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Garrett Sutton, Esq Articles and Resources

The Q-Sub

By: Ted Sutton

What a Q-Sub is and How It Can Help Your Business

Diane has been obsessed with dogs from a very young age. She was very close with her childhood hound, and enjoyed spending time with other dogs she knew. After the hound’s passing, she vowed to make a career out of tending to our four-legged friends. She kept her word into adulthood. After graduating high school, she set up a dog store in town. Like a responsible business owner, she properly formed an LLC taxed as an S-Corp for the store.

After setting up shop, Diane soon discovered that there were very few dog grooming services in town. Given this business opportunity and her passion for dogs, Diane decided to capitalize. A few weeks later, she set up a dog grooming service in the dog store.

Over time, Diane began establishing a rapport with her clients. She noticed that many of them dropped off their dog for grooming before work and picked them up after the work day ended. What were the dogs to do after they had been groomed? Because the dogs spent all that time with her, Diane decided to provide a dog walking service.

Now Diane is in charge of three separate businesses operating under the same LLC. She has employees who work for all three and has separate obligations for each. Diane has a lot on her plate. She begins to worry about the direction of her businesses. What will she do with employee payroll? What if someone slips in the dog store? What happens if a dog bites someone while on a walk?

To address these fears, the IRS has a solution. Diane can set up Q-Subs for each of her businesses.

What are Q-Subs?

A Qualified Subchapter S Subsidiary (Q-Sub) is an S-Corp that is 100% owned by a parent S-Corp. Both the parent entity and the Q-Sub can be a corporation or an LLC. Parent S-Corps can own more than one Q-Sub, but they must make the election for each Q-Sub by filling out Form 8869 on the IRS website. This election must also be timely filed. If it is not, the Q-Sub will be taxed as a C-Corp.

Because the parent S-Corp files the tax return, the Q-Sub is not treated as a separate entity for tax purposes. However, Q-Subs are still responsible for a few things. Q-Subs must still obtain an EIN number from the IRS. Q-Subs are also separately responsible for some taxes, including employment taxes, some excise taxes, and certain other federal taxes. They should also follow all the corporate formalities (i.e. annual minutes) of a separate entity.

How they can help your business

There are a wide range of benefits that Q-Subs offer for business owners.

Q-Subs aid business owners when their S-Corp has more than one business activity. The S-Corp can limit its liability by separating its different business activities into different Q-Subs. Having this structure is certainly advantageous from an asset protection standpoint. Here, Diane only has one LLC set up for her dog store, dog grooming business, and dog walking business. Because Diane is concerned about liability, she sets up two separate Q-Subs for the dog grooming and dog walking businesses. In the event a dog bites someone on a walk, that person can only reach the assets inside the Q-Sub set up for the dog walking business. This business structure is diagrammed below:

qsub graph 1

Q-Subs come in handy when there are state and local transfer taxes that apply to sold property. In some states, transferring the property to a Q-Sub in exchange for 100% of the Q-Sub’s stock can avoid these types of transfer taxes. Let’s say that Diane lives in a state that allows these transfers without incurring tax. After setting up the Q-Sub for the dog grooming business, she wants to transfer title to the dog grooming tables into the new entity. If this transfer involves the dog store owning 100% of the dog grooming company’s stock, Diane will not have to pay any transfer taxes.

The IRS provides business owners with incentives when forming a Q-Sub. An S-Corp can deduct up to $5,000 in organizational costs the first year the Q-Sub is formed. After setting up the new dog grooming and dog walking businesses, Diane incurs $17,000 in such costs during the first year. Because the IRS offers these deductions, she can deduct $10,000 in organizational costs between the two new businesses, and deduct the remaining $7,000 in later years.

Businesses with two or more related entities use Q-Subs to minimize employee payroll taxes. When employees work for two related corporations, one corporation can set up a Q-Sub to employ the employee to avoid any double tax. Diane employs people who assist with the dog store, dog grooming, and dog walking. Instead of placing them on the payroll of all three entities, Diane sets up a third Q-Sub to employ everyone who helps with all three. This will prevent Diane from overpaying on payroll taxes. This business structure is diagrammed below:

qsub graph 2

Instead of filing separate tax returns for each entity, the parent S-Corp only needs to file one tax return for itself and its Q-Subs. At this point in time, Diane owns the dog store, dog grooming business, dog walking business, and a Q-Sub that employs everyone. With four entities, Diane thinks that tax season will be a nightmare. Fortunately, only the dog store will need to file a tax return on behalf of all four businesses. This certainly makes life easier for everyone during tax season.

Q-Sub elections are useful when S-Corps are bought and sold. If one S-Corp buys a second S-Corp, the first S-Corp could elect to treat the second as a Q-Sub.

Jack is a well-known figure and has the only doggy daycare in town. Many of the clients who buy products at Diane’s dog store give their dogs to Jack when they take a trip. At this point in time, Jack has run the daycare for over 30 years. While he also shares a passion for dogs, he decides that it is time to move on and calls it quits.

Diane views this as a perfect opportunity to add to her growing repertoire of dog businesses. Diane approaches Jack with an offer to buy the daycare. Jack is excited by this proposal. He can cash out, retire, and buy that coveted house in Hawaii to spend the rest of his days with his wife.

Both agree to the arrangement. After consultations from competent accountants and attorneys, Diane uses the dog store to buy the doggy daycare. The dog store now owns four Q-Subs, but both parties are happy. Diane has a near monopoly on dog products in town, and Jack can finally retire to Hawaii. This business structure is diagrammed below:

qsub graph 3

Lenders may want to create more lending protection by requiring S-Corp borrowers to hold loan collateral in a Q-Sub. After buying the doggy daycare from Jack, Diane realizes that she needs more kennels to house the growing number of dogs staying overnight. This will not be a cheap purchase.

Diane decides to buy the kennels on credit and approaches the bank seeking a loan. After reviewing her business credit, the bank tells Diane that they will need the kennels to be held as collateral in a Q-Sub. Fortunately, the doggy daycare business is already a Q-Sub. Both parties agree to the arrangement, and the kennels are held in the doggy daycare business as planned.

Given the numerous benefits that Q-Subs provide, business owners should consider forming them in the right circumstances. They helped Diane. And if you are faced with similar issues, they can certainly help you.

Section 1202

By: Ted Sutton, Esq.

