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.

The American Jobs Act, recently proposed by President Obama, contains a provision closing the co-called “carried interest tax loophole” that benefits many investment fund managers.  Just about all hedge funds, real estate investment partnerships, private equity funds, and venture capital funds in the U.S. are structured as partnerships for tax purposes.  The incentive fee that the manager is paid (usually 20% of all net gains of the partnership) isn’t actually a fee at all.  Rather, when the partnership is formed, it is structured so that the manager (or an affiliate of the manager) owns a 20% interest in all profits generated by the fund.  The benefit to the manager in structuring the incentive fee this way is that all favorable tax treatment that the fund may receive for certain types of income are preserved for the fund manager.  For instance, if the fund earns a gain on the sale of assets that it owned for over one year or if the fund receives qualified dividends from stock, those gains and dividends are taxed at the lower capital gains rate (15%) rather than being treated as ordinary income.  In addition, the manager of the fund does not pay social security or Medicare taxes on the portion of the fund’s profits allocated to the manager, as he would if he were earning it as wages or were otherwise self-employed.  As a result, the fund manager only pays federal income taxes at a rate of 15% on a large portion of his income, and also pays no social security and Medicare taxes on any of the incentive fee earned by him. [1]  If the law were changed, fund manager incentive allocations would be taxed as ordinary income and would also be subject to the self-employment tax (ordinarily 15.3%) to pay both the employee and employer portions of social security and Medicare taxes on such income.

Arguments can go back and forth whether the current tax treatment of investment partnership incentive allocations is (a) a good idea or (b) fair.  Proponents of changing the law say that it is unfair that investment fund managers should pay a lower level of taxation than people in other professions, especially considering that this income is essentially a fee in substance, if not form.  Opponents counter that fund managers take a huge risk in taking much of their fees in this manner, because (a) it is contingent upon the fund making a profit and thus the fee may never materialize and (b) is often (but not always) deferred for a number of years until gains can be realized.  Because of these unique features, they argue that this favorable tax treatment is fair and reasonable.

Regardless of who you may think is right, luckily for fund managers, the legislation is unlikely to pass in the near term.  Given the gridlock in Washington, and the fact that the Republican-controlled House of Representatives would never approve such a provision, fund managers are currently safe.  However, in the long term, the outlook is far more uncertain.   With tax reform on the horizon, fund managers and their representation in Washington will need to be vigilant.  A change like this to the tax code is likely to be popular with voters and since the people who who would be negatively impacted by it are few, it could be an easy concession for Republicans to make in their quest to lower overall tax rates.  As always, stay tuned.

Footnotes

[1] However, the Health Care and Education Reconciliation Act of 2010, among other provisions, enacted a new additional tax, referred to as the “unearned income Medicare contribution,” on net investment income, like the partnership allocations of income and gain from investment funds at a rate of 3.8% which will, if no additional changes in law are enacted, take effect January 1, 2013.  The tax only affects individual taxpayers with a modified gross income over $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for single taxpayers.

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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.

Business owners will often say that they hired someone as a “1099 employee.”   What they actually mean is that the business came to an arrangement with a worker that deems him to be an independent contractor, and as a result, it doesn’t have to follow any of the laws involved in hiring an employee.  This includes not having to withhold any amounts for taxes, not having to pay the employer’s portion of social security and Medicare taxes, and not having to pay any premiums for workers compensation or unemployment insurance.  It becomes the worker’s responsibility to pay the employer’s portion of social security and Medicare taxes through the self employment tax. The worker must also perform their own withholding through quarterly payments to the IRS.  From the employer’s perspective, this seems to be a great arrangement.  They avoid administrative and tax expenses.  The only problem is that it is often illegal.

There is no such thing as a “1099 employee.”  The “1099″ part of the name refers to the fact that independent contractors receive a form 1099 at the end of the year, which reports to the IRS how much money was paid to the contractor. In contrast, employees receive a W-2. Service providers are either employees or independent contractors; they cannot be both.  Often a company may choose to designate certain service providers to be independent contractors instead of employees, but this is not always up to the parties to decide.  In many situations, workers who are deemed to be independent contractors by agreement between the company and the worker are still considered to be employees by law.  When that happens, the IRS, the department of labor, and state agencies, will reclassify the worker to be an employee and treat the employer as if it simply violated its legal obligations in how it handled that employee.  As a result, the consequences for misclassifying a worker can be quite severe.

How do you correctly decide whether a worker can be considered an independent contractor and when they must be considered an employee?  The IRS has published guidelines on making this determination based on three sets of factors: behavioral control factors, financial control factors, and relationship control factors. [1]  Examples of each are:

Behavioral Control Factors

• Does the worker decide their own schedule and location of work?
• Is the company providing training to the worker?
• Does the worker have their own employees?
• Does the worker decide the order and sequence of services?
• Does the worker decide what kind of reporting is provided to the company?

