapest lawyer, I strongly suggest that business owners take the time to find the best lawyer for the situation, avoiding what might be a costly mistake. So here are 5* questions I always ask when I engage counsel for business matters:

1. Who at the law firm will handle my work?

  • If it is a team, who will be on the team?
  • Who will be the lead and my contact?
  • How was the team selected?

2. What is [each working attorney’s ] experience in handling matters like the one that I have described?

  • Has this attorney ever handled this type of matter before?
  • Has the lead attorney ever been the lead in a matter like this before?

3. What is the attorney’s and firm’s workload and ability to handle the work in my time-frame?

  • Any time off or vacations planned?
  • Is the lead attorney accessible?
  • How will communications work? Email or Telephone? In Person Meetings?
  • How often should I expect to receive a status report?

4. What does the attorney anticipate the process to be?

  • What outcomes might I expect or should I consider?
  • What are the issues are concerning?
  • Make sure you understand the terms the lawyer uses and do not be afraid to stop a lawyer and ask what something means!

5. Billing and Fees:

  • How does the firm/attorney charge?
  • Can the firm provide a detailed invoice no less often than monthly for my review?
  • How can the firm and I positively or negatively impact fees?

As you can see, fees and costs are last, but not forgotten. It is important to understand that an inexperienced attorney can consume excessive time researching a matter just like a disorganized client can consume excessive amounts of attorney time just to get information gathered — both situations can significantly increase legal cost.

I have found that for some matters, an hour of a very experienced, albeit pricey, lawyer’s time is often more valuable than ten hours of the time of an attorney who is a newcomer to the topic. When I expect the transaction or litigation to have big rewards or expose my company to significant risk, I choose experience over hourly rate every time.

*By way of disclaimer, I usually ask more than 5 questions, I always do plenty of research,  and I also ask business friends and other professionals I trust for referrals to appropriate business lawyers. My five questions are in addition to references and research.

 

 

Business Identity Theft: What is it? And how do I protect my business assets?

What is it?

Business identity theft is the fraudulent and unauthorized use of an entity’s identity.  It’s not just an information security breach. Rather, like consumer identity theft, business identity thieves impersonate the business or hijack the business’s identity in order to steal money or property, often by establishing lines of credit with banks and/or retailers. A corporate identity is an asset that needs protection!

Who is targeted?

The potential for more lucrative results has spawned an evolution of identity theft.  Rather than targeting a consumer, identity thieves are targeting unsuspecting businesses because businesses tend to have larger bank account balances, higher credit limits, and larger purchases made on behalf of a corporate entity generally don’t set off bells and whistles.  Small businesses are particularly vulnerable because they don’t have resources to constantly monitor accounts and records, and because they don’t have the structured security that large businesses have.

What is the result?

Generally, the damage that results from business identity theft is more severe than the results from consumer identity theft.  In consumer identity theft, the consequences tend to reach only the consumer targeted.  In business identity theft, the consequences affect the targeted business, but also the business’s employees and subcontractors, the business’s creditors, and the economy at large.

You might struggle obtaining a line of credit, which could impact operations. The cost of repairing or cleaning up the aftermath of a business identity theft can be costly with legal and accounting fees.

The terrible irony is that few businesses and business owners think about identity theft prevention as asset protection. But it actually is the most important asset protection plan a business can have.

How to prevent it?

At the Walk Law Firm, as Tampa small business attorneys, we advise our clients to take the same actions that public companies take:

  1. Protect your business information records – treat your EIN and Tax ID numbers like they are your social security number and limit access to all corporate records
  2. Monitor your corporate filings – many secretaries of state, including Florida, have email alert systems that notify you of any and all activity – enrolling in this service can provide early fraud detection
  3. Segregate Duties – accountants and auditors will tell you that no employee should be given access to all banking information as well as typical bank logins and passwords; segregate the duties relating to account access from those handling payroll and accounts payable
  4. Monitor your accounts and bills – frequent monitoring and reporting of suspicious transactions will limit your liability significantly
  5. Monitor the business’s credit report – routinely obtain a business credit report and review it for suspicious activity
  6. Train your employees to protect business information and to be aware of these crimes
  7. Be wary of phishing scams
  8. Install and utilize a firewall on your business computer and network
  9. Contact your creditors to ask about unusual activity

 

The Benefits of Year-End Corporate Record Keeping

With the end of 2012 fast approaching, it is an excellent time to review your record-keeping practices and make sure your records are updated.  As a small-business owner, you invest a significant amount of time and money to ensure your company’s progress and success, and taking the time now to update your records can help in a number of ways.

How to go about updating records?

Regardless of the form of entity, the manner or process for updating your records is fairly simple and straightforward.  First, it is important to review the entity’s governance documents – yes, the documentation you received and may not have read or reviewed since the time you organized your company – because this documentation will advise you as to how to proceed with corporate changes and updates.  So, if you have a corporation, this will be your articles of incorporation and your bylaws; if you have an LLC, this will be your articles of organization and your operating pr management agreement; and if you have a partnership, this will be your partnership agreement. You may have a shareholders’ or close corporation agreement, too.

Even if you have already implemented transactions, changes and updates in and to the business, it is important to ratify those actions by the manner or process defined in the governance documents.  Why?  In order to record the changes or updates and to evidence the fact that such modifications were authorized by the entity.   Failure to ratify and substantiate a change to the business can create issues like stalled or failed business transactions in the future or undue questions from the IRS or State when they audit. It is much easier to make these recordings contemporaneously with the actions so that later partners and outsiders do not question that authority. Also  as some of our clients will attest, the cost of recreating the history of the company years down the road so that you can sell or move or enter into a significant transaction is costly and time consuming.

Subject to the language in your governance documentation, many updates and changes can be authorized in writing.  Other updates may require a meeting – a board meeting, or a meeting between managers, members, or partners – and a vote.  In the event that you call a meeting, here are some things to keep in mind:

  • Be Prepared and Provide Sufficient Notice to Appropriate Parties
  • Make Sure You Have a Quorum or the Necessary Number of Voting Parties to Take Action and Know What Vote is Necessary to Approve the Actions Desired
  • Have an Agenda and Include Potential Ratification of Past Actions, and Other Potential Actions
  • Record Actions Taken at the Meeting and to whom Future Duties were Assigned
  • Get Feedback to Improve Meeting Process and Record-Keeping
  • Contact Outside Counsel in advance of the meeting if you have any questions and consider having counsel present if you anticipate a contentious issue or needing assistance documenting or explaining the situation

~ Rochelle Friedman Walk, Esq. and Matthew A. Welker, Esq., Walk Law Firm, PA