Introduction

From a very young age, Elong Muskrat was always passionate about providing solutions to the world’s most difficult problems. Over the years, Elong had founded multiple companies in different industries. Many of them failed. However, some of them were wildly successful.

One day, Elong wanted to provide a solution to help reduce the world’s fossil fuel usage. Since cars contribute heavily to this use, Elong decided to start an electric car company. These electric cars would have all the same features without having to make the trip to the gas station.

After reducing his idea into a business plan, Elong formed Edison Electric Vehicles in 2011, a Delaware C-Corp, where he initially owned 100% of the stock.

In the following decade, Edison manufactured over 1 million electric vehicles. Because car manufacturing is an expensive endeavor, Edison’s gross assets were only worth $40 million.

In 2021, Elong was drawn to another serious issue. He noticed the ubiquity of social media and all of its negative impacts. Titter, a platform where users would constantly exchange a tit for tat, was the primary culprit. Elong wanted to purchase Titter and change its algorithms for the betterment of society. However, he would need to finance the purchase of Titter by selling his stock in Edison.

In 2022, Elong sold his stock in Edison to Riviera Motors, another electric vehicle maker, for $9 million. He then used that sum to finance his purchase of Titter.

Being an extremely smart person, Elong was curious as to the tax consequences of his stock sale. His tax advisor told him that he may qualify for the Qualified Small Business Stock (QSBS) exemption. If he does, he could save millions of dollars in taxes.

Qualified Small Business Stock

So what exactly is QSBS? Under Section 1202 of the Internal Revenue Code, a taxpayer may be exempt from paying capital gains tax when selling QSBS stock if they meet certain requirements. Each of these are listed below.

  1. QSBS Only Applies to C-Corp Stock

First, the stock must be held in a C-Corp. S-Corp stock, LLC units, and partnership interests are not eligible for the QSBS exemption.

Edison was formed as a C-Corp. The first requirement is easily met.

  1. The C-Corp Shares Must be Acquired in the Original Issuance

Second, the C-Corp shares must be acquired in the original issuance.

Because Elong owned 100% of Edison’s stock when he formed it, the second requirement is met.

  1. The C-Corp Must be a Qualified Small Business

Third, the C-Corp must be a qualified small business. A qualified small business is a domestic C-Corp which holds gross assets that have never exceeded $50,000,000.

Here, Edison’s gross assets were only ever worth $40 million. Because of this, Edison meets the definition of a qualified small business.

  1. 80% of the Firm’s Assets must be Used in Active Conduct

Fourth, a minimum of 80% of the firm’s assets must be used in active conduct, or in an ongoing business. If stock is acquired in a passive C-Corp, it cannot qualify for the QSBS exemption.

Because Edison manufactures cars, it easily meets the requirement of active conduct.

  1. The Stock Cannot be in Certain Lines of Business

Fifth, the stock of certain lines of business will not qualify for the QSBS exemption. Some of these include banking, insurance, farming, leisure and hospitality, and other professional businesses.

Because Edison manufactures cars, it does not fall into any of the aforementioned categories. It still qualifies for the QSBS exemption.

This is all great news for Elong. His stock qualifies for the QSBS exemption because it has met the aforementioned requirements. He can save money by not having to pay the capital gains tax associated with the sale of stock. However, how much Elong saves depends on when the stock was held and how much the stock sold for.

  1. When the Stock was Held

If the taxpayer acquires QSBS stock after September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 100% of the capital gain upon its sale.

If the taxpayer acquires QSBS stock between February 18, 2009 and September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 75% of the capital gain upon its sale.

If the taxpayer acquires QSBS stock between August 11, 1993 and February 18, 2009, and holds it for more than 5 years, the taxpayer can exclude 50% of the capital gain upon its sale.

Elong formed Edison in 2011 and sold his Edison stock in 2022. Because of this, Elong may exclude 100% of the gain.

  1. Maximum Excludable Gain Recognized

The IRS sets limits on how much a taxpayer can exclude upon the sale of QSBS stock. The maximum eligible gain that a taxpayer can recognize is capped at the greater of $10 million, or 10 times the aggregate adjusted basis in the stock.

Here, because Elong sold his Edison stock for $9 million, he is able to exclude the entire gain associated with its sale. 

Conclusion

If they meet the requirements, qualifying for QSBS can be advantageous to taxpayers who acquire and sell stock in smaller C-Corps.

The Corporate Transparency Act

The Corporate Transparency Act

By: Ted Sutton, Esq.

The Final Rules Are In – New Requirements Ahead for Every Corporation, Limited Partnership, and Limited Liability Company 

Introduction 

Powertainment, LLC is a profitable company that helps aspiring entrepreneurs become the best version of themselves. It was founded by Patrick, Tom, and Adam. The three of them each agreed to own 1/3 of the LLC’s membership interests. Robert, a friend of theirs, comes to the company 45 days later. While he doesn’t own any membership interests, he has agreed to be the manager of Powertainment.

Each of the four men have different backgrounds and different areas of expertise. This wide range of available knowledge has resulted in Powertainment’s success. On top of employing 18 employees, the company generated over $6 million in revenue in the past year.

Tom recently found out from a friend that Congress passed the Corporate Transparency Act (or ‘CTA’). Nervous of what it would do to Powertainment, he went to the other three to voice his concerns. How would it affect their business? How would they have to report personal information to the government? What penalties would they face if they failed to comply?

The answers to each of these questions follow.

Corporate Transparency Act 

The CTA was enacted (said the bill’s sponsor) “to combat malicious actors using shell corporations” to move illegal funds throughout the United States. Many policy makers believe the CTA will deter criminals and their criminal acts. However, the effectiveness of this Act is yet to be seen.

The CTA requires both companies and beneficial owners to submit a report to the Department of Treasury’s Financial Crimes Network (FinCEN). Both requirements are discussed below.

Company Requirements 

So which companies are required to file? Under the CTA, companies must file if they are either formed by filing a document with the secretary of state or similar tribal office, or formed in a foreign country that’s registered to do business in the US. The Act also states many exemptions, most notably the “large operating companies” exemption. The requirements for being a “large operating company” include employing more than 20 full-time employees, accruing more than $5 million a year in gross receipts or sales, and operating from a physical office in the US. If your business meets these three criteria, you are exempt from filing.