Financial Control Factors

• Will the worker submit invoices?
• Will the worker pay their own business and travel expenses?
• Does the worker furnish his own tools and materials
• Does the worker have his own business?
• Does the worker advertise their services?
• Will the worker recognize profit or loss based on good or bad decisions?

Relationship Factors

• Is the worker is retained for a specific project or are they involved in ongoing operations?
• Does the worker have other clients?
• Will the worker maintain independent activities?
• Does the worker maintain his own insurance?
• Is there a signed contract between the worker and the company specifying that they have an independent contractor relationship?
• Does the worker receive benefits?
• Is the relationship temporary or open-ended?
• Are the services provided a key aspect of the regular business of the company?

The final determination is made by weighing whether the factors favor classifying the worker as an independent contractor or as an employee.  If the weight of the factors indicate that the worker should be classified as an employee, then the worker must be so classified, regardless of any agreement between the employer and the worker.  Misclassifying a person who should be an employee as an independent contractor can have significant consequences.  The IRS can and often does take action against employers who misclassify employees, including requiring the employer to pay all taxes that should have been withheld plus an additional penalty.  In addition, the state government may seek worker’s compensation insurance and unemployment insurance premiums that should have been paid.  Finally, the worker himself may file suit, seeking back pay for overtime, payroll tax contributions, and employee benefits.

Misclassifying employees as independent contractors can be an expensive mistake for a business.  Therefore, you should consult an attorney or accountant to ensure that your employment relationships are in compliance with the law.

Footnotes

[1] The IRS previously used a 20-factor test to make this determination.  This 20-factor test has since been replaced with the one described in this post.

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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.

In any business with multiple owners, there is a good chance that at some point, one or more of those owners may no longer be affiliated with the company, whether by choice, death, bankruptcy, or divorce.  It’s important for business owners to plan for this in advance, so that when one of these situations occur, there is a preexisting agreement that sets out an orderly way to handle the situation.  The best way to do this is with a buy-sell agreement.  A buy-sell agreement is a contract between business owners that dictates who can buy a departing owner’s share of the business and establishes a fair price for the owner’s stake. The agreement may also provide procedures to resolve disagreements when a majority of the owners but not all of the owners decide to sell the business.  Here are some reasons why you, as an entrepreneur, don’t want to be in business with other people (even family) without a buy-sell agreement in place:

1. You should be able to choose your partners.  When you made the decision to enter into business with your partners, hopefully you thought extensively about it and did some due diligence on them.  It would be unfortunate to have that diligence and thought go to waste, because if you don’t have a buy-sell agreement in place, your partner’s stake in the business can be transferred to third-parties for a variety of reasons: your partner decides to sell, goes bankrupt and is forced to sell, dies, or gets divorced and his spouse ends up with some or all of his shares.  In this event, you will have new partners that you never counted on having, and this may threaten your business’s ability to continue on its current path.

2. If your partner decides he no longer wants to be involved in the business, you have a way of obtaining his stake in the company so that he can’t continue to influence the business after he is no longer involved.  Buy-sell agreements often provide that if an owner-employee were to become no longer employed by the company, that owner-employee must sell his stake back to the company or the other owners.  Also, since buy-sell agreements provide a mechanism for determining a fair price in the departing partner’s stake, he will be unable to extort an unreasonably high sum on his way out.

3. If you want to leave the business and no longer want to own stock in the company, you have a way of fixing the fair price in your stake.  Again, since a buy-sell agreement sets out a method of determining the fair price of the stake of the departing owner, you can eliminate potential lawsuits and disputes by agreeing in advance what is fair.  This can be of benefit to you if you are the one leaving the company.  Be careful though; if the valuation method is not well thought out, you could end up being unable to get a fair price on your stake in the company on your way out.

4. It could reduce your estate tax burden.  The valuation method contained in a buy-sell agreement is set not only for purposes of an eventual sale, but also for estate tax valuation purposes. Privately owned businesses are difficult to value. An owner’s idea of a business’s worth at his death may be much lower than the IRS’s. However, if you have a buy-sell agreement in place, as long as such agreement is a bona fide arms length transaction, you can use the method contained in that agreement as evidence as to how the business should be valued. But if no process for valuing the business has been put into place, the IRS will be free to determine its own value.

5. It lets the partners set expectations as to the transferability of interests in the company.  Even when a partner does not want to leave the company, he still may want to sell part of his stake in the company to partially “cash out” for any number of reasons.  Putting in place a buy-sell agreement can give the remaining partners a right of first refusal or other protections to give them more control over ownership changes in the company.  In the least, the mere process of writing a buy-sell agreement is beneficial because it gives the partners a chance to discuss and decide these issues at a time when there is often a surplus of good will.

6. It can prevent minority shareholders from vetoing a sale of the business.  If a buy-sell agreement contains a drag along clause, then a majority of owners can force the entire business to be sold.  Without this, it is possible that even a 1% owner could hold up an entire deal, possibly to extort the other owners for a greater portion of the sales proceeds.

