Strictly Business

One of the benefits to using a limited liability company is the flexibility of being able to choose how the entity is taxed.  After a new LLC is formed, its owners must decide the method by which they would like their business taxed.  By default, an LLC is treated as a pass-through entity, which means that it does not pay federal taxes directly, but its income or loss is allocated to the owners, who then pay taxes on that income.  If the LLC has only one member, it files no tax return and all transactions of the LLC are treated as transactions of the owner for tax purposes.  If the LLC has more than one member, the LLC files a partnership tax return, which reports the LLC’s income and how that income is to be allocated to each owner.  Partnership style taxation is governed by Subchapter K of the Internal Revenue Code.  However, the owner(s) of an LLC, whether the LLC has a single member or multiple members, may choose to have their LLC taxed as a corporation.  In this case, the LLC can be taxed as a so-called “C Corporation,” which is governed under Subchapter C of the Internal Revenue Code, or an “S Corporation,” which is governed by Subchapter S.  This ability of LLC owners to elect the company’s means of taxation is called the “check the box” regulations. Below are summaries of the four methods of taxation of an LLC:

• Disregarded Entity – This is the default rule for any LLC that has only one member.  A single member LLC is treated as though it does not exist for tax purposes and thus the owner is treated as if he were running a sole proprietorship.  All transactions — income and expenses — are included on the owner’s tax return.  Therefore, no separate tax return need be filed for the LLC.
• Subchapter K (aka partnership taxation) – This is the most flexible form of taxation for a multi-member LLC.  All income and losses of the LLC are allocated to the owners, who pay taxes on that income regardless of the amount of cash they received from the company.  A distribution of cash to owners is itself a tax-free event.  The owners of the LLC can be compensated for service to the company (called “guaranteed payments”) in which case the payments are treated as an expense to the partnership and income to the owner.  Subchapter K is quite flexible, and allows the owners to allocate the income between themselves in a variety of ways, sometimes in quite complex formulas (subject to certain limited restrictions in the Internal Revenue Code).  One downside to using a partnership taxation structure is that the income of the partners is generally subject to the self-employment tax.
• Subchapter C – If an LLC elects to be taxed under Subchapter C, it is treated for tax purposes, as if it were a corporation.  The company must file a corporate tax return (regardless of whether there is one member or multiple members) and the LLC itself pays taxes.  Any income that is paid to owners in the form of dividends is also taxable income to the owner (so-called “double taxation”), though the dividends are taxed to the owner at the capital gains rate.  Because of this, many C Corporation owners pay themselves a salary or bonus.  Such income is deductible to the corporation, though the compensation must be “reasonable.”  If the IRS were to deem the salaries paid to an owner as higher than what would be reasonable if the owner were just an ordinary employee, it could reclassify part of the salary as a constructive dividend, subjecting the company to additional taxes and potential penalties.
• Subchapter S – If an LLC elects to be taxed under Subchapter S, it is treated for tax purposes, as if it were a corporation that had elected to be treated as an S Corporation.  In this form, the company will still file a corporate tax return but does not itself pay taxes.  Instead, each owner is allocated a portion of profits or losses based on the percentage interest that they each own.  As in a partnership, the owners must then pay the taxes themselves, regardless of whether any cash has been distributed to them.  Any cash payments to owners (called distributions or dividends) are tax-free.  Active owners are considered employees of the company and can also be paid for their services to the company in the form of a salary or other payments, in which case, the payment will be deductible to the company and will be taxable wage income to the owner.  The benefit of taxing an LLC as an S Corporation is that income that is not paid out as a salary is not subject to self-employment taxes.  However, the IRS can scrutinize the salaries paid to owners and if it deems that the owners have been underpaid, it may reclassify some of the LLC’s income as wages, subjecting the LLC and the owners to additional payroll taxes and potential penalties.  Another disadvantage to using Subchapter S is that the designation is very “fragile.” There are a number of requirements the company must adhere to (such as having only one class of stock and no more than 100 owners).  If the company fails to adhere to these requirements, it will automatically be converted to a C-Corp and face double taxation.  The single class of stock requirement is especially easy to violate inadvertently.  If the LLC gives any owners preferred distributions or distributes distributions in any way except through a straight pro rata method, it could be deemed as having more than one class of stock.  In addition, many of the default provisions in LLC statutes violate the single class of stock requirement, which means that the operating agreement of an LLC taxed under Subchapter S must be carefully written to override the default provisions.

As you can see, there are many factors to consider in choosing how to have an LLC taxed.  Your final choice should be based on your own specific situation.  Therefore, before making any decisions on your form of business, you should speak with your attorney or accountant.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

One situation I often encounter with small businesses is that sometimes they don’t always document the transactions they enter into with their owners and other related parties.  For instance, let’s say that two owners of a corporation decide that their corporation needs more funding.  However, they don’t want to invest more equity into the business.  They are willing to extend a loan to their company and expect to get paid back over the next few years with interest.  Here’s how that should work (assuming this company is a C Corporation):

The corporation would make payments of principal and interest back to the shareholders.  The corporation would be able to deduct the interest as an expense.  The owners would not need to pay taxes on the principal but would pay taxes on the interest.  There are no double taxation issues because the interest expense is deducible to the corporation.