While Powertainment meets two of the three requirements of a “large operating company”, it only employs 18 people. Thus, the exemption doesn’t apply to them. Powertainment must still report to FinCEN.

Beneficial Ownership Requirements 

So who exactly is a beneficial owner of the company? The CTA lists out two criteria, each being sufficient on its own to meet the Act’s definition. The first criteria mandates FinCEN notification for individuals owning or controlling at least 25% of the reporting company’s ownership. The second criteria requires reporting someone (and not necessarily an owner) who exercises “substantial control” over the reporting company.

This begs the question: What constitutes having “substantial control” over a company? It can encompass many different forms. It can mean serving as a company officer, having the power to appoint or remove members, making decisions for the company, and exercising “substantial influence” over the company’s important matters. In addition, the government can also look at other characteristics not listed to determine if an owner has “substantial control” over the company. Clearly, this definition is not entirely definite.

Because Patrick, Tom, and Adam each own 1/3 of the LLC, they automatically meet the 25% requirement. They must report as individuals. On the other hand, Robert does not own any interest in the LLC. But because Robert serves as the manager and is thus a company officer of Powertainment, he must still report. And, because he came to the company after the first report was filed, Powertainment must file an amended report within 30 days of his hiring.

What must be Reported 

There are two reports that need to be submitted to FinCEN. First, companies must report four information items. These include:

  • The company’s name and any trade name or DBAs (if applicable)
  • The business street address
  • The formation jurisdiction, and
  • A “unique business number” (This can be a company’s EIN number from the IRS)

Second, beneficial owners must report four information items. These include:

  • The name of the beneficial owner
  • Their birthdate
  • Their residential street address, and
  • A “unique identifying number” (This can be either a passport or a driver’s license, a copy of which must be submitted)

For companies formed before January 1, 2024, they must report this information before January 1, 2025. For companies formed after January 1, 2024, they must report this information within 30 days after receiving notice of the entity’s creation. As well, anyone who files the documents creating the company, such as a lawyer or paralegal, must have their information reported.

Because Powertainment was in existence before January 1, 2024, these reports are due by January 1, 2025. Here, Powertainment would have to report all four information items as the company. On top of this, Patrick, Tom, Adam, and Robert would each have to report all four information items as beneficial owners. A total of five reports, all for one business. For businesses with more people having substantial control, that number is even higher. If Powertainment has a change in ownership, or hire more people with substantial control over their operations, they have 30 days to file an amended report.

Penalties for Not Filing 

What’s the point of passing a federal law if there are no penalties? The CTA has its fair share of them, and they are steep if you don’t report. Fines can be up to $500 a day after the reports are due and can even accumulate up to $10,000. Even worse, you can be sentenced to prison for up to 2 years for failing to comply. Mere negligence here can lead to a criminal violation.

Let’s say that the Powertainment owners shift their ownership percentages and bring on a new vice president who now exercises substantial control. As mentioned, an amended report to FinCEN is due within 30 days. Like many Americans who forget about the numerous federal reporting requirements, if the Powertainment team forgets to report they may soon owe the government $10,000 in penalties. The government may grant no leeway in this situation. When the Act takes effect, everyday Americans could face significant consequences for not complying.

Conclusion

The CTA has far-reaching effects. Almost every entity ever formed will have to comply in some fashion. Will Congress’s aims actually work? Or will the bad guys figure out a way around the rules, leaving millions of American businesses with yet another government burden?

The CTA seems unlikely to be repealed. Fortunately, we at Corporate Direct are here to help. Starting in January of 2024, we can prepare your initial and amended reports and submit them to FinCEN. Feel free to contact us for more details.

 

How LLCs Can Protect Doctors

By: Ted Sutton

Doctors are frequent targets of medical malpractice suits. This is why many of them have malpractice insurance to cover these claims. But what happens when the insurance does not cover the full amount? In this situation, the last thing doctors want is to have their personal assets exposed. Fortunately, doctors have a few options to protect their assets.

Forming an LLC for their Practice

The first thing doctors can do is set up an entity for their practice. The entity must be formed in the state where the doctor is licensed to practice, and each state has different requirements. Some states allow doctors to simply form an LLC for their practice. Others such as California require doctors to set up a Professional Corporation (PC). A third group of states, including Illinois, require doctors to set up a Professional Limited Liability Company (PLLC). For the latter two categories, entity owners must be licensed members of their respective profession.

Forming an LLC for their personal assets

Using an entity for a medical practice is useful to protect against a slip and fall or other accidents on the premises. But what happens when the doctor is sued personally? A malpractice claim is personal, meaning the doctor can’t hide behind the entity. The patient, after collecting against malpractice coverage, can reach the doctor’s personal assets. Having a separate LLC for personal assets can prevent an easy taking.

To insulate from personal liability, many doctors use LLCs to hold title to personal assets, including stock portfolios and real estate holdings. But the patient may still attach the doctor’s interest in the LLC to pay their claim. Choosing which state to form the LLC makes the biggest difference in what the patient can collect.

Form an LLC in a Strong State

Some states, including Wyoming, offer better protection for one simple reason: the charging order. This order only allows the patient to collect any distributions the doctor may receive, and gives them no right to participate in the LLC’s management.

In Wyoming, the charging order is the only way that the patient can collect anything from the LLC. You do not have to make any distributions from a stock portfolio. So if no distributions from the LLC are made, the patient collects nothing. This can aid doctors, especially if the LLC holds valuable assets.

Other states, including California, have weaker protections. Contrary to only allowing the patient to receive distributions, a California court may force the sale of the doctor’s LLC to pay the claim. Do doctors want this to happen? Of course not, and fortunately, this scenario can be minimized. By forming the LLC in a state with better protection, the doctor is better protected.

Conclusion

Doctors must not only consider an entity for their practice, but also an LLC for their personal assets. When faced with a claim, these considerations make the difference between how much or how little a claimant can collect.

Multi-Member LLCs: Structure and Issues

By: Ted Sutton

LLC structure with regard to members

Graham has been a prominent real estate investor for over a decade. After coming from humble beginnings, he has built a large portfolio that holds over 100 properties. He decided to teach people how he did it, so he started making YouTube videos. Graham figured this would be a good opportunity for him to both educate a younger audience and generate a second stream of passive income. Over time, Graham began to build a large following. He also met many like-minded YouTubers along the way. He became especially close with Jaspreet, Marko, and Natalie.

Given their popularity, Graham and other three YouTubers decided to make a financial education super-conglomerate. A one-stop shop for financial education organized under one business entity. This fearsome foursome formed an LLC, contributed capital, and received membership interests in return.

This article illustrates how multi-member LLCs are formed, managed, and continued after a member departs. Each will be discussed in detail below, continuing with the example above.

What is a member? 

A member is an individual or an entity that owns an ownership interest in an LLC.

Here, Graham, Jaspreet, Marko, and Natalie are all members. A chart reflects their membership interests:

Multi Member LLC Graphic 1

When Entities Are Members 

LLCs are also allowed to be owned by another legal entity. In many cases, they are owned by another LLC. They can also be owned by a corporation.

The entity’s ownership must be reflected in both the Operating Agreement and the meeting minutes. When one LLC owns another LLC, the Manager from the entity with the authority to sign should sign both the Operating Agreement and minutes.

Marko has a very large stock portfolio. Because he is concerned about personal liability, he set up an LLC to hold his paper assets and another to hold his syndication interests. These two are owned by a passive Wyoming holding LLC. He then decides to have his Wyoming holding LLC own the new Financial Education LLC. This provides an extra layer of protection between Marko personally, and his interest in the financial education LLC. He signs both the Operating Agreement and the meeting minutes as the manager of his LLC. A chart illustrates Marko’s ownership interest below:

Multi Member LLC Graphic 2

If Marko is sued personally (after a car wreck, for example) a victim will have to fight through Wyoming’s very strong protections to try and get at Marko’s paper assets, syndication and financial education interests.

Ownership percentages 

Members can own different ownership percentages in an LLC. Generally, ownership percentages are based off the member’s capital contributions. However, members are also free to allocate the ownership percentages that have an economic basis in any manner that makes economic sense.

Graham has been a successful real estate investor who has a large portfolio. Since his net worth is significantly higher than the remaining members, he agrees to contribute $1 million to the Financial Education, LLC. Because Graham also manages each of his rental properties, he decides to take a more passive role in the LLC. He agrees to own a 10% membership interest. Jaspreet, Marko, and Natalie agree to run the operations and own 30% each. But Graham wants a priority return on his money, since he is putting up the most. It is agreed that he will receive the first $1,500,000 in profits, his money back plus 50%. These interests are reflected below:

Multi Member LLC Graphic 3

The LLC taxed as a partnership allows for priority returns like this. Be sure to work with your CPA on these issues.

Who is the manager? How to decide who will act as the Manager. 

The manager is, quite simply, a person who manages the LLC. LLCs can have more than one manager, and they also provide for two different management structures. 

Member-Managed LLC

The first is member-managed. In a member-managed LLC, the manager can only be one of the members. A member managed board can be all of the members. Management is determined by a vote of the members during a meeting. Members who want to have more control in the LLC may prefer this structure.

If their Operating Agreement specifies that the LLC is member-managed, then only Graham, Jaspreet, Marko, and Natalie are allowed to manage the LLC. 

Manager-Managed LLC

The second option is manager-managed. In a manager-managed LLC, the manager can either be one of the members, or the members can elect to hire an outside manager. This structure is ideal where members prefer a more passive role in the LLC’s affairs. We prefer manager management to better clarify and separate the roles between ownership and management, which can help solidify the corporate veil of protection.

Let’s say the LLC’s Operating Agreement states that the LLC is manager-managed. Kevin is a friend of the group and is also very passionate about financial education. He is known for his hard work and wants to be involved with the LLC. However, none of the other members want Kevin to own a membership interest. This doesn’t bother Kevin one bit. At their next meeting, the four members agree to elect Kevin to manage the LLC’s affairs. Everyone is happy. Kevin gets to do the management work nobody else wanted to do, and the four members get to watch their business grow. A chart illustrates this below:

Multi Member LLC Graphic 4

Member Leaves 

As is true with life, membership interests in LLC constantly change. LLC members can leave for a number of reasons, and there are several different ways they can leave, and how the remaining members can handle the ownership of the departed member’s interests. The most common method is including a right of first refusal provision in the Operating Agreement, described below.

Right of First Refusal

A multi-member LLC may select a right of first refusal provision. This procedure gives the remaining members first priority to buy a departing member’s interest. This helps the remaining members because have a say in who can take the departing member’s place. For this reason, we include such a provision in our Operating Agreement.

Here’s how it works. In the event that a departing member receives an offer to buy their interest from a third party, the departing member must first take that same offer to the remaining LLC members. The remaining LLC members then have the right to buy that interest on the same terms proposed by the third party. If the remaining LLC members refuse that offer, then the third party can buy the departing member’s interest on the same terms.

Let’s assume that the honeymoon period ends and relationships begin to sour. Graham is disappointed with the direction of the LLC and the other members’ philosophies. He certainly regrets contributing additional capital for a smaller ownership percentage since his priority return has not materialized. Graham’s friend, Andrei, learns of his discontent and offers to buy his membership interest. Andrei has always wanted to be involved in a financial education business. He also gets along with the remaining members. Andrei puts in an offer to buy Graham’s 10% membership interest for $750,000.

The Operating Agreement has a right of first refusal provision. Graham then goes to Jaspreet, Marko, and Natalie with Andrei’s offer. If the three members agree to buy the interest, they can pay $250,000 each to own the remaining 10% membership interest. If Jaspreet, Marko, and Natalie decline the offer (the more likely outcome here), then Andrei buys Graham’s 10% interest for $750,000. Andrei then must be voted in by the others to become a full member of the LLC with a 10% ownership interest and the rights to the priority return. A chart illustrates this process below:

Multi Member LLC Graphic 5

A Member Dies 

Another fact of life is that people die. When an LLC member passes away, there are several ways their interests can transfer. Each are described below. These transfers may also apply when a member leaves the LLC.

Jaspreet left the United States to visit family in India. However, his plane had mechanical issues en route and crashed into the ocean. Nobody survived. The remaining members were not only devastated but also unsure what to do with Jaspreet’s membership interest. Fortunately, the Operating Agreement may tell them how to proceed. 

Right of First Refusal 

As discussed, before, the company and the other Members may have the first right in the Operating Agreement to buy the deceased member’s interests. This can be useful if the other members don’t want to have Jaspreet’s heirs inside the business. The Operating Agreement provides a method for valuing Jaspreet’s interest. With Jaspreet’s estate paid off (in some cases overtime pursuant to a promissory note) the business continues with the working members.

Estate Transfers 

If allowed by the Operating Agreement, Jaspreet’s Estate (and/or other beneficiaries) may be allowed to own an interest in Financial Education LLC. The estate can always sell the interest to the other members if needed. Assume that Jaspreet’s wife Alex holds onto the LLC interest, then the chart below illustrates the ownership:

Multi Member LLC Graphic 6

Agreement is Silent 

If the Operating Agreement is silent on a certain event, then state law governs. Some states require that the LLC must be dissolved entirely when a member dies.

Let’s assume that the LLC is formed in a state with such a law, and the Operating Agreement is silent on the event of death. After Jaspreet’s death, the LLC is required to be dissolved. It doesn’t matter that Andrei, Marko, and Natalie are still alive. Their financial education business must end.

To avoid this unfair result, it is important to include Operating Agreement provisions that govern how membership interests transfer upon death or departure.

Conclusion

The above examples demonstrate that the LLC provides flexibility with regards to formation, governance, and membership departure. When forming a multi-member LLC, it is important to have a well-drafted Operating Agreement that spells out what to do when each event happens. Corporate Direct can help with all these issues. Schedule your free 15-minute consultation with an Incorporating Specialist to find out more!

 

 

Are You a California Resident?

Are you a California Resident?
You: I am out of your state for six months and a day!
California: Hold my non-alcoholic beer!

Many people believe that as long as they are outside the state of California for six months and a day they are not residents of California. And thus don’t have to pay California’s high income taxes. But the state of California is both broke and arrogant. And they make the rules the way they want.

The short answer is that you must be in your ‘home state’ more days than in your California home to avoid the state’s taxation. And for those who like to travel, tramping to Europe, New Zealand and the Nevada side of Lake Tahoe for just half the year won’t work with California’s wide, casting net.

What follows is a more technical explanation of California’s Franchise Tax Board (“FTB”) position on the issue. Please know that the FTB has more attorneys on the payroll than you do.

THE FTB’S DETERMINATION OF CALIFORNIA RESIDENCY

According to the FTB, a California resident is any individual who meets either of the following:  (1) present in California for other than a temporary or transitory purpose; or (2) domiciled in California, but outside California for a temporary or transitory purpose. As such, a California nonresident is any individual who is not a resident; and a part-year California resident is any individual who is a California resident for part of the year and a nonresident for part of the year. See, FTB Publication 1031, Guidelines for Determining Resident Status (2021), p. 4.

Residency is significant because it determines what income is taxed by California. The underlying theory of residency is that you are a resident of the place where you have the closest connections. These connections include, but are no means limited to, the following:

  1. amount of time you spend in California versus amount of time you spend outside California;
  2. location of your spouse and children
  3. location of your principal residence
  4. state that issued your driver’s license
  5. state where your vehicles are registered
  6. state where you maintain your professional licenses
  7. state where you are registered to vote
  8. location of the banks where you maintain accounts;
  9. the origination point of your financial transactions;
  10. location of your medical professionals and other healthcare providers (doctors, dentists, etc.), accountants, and attorneys;
  11. location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member;
  12. location of your real property and investments;
  13. permanence of your work assignments in California. In using these factors, it is the strength of your ties, not just the number of ties, that determines your residency. See, FTB Publication 1031 (2021), p. 5.

Generally speaking, your state of residence is where you have your closest connections. If you leave your state of residence, it is important to determine if your presence in a different location is for a temporary or transitory purpose. You should consider the purpose and length of your stay when determining your residency.

When you are present in California for temporary or transitory purposes, you are a nonresident of California.

For instance, if you come to California for a vacation, or to complete a transaction, or are simply passing through, your purpose is temporary or transitory. As a nonresident, you are taxed only on your income from California sources.

When you are in California for other than a temporary or transitory purpose, you are a California resident.

For instance, if your employer assigns you to an office in California for a long or indefinite period, if you retire and come to California with no specific plans to leave, or if you are ill and are in California for an indefinite recuperation period, your stay is other than temporary or transitory.

As a resident, you are taxed on income from all sources. You will be presumed to be a California resident for any taxable year in which you spend more than nine months in this state.

Although you may have connections with another state, if your stay in California is for other than a temporary or transitory purpose, you are a California resident. As a resident, your income from all sources is taxable by California. See, FTB Publication 1031 (2021), p. 6.

HOW THE FTB APPLIES THE SO-CALLED “SIX-MONTH PRESUMPTION”

There is widely thought to be a “six-month presumption” in California residency law to the effect that, if you want to avoid becoming a resident of the State of California, then all you need to do is to spend less than six months in California during any calendar year. Although the amount of time you spend in California does play a critical role in determining your legal residency, the real rule is more complex.

There is, indeed, a “six-month presumption,” established by regulation, that if a taxpayer spends an aggregate of six months or less in California during the year, and is domiciled in another state, and has a permanent abode in the domicile state, and does nothing while in California other than what a tourist, visitor, or guest would do, then there is a rebuttable presumption of non-residency.

As such, the real rule, established by regulation, is that the so-called “six-month presumption” consists of an aggregate of 183 days. Thus, if you spend a total of more than 183 days in California during any calendar year, then you are not entitled to the presumption. Furthermore, in order to qualify for the presumption, you have to be a domiciliary of another state and have a permanent home there (owned or rented).

For residency law purposes, “domicile” is defined by case law and the regulations as “where an individual has his true, fixed, permanent home and principal establishment, and to which place he has, whenever he is absent, the intention of returning.” If you are not a domiciliary of another state, and if you do not have an abode there, then you are not entitled to the six-month presumption. Furthermore, in order to qualify for the presumption, you must have only the kinds of limited contacts a tourist or visitor might have.

The FTB regulations envision this as restricted to owning a vacation home, having a local bank account, and joining a country club. Thus, if a taxpayer has any other contacts, there is no presumption. Furthermore, the presumption is rebuttable. As such, even if you meet all the requirements for the establishing the presumption, the FTB still is entitled to offer evidence to prove that you are a California resident. In addition, there is yet another presumption (otherwise known as ‘stacking the deck’) that the FTB’s rulings are correct, which you then must also rebut.

Despite these formal considerations, it should be noted that, as a practical matter, the FTB uses a “ledger analysis” in determining California residency. Under this “ledger analysis,” the FTB literally makes a ledger with three columns. One column itemizes your time spent in California; a second column itemizes your time spent in your home state; and a third “other” column itemizes your time spent elsewhere.

The FTB then compares your “California column” with your “home state column.” If you spent more time in your home state than you spent in California, then you prevail in the time category; and if you spent less time in your home state than you spent in California, then you lose in the time category. The idea is that the place where you spent most of your time (not necessarily the majority of the year) is more likely to be your home than not.

BRIEF DISCUSSION

Applying the California FTB’s so-called “ledger analysis” to the problem at hand, the problem may be restated, as follows: if you spend three months of the year in the State of Nevada (presumably in the “home state” column); you spend three months and a day of the year in Europe (presumably in the “elsewhere” column); and say, for example, you spend four months of the year in California (presumably in the “California” column), then it is easy to see that you spent more time in the State of California than in your “home state” of Nevada (the “elsewhere” column is not really relevant).

Thus, your stay in the State of California is not “temporary or transitory,” because you spent more time in the State of California than in your “home state” of Nevada. The underlying rationale is that the place where you spend most of your time (and not necessarily the majority of the year) is more likely to be your home than not.

CONCLUSION

As a practical matter, the California FTB applies a “ledger analysis” in determining California residency, and what really matters is that you must spend more time in your “home state” than in California.

One sure way to avoid all the FTB’s technical considerations for asserting their taxation is to sell your California home and move to another state.

Design Your Asset Protection Plan

You design a lot of things in your life. The layout of your house, the flow of your business, the requirements on your children, and many more scenarios are all elements of conscious design.

Asset protection is no different. There is an architecture, a cohesive structure, to your properly planned legal safeguards. Sometimes you try and do it yourself, which could be fine. Many people are into DIY. And yet, with all the asset protection misinformation on the internet, you’ve got to be careful. Does that overpriced ‘guru’ really know what they’re doing? You won’t know until the plan they’ve designed holds. Or fails.

Designing your asset protection plan does not improve with setting up more entities than you need. When your plan is solid with three LLCs, who benefits by adding 5 more LLCs to the mix? I know you will answer that question correctly.

Your effective design should never be a matter of confusion to you. If you don’t understand what your asset protection planner is suggesting, demand a clear explanation. If they respond that most attorneys and no clients will ever understand their ‘brilliant’ structure, get up and walk out. That’s not how it works. As well, if you ask to get a second opinion from another lawyer about the plan and they claim that no lawyer will even begin to comprehend what they’ve put together for you, as a special client and part of the elite inner circle, it is also time to leave. You need to clearly understand the plan. And so does your spouse.

Sometimes, like an old bridge, a plan design has fault lines. The structure appears fine, until it collapses under pressure. This can be the case with land trusts. Promoters tout them for their asset protection benefits while they offer no such feature. To cover this inconvenient issue, they suggest that one or more land trusts be beneficially owned by one LLC. The structure appears as follows:

Land Trust Structure

How will this structure hold up?

When a tenant in the duplex is injured on the property, they have the ability to sue the land trust for their damages. Some promoters claim that the tenant will never know the owner of the land trust because such information is confidential. Without exaggeration, this is one of the greatest legal fallacies in history. If the tenant’s attorney can’t locate the land trust owner all they have to do is publish notice of the lawsuit in the paper. It is very easy to do. And if the owner doesn’t respond to the lawsuit the tenant can win by default. You’ve lost the case and they are foreclosing on the property. “Well,” says the land trust promoter as they close shop and move 1,000 miles away, “I guess that didn’t work.”

Contrary to what these promoters may suggest, you don’t want to hide. You actually want to be found if needed, so that you can receive the notice of a lawsuit. You want to promptly turn the claim over to your insurance company so they can defend you and hopefully settle the case. If you hand them the claim after a default is entered in virtually all cases they don’t have to cover you. You didn’t give them proper notice of the lawsuit. Your design flaw is not their problem.

There is another design flaw in the structure above. Let’s say the promoter acknowledges that an LLC needs to be in the mix for its benefits of limiting liability. So, the beneficial owner (a required feature of land trusts and akin to a shareholder in a corporation or a member in an LLC) is listed as XYZ, LLC. When Land Trust #1 is sued by the tenant the liability flows to the beneficial owner, or XYZ, LLC.

Now if XYZ, LLC were on title to the property instead of the land trust, the liability would be contained within that one LLC. But in our design flawed structure, the liability flows from the land trust into the LLC. What does the LLC own? Not only Land Trust #1 but also Land Trust #2 and Land Trust #3. So the tenant can also get what the LLC owns, which is equity in all three land trusts. “Well,” says the land trust  promoter as they prepare to move to Alaska, “that didn’t work either.”

As is clear, the design of your asset protection plan really does matter. When building it listen to your little voice, the one that is always there and always protective. If the proposed plan doesn’t make sense, if it doesn’t add up, think again. Get another opinion. Your asset protection is too important to be left to unquestioned amateurs.

Corporate Direct, on the other hand, does not advise using land trusts or any overly complicated structures. We have been in the business of asset protection for over 30 years and we can help you structure your entities correctly and in a straight forward and affordable manner. Get your free 15-minute consultation to get started today!

Corporate Opportunities

Does the Rule Apply to Real Estate?

If you invest in and/or syndicate real estate what are the duties to your investors? You owe them a duty of loyalty. But how far does that go?

The issue of corporate opportunities is important. I wrote a whole chapter on it (from which part of this is excerpted) in my newest book “Veil Not Fail.” Before discussing its applicability to real estate lets review it in a business setting.

The simplest case involving a breach of the duty of loyalty is where a corporate executive expropriates for themself a business opportunity that rightfully belongs to the corporation. For example, assume that a company distributes window shades but a key executive takes the exclusive distributorship rights for a new type of awning. The corporation should have obtained the distributorship. It is in their core business.

The duty of loyalty requires officers and directors to apprise the corporation (or LLC or LP) of “corporate opportunities.” The corporation gets to decide if it wants it or not. If the company doesn’t move forward then the executive may be free to pursue it, or not. The decision may be at the company’s discretion.

A corporate opportunity is any investment, purchase, lease or any other opportunity that is in the line of the corporation’s business, and is of practical advantage to the corporation. If an officer or director embraces such opportunity by taking it as their own, they may violate their duty of loyalty, especially if by doing so their self-interest will be brought into conflict with the corporation’s interests. Will the officer be loyal to the company or their own business? The conflict is clear.

During their time in office, officers will likely discover business opportunities for the corporation. The officer may also have personal business opportunities that are somehow related to the corporation’s business. For example, if the officer is an inventor who focuses on telecommunications products, they will likely be interested in all such business opportunities. The corporation may be able to pursue some opportunities the officer discovers for the corporation, others it will not. If the corporation turns down one opportunity is the officer then able to pursue it?

Delaware courts have established a test for corporate opportunities. If an officer’s self-interest comes into conflict with the corporation’s interest, the duty of loyalty can be breached. The law will not permit an officer to pursue opportunities (1) that the corporation is financially able to undertake, (2) that is in the line of the corporation’s business, and (3) that is of practical advantage to the corporation.

On the other hand, if the corporation is not financially able to embrace the opportunity, has no interest in the opportunity, and the officer does not diminish their duties to the corporation by exploiting the opportunity, then the person may be allowed to pursue the opportunity.

Evidence that the opportunity was presented directly to the individual, and then not shared with the corporation, may be used to show that the corporate opportunity rules were not followed. In most states, the simplest way to avoid a problem is to present the opportunity to the corporation and allow it the chance to pursue or reject it. If the corporation cannot or will not take advantage of the opportunity, the employee, officer, or director may be free to pursue the opportunity.

Though formal rejection by the board is not strictly necessary, it is safer for the whole board to reject a corporate opportunity. The decision shouldn’t be based on individual board member’s opinions. There must be a presentation of the opportunity in some form.

After the corporation has rejected the opportunity, and before pursuing the opportunity, the employee, officer, or director should unambiguously disclose that the corporation refused to pursue the opportunity and ensure that there is an explanation for the refusal.

Resignation before completion of the questionable activity may not constitute a defense to liability arising from a corporate opportunity. Courts have found liability even where officers and directors resigned before the completion of the transaction. Although there are no certain guidelines for determining which opportunities belong to the controversy and liability may be avoided if officers use rigorous caution regarding corporate opportunities.

But again, what about real estate opportunities? Many syndicators are pursuing several investments at the same time. They always owe a duty to do their best. But does that prevent them from pursuing new projects without involving every investor?

The key to this issue is clarity. In a real estate based LLC Operating Agreement it must be stated that the principals are free to go after any investment. While existing investors may be offered the right to invest in future projects (always a good marketing technique) the syndicators must be allowed the freedom to pursue any and all opportunities for their own account.

Check your Operating Agreement and Offering Documents to make sure this important language is included.

Checkbook IRA

Checkbook IRA – Checkbook LLC

Whatever You Call It –There’s Trouble Ahead

A recent case has shed light on one of the riskiest retirement plan strategies put forth by promoters. In McNulty v. Commissioner (157 T.C. 10) a U.S. Tax Court brought clarity to the scheme of using self-directed IRAs for personal investments. While the rules are strict, they had become lax and unenforced in recent years. The McNulty case brings the requirements back into line, and serves as a warning of what may come.

If you have a checkbook IRA or LLC you may want to speak with your lawyer immediately.

The facts in McNulty are fairly common. We have seen such promoters at investment conferences for years.

In August 2015 Mrs. McNulty purchased services from Check Book IRA, LLC (Check Book), through its website, that included assistance in establishing a self-directed IRA and forming an LLC to which she would transfer IRA funds though purchases of membership interests and then purchase American Eagle (AE) gold coins using IRA funds. During 2015 Check Book’s website advertised that an LLC owned by an IRA could invest in AE coins and IRA owners could hold the coins at their homes without tax consequences or penalties so long as the coins were “titled” to an LLC.

So, Mrs. McNulty used the company to set up Green Hill Holdings, LLC (Green Hill) to own the coins. Green Hill was then owned by her IRA.

There were a few problems with this. First, an IRA trust must be administrated by an independent trustee, not the beneficiary of the retirement assets. The trustee is responsible for storing the coins in an adequate vault. In this case, Mrs. McNulty, following the promoter’s advice, took personal possession of the coins herself and held them in her own safe at home.

McNulty and the IRS made numerous arguments and counterarguments as to why the whole chain of events was either appropriate or amiss. The court could have decided the case on a number of issues but chose just one — this is important and we will come back to it.

The Tax Court noted that an owner of a self-directed IRA is entitled to direct how her IRA assets are invested without forfeiting the tax benefits of an IRA, and that a self-directed IRA is permitted to invest in a single-member LLC.

However, IRA owners cannot have unfettered command over the IRA assets without tax consequences. The Tax Court stated that it was on the basis of Mrs. McNulty’s control over the American Eagle coins that she had taxable IRA distributions.

A qualified custodian or trustee is required to be responsible for the management and disposition of property held in a self-directed IRA. A custodian is required to maintain custody of the IRA assets, maintain the required records, and process transactions that involve IRA assets.

The presence of such a fiduciary is fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement saving and to protect those savings for retirement.

The Tax Court emphasized that independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme; that when coins or bullion are in the physical possession of the IRA owner (in whatever capacity the owner may be acting), there is no independent oversight was clearly inconsistent with the statutory scheme; and that personal control over the IRA assets by the IRA owner was against the very nature of an IRA.

The Tax Court concluded Mrs. McNulty had complete, unfettered control over the American Eagle coins; that she was free to use them in any way she chose; and that this was true irrespective of Green Hill’s purported ownership of the American Eagle coins and her status as Green Hill’s manager.

Once Mrs. McNulty received the American Eagle coins, there were no limitations or restrictions on her use of the coins, even though she asserted that she did not use them. While an IRA owner may act as a conduit or agent of the IRA assets, an owner of a self-directed IRA may not take actual and unfettered possession of the IRA assets. It is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it. Constructive receipt occurs where funds are subject to the taxpayer’s unfettered command and she is free to enjoy them as she sees fit.

The Tax Court concluded that Mrs. McNulty’s possession of the American Eagle coins was a taxable distribution. Accordingly, the value of the coins was includible in her gross income. The Tax Court noted that the McNultys’ arguments to the contrary would make permissible a situation that was ripe for abuse and that would undermine the fiduciary requirements of the act. Mrs. McNulty took position of the American Eagle coins and had complete control over them. Accordingly, she had taxable distributions from her IRA in excess of $300,000 — a painful financial mistake.

We have long warned about the risks of the check book scheme. In my 2015 book Finance Your Own Business the hazards were enumerated with the conclusion being “The safer course is to stay away from Checkbook IRAs.”

Interestingly, some promoters claim that the McNulty case is limited to situations in which gold coins were taken into personal possession. But that narrow view misreads the whole case. (Indeed, if they argue otherwise ask for a legal opinion letter on the viability of the Checkbook LLC.)

Remember when we said the court chose just one issue as a discussion point? The court mentioned numerous prohibited transactions (rule violations) and problems with the Checkbook scheme. But it focused on just the physical possession of the coins in this specific case.

The court may be doing everyone else using a Checkbook IRA a huge favor. The court may be signaling that future limitations on the scheme are coming. The court may be giving everyone a head’s up that its time to change your Checkbook IRA structure.

Be sure to talk to your own attorney about this. But here is a scenario to consider: Let’s say you are the manager of the LLC that controls your IRA investments. As such, you have management control over your IRA assets. You are keenly aware that the court in the McNulty case stated: “Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.”

So to clean things up you need to step aside as manager of the Checkbook LLC. You appoint your CPA or attorney or other fiduciary as the manager so that you no longer have any personal control over your retirement assets.

If the IRS ever later questions you on such a move you tell the truth. You had initially been led to believe that the Checkbook IRA scheme was acceptable. But then you learned of the McNulty case. And in an attempt to follow IRS guidance you appointed a new, non-related fiduciary to serve as the LLC manager overseeing your personal IRA investments. You have made a good faith effort to be compliant with their rules in light of new information. Instead of doing nothing, by taking prompt corrective action you are in a much better position to ask for forgiveness.

The McNulty case is not the only challenge to the Checkbook LLC. Proposed legislation in Congress also seeks to crack down on IRA abuses. Talk to your professionals now to stay ahead of what is coming.  

Piercing the Corporate Veil – How to Avoid It

50% of piercing the veil court cases nationwide succeed because owners are failing to properly follow corporate formalities. This exposes business owners to personal liability – meaning they can lose their possessions.

What is the Corporate Veil?

What is the corporate veil? How can it protect me and what does it mean when it is pierced? We’ll cover these ideas critical to liability, wealth and asset protection. By properly forming a corporation, LLC or Limited Partnership (LP) and taking the steps required of corporate formalities, a corporate veil is raised that may protect shareholders, officers and directors from personal liability and provide tax benefits. However, to ensure that the corporate veil remains intact and business meets its potential, all persons involved in the corporation must follow certain corporate formalities. (While we refer to corporations in this article, the concepts and issues apply to LLCs and LPs as well. Don’t be misled by those who claim that the need for following formalities only applies to corporations.)

If you fail to follow the requirements of corporate formalities, you could be vulnerable to court decisions which pierce the corporate veil. Today, 50% of piercing the veil court cases succeed because owners are failing to properly follow corporate formality requirements.

This topic is so important, I wrote a book on it!

Veil Not Fail

Upcoming book!

When protective entities like LLCs and corporations fail and businesses risk piercing of the corporate veil, experienced legal guidance is imperative. In Veil Not Fail, the author explores potential risks and weak spots in LLCs and corporations and helps readers better prepare for what he considers an inevitability in a sue happy society ― it isn’t if you’ll be sued…it’s when.

Ebook prelaunch, April 2022 at

Amazon.com

 

Definition of Piercing the Corporate Veil

A situation in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts. Veil piercing is most common in close corporations. While the law varies by state, generally courts have a strong presumption against piercing the corporate veil, and will only do so if there has been misconduct like abuse of the corporate form (e.g. intermingling of personal and corporate assets) or undercapatitalization at the time of incorporation. (Undercapatitalization would apply if the corporation never had enough funds to operate, and was not really a separate entity that could stand on its own).

If corporate formalities such as annual corporate filings and meeting minutes are not maintained in a timely and proper manner, courts can hold YOU, the entity’s owner, personally responsible for claims filed against the company. You need to keep your corporation filings current, and your legal protections intact.

How to Prevent Piercing the Corporate Veil

Limited liability and tax benefits are not a right granted to every business person, but privileges earned by following corporate formalities. The following nine rules provide general guidance for maintaining the corporate veil while conducting business through a corporation:

  • Perform all annual filings;
  • Maintain internal formalities, including having a resident agent in their state of formation and in any state the company qualifies to do business in;
  • Maintain a written record of corporate decisions;
  • Provide the world with corporate notice;
  • Ensure the corporation is sufficiently capitalized;
  • Maintain the distinction between corporate assets and personal assets;
  • Use caution when distributing corporate profits;
  • Separate bank accounts; and
  • Separate tax returns

Although the burden of maintaining corporate formalities may not be appealing, the consequences of neglecting corporate formalities are great. Whether the corporation has followed the foregoing rules becomes important when a creditor seek to receive payment through the assets of the corporation’s individual shareholder, director or officer. Each rule and its various implications are discussed more in depth below.

If you are unsure if you are in compliance or would like hire Corporate Direct to ensure that you are, we offer a service to assist.

Get Our Corporate Clean-Up Service

  • We prepare your first Corporate Minutes.
  • We perform the research and analyze if you are current in all areas of the corporate formalities and whether or not your entity is positioned for full protection.
  • We do all the work necessary to bring your affairs current to verify you are legally compliant and you save time.

We have helped clients become compliant after as much as 23 years of improper record keeping. But remember, it’s important to have the corporate veil properly maintained before a lawsuit or claim is brought against a corporation. Once that happens, its too late and personal assets can be jeopardized.

How to Raise the Corporate Veil

Once you have decided that a corporation, LLC or Limited Partnership (LP) is the right entity for your business or asset holding purpose and you have decided which state to incorporate in, corporate formalities begin. Events occurring immediately after formation must be performed properly to maintain the corporate veil and ensure the corporation’