7. It can protect minority shareholders from being cheated out of the proceeds of a sale of the business.  Along with point 6 above, if a buy-sell agreement contains a tag along clause, then upon the sale of the business, the minority owners will be entitled to the same price per share as the majority owners.  This prevents majority shareholders from conspiring with a buyer of the business and extracting a control premium from the buyer to the detriment of the minority shareholders.

8. The time when someone leaves a company is not the time to be negotiating the fair value of a business. Often partings are awkward and sometimes downright unpleasant.  Emotions may run high, precluding a careful and thoughtful discussion of how to resolve disagreements. Instead, you should set the mechanism for calculating the value while spirits are high.

9. It can protect your family. One of the most likely reasons why you may need to leave your company or transfer your stake is upon your death or disability. At this point, you will not be capable of negotiating on behalf of your family.  Your family will need and deserves to be paid the fair value for your interest.  If there is no buy-sell agreement in place, the surviving owners may be reluctant to pay a fair amount for your stake and are likely to at least negotiate against your family members.  A buy-sell agreement provides a pre-agreed method of making sure the work you put into your business takes care of the people you care about most.

Buy-sell agreements are a crucial part of business planning for any venture which is owned by multiple parties.  They can be used for corporations, limited liability companies, and partnerships.  Drafting one should not be put off, because if you don’t put one in place at the outset, you are unlikely to do so until issues arise.  You should consult an attorney with experience in business and corporate matters for more information.

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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 of the first decisions a small business owner faces is choosing the right form of entity for his or her company.  The most popular form of business in recent years is the limited liability company (LLC), because it is simple to organize and manage and can be taxed as a partnership (i.e. without the “double taxation” associated with C-Corporations).  However, there are many reasons why you should avoid structuring your new business as an LLC taxed as a partnership and instead use a C-Corp structure.  Here are some of them:

1. Venture capital funds will usually only invest in a C-Corp.  Many VCs are funded by pension funds and the Internal Revenue Code makes it difficult for pension funds to invest (even indirectly) into an entity taxed as a partnership (as LLCs by default are) if that entity carries on an active business. Therefore, if your goal is to eventually attract venture capital or private equity money, using a C-Corp structure is essential.

2. With a C-Corp, you will receive a W-2 instead of a K-1.  If your company is an LLC taxed as a partnership, as an owner of the company, you will not be permitted to also be an employee.  Therefore at the end of the tax year, you will receive a K-1 instead of a W-2.  If you want to finance anything (like a house or a car), banks prefer to see a W-2.  It’s just what they are used to seeing.  But if you use a C-Corp, you will also be permitted to be an employee of your company and can take your compensation as wages, and will thus have proof of your income in the form of a pay stub and a W-2.

3. With a C-Corp, you will be able to get your personal taxes done quickly.  If you are in a partnership, you must wait until you receive a K-1 from your company before you can file your own taxes, and the K-1 can only be completed once your company’s partnership tax return has been completed (which depending on the complexity of your company, may take some time).  In contrast, if you are an employee of your own company, all you will need is your W-2 to do your taxes (and a 1099-DIV if you get any dividends, but see item 7 below on why in most cases you shouldn’t be receiving dividends).  W-2s and 1099-DIVs are based solely on the cash your company pays to you, so they can be completed far in advance of your company’s tax return.

4. With a C-Corp, all your employee benefits are deductible.  Owners of partnerships and S-Corporations are limited in the amount they can deduct for certain benefits like medical, life insurance, education, childcare, and retirement plans.  Owners of C-Corps have no such limitation.

5.  C-Corps have their own progressive tax brackets.  This means that you can split your income between your company and yourself by choosing how much you pay yourself in compensation. Since the income will be split between two entities, each will be better positioned to avoid the higher tax brackets.

6. You don’t have to forego the simplified management structure of an LLC.  If you really want a simple LLC-type management structure, form an LLC, then file Form 8832 with the IRS and elect to have your LLC taxed as a C-Corp.  You will get the best of both worlds.

7. Double Taxation isn’t really the big problem that it seems.  For C-Corps, if you are an active owner in your business, then you are both an owner and an employee.  The compensation you receive can be treated as wages rather than a dividend, in which case, it is only taxed once.  Done right, you can avoid double taxation completely.  Please note however, this strategy would not work with a capital-intensive company that invests in acquiring significant assets like real estate or machinery.  If a large part of your company’s income is derived from its assets, then your company’s income may exceed what you would reasonably expect to make as an employee.  If this happens, the IRS may try to re-characterize part of your wage income as a dividend.  On the other hand, the C-Corp structure is great for companies whose entire income is derived from the efforts of their employees (like consulting firms and law firms) because it would be difficult for the IRS to challenge paying out all of the income to employees since they are responsible for generating it.

As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final 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.