Unfortunately, small business owners often don’t take the time to properly document transactions like this.  They may enter it into their accounting books, but the don’t prepare any loan documents, nor do they prepare any board resolution authorizing the company to enter into the loan.  After all, from the owners’ perspective, this is a loan to “themselves” and it seems like a waste of time and money to have official documents prepared.  This can cause a couple of problems down the road.

First, if the IRS audits the company, they will ask to see the loan documents and resolutions authorizing the transaction.  When the owners can’t produce them, the IRS can (and often does) recharacterize the transaction as a dividend.  As a consequence, the loan interest is no longer deductible.  Therefore the owners will pay double taxation on the interest.  In addition, depending on the capital structure, the principal payments could also be deemed a taxable distribution, thus causing the owners to pay income taxes on the return of principal (which never would have happened had the transaction been properly documented as a loan).

Another area where this can cause problems is when the owners decide to sell their business or sell an interest in it to outsiders.  Failing to properly document earlier transactions can cause problems in due diligence, which any sophisticated purchaser or investor would perform on a business he intends to acquire.  The process of cleaning the mess up could be expensive (far more expensive than simply having documents prepared from the outset.)

A loan is just one example of the type of transaction that should be documented even when made between related parties.  Another example is leases.  Many business owners lease their own property to their business.  But if they don’t prepare a written lease, the rent payments could be recharacterized as dividends or distributions.  Here’s a couple of other examples:  employment agreements, service agreements, purchases and sales of assets, and sale-leaseback transactions. All of these transactions between a business and its owners should have some level of legal documentation.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Representative David Schweikert (R-AZ) recently introduced a bill called the “Private Company Flexibility and Growth Act,” which promises to allow private companies to remain private for a longer period of time.  Currently, if on the last day of a company’s fiscal year, any class of securities of the company is held of record by 500 or more shareholders and the company has total assets of more than $10 million, then it must register under the Securities Exchange Act of 1934.  This brings upon it a multitude of responsibilities and obligations including filing annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and meeting proxy regulation requirements.  With these added obligations, most companies will simply choose to go public (i.e. engage in an IPO), since they might as well gain the advantages of the public markets given that they will now be dealing with all of the compliance expenses that come along with them.  An example of a company that is likely dealing with this issue now is Facebook.  It has been widely reported that it is either past the 500 shareholder limit or soon will be, since its shares are held by many employees, some of which may have sold their shares to other parties.  Many people believe that Facebook has no desire to go public, but will likely be forced to do so early next year.  Is that fair?

Certainly Rep. Schweikert doesn’t think so.  His bill would make a couple of changes.  First, it would increase the shareholder limit to 999 from the existing 499.  Second, accredited investors and persons who received shares pursuant to an employee compensation plan would no longer count towards the limit.  The second change is the far more important one, since it will allow private companies to grow to almost a limitless size without ever being required to go public.  A vast majority of the shares of private companies are issued in one of two ways: (1) private offerings made only to accredited investors and (2) shares issued to employees as compensation.[1]  Since the two largest categories of shareholders in a private company would no longer be counted towards the limit, this bill would effectively do away with the requirement of companies to go public as they expand.

Since I also write a lot on private investment funds, I would also point out that this bill would be of significant benefit to some of the larger hedge funds and private equity funds.  Large private funds tend to be so-called “(3)(c)(7)” funds.  3(c)(7) funds are offered only to qualified purchasers, which general speaking are individual investors with investment assets over $5 million or companies with investment assets over $25 million.  Because of the Exchange Act’s 499 investor limit, these funds cannot have more than 499 investors under current law.  If this bill were passed, there would be no limit to the amount of investors that a 3(c)(7) fund could have, since any qualified purchaser would easily qualify as an accredited investor.  Many people often incorrectly believe that the 3(c)(7) exception itself contains the 499 investor limitation. It does not; the limitation is in the Exchange Act.  Thus this bill would allow the largest private hedge funds, private equity funds, and venture capital funds to get even larger.

I agree with the overall premise of this bill.  I do think that companies should have more control over when and if they go public.  I also think that the bill is unlikely to pass in its current form for a couple of reasons.  First, regulators are likely to lobby against it rather aggressively.  Since accredited investors and employee shareholders will no longer count towards the limit, the limit would be effectively eliminated.  For a lot of people in the securities regulation field, that would be a step too far, potentially undermining the investor protection policy goals of the Exchange Act.  Second, I’ve already pointed out that large hedge funds will be unintended significant beneficiaries of the bill, and it will be too easy to paint this bill as something favored by “Wall Street.” (And we would never want to do anything like that!)

That said, this bill is part of a conversation that is has begun over the last year.  Even Mary Shapiro, chair of the SEC has written about the possibility of loosening the 499 investor limit on private companies.  I think that if some of the concerns mentioned above are addressed, the introduction of this bill moves us closer to the possibility of reforming the Exchange Act’s limits on private companies.

Footnotes

[1] Some may point to Rule 12h-1(f), which exempts employee stock option holders from the 499 investor limit, if certain conditions are met.  But this rule does not exempt actual employee stock holders from counting towards the limit, so the exemption on employee shareholders in this bill is a significant loosening of restrictions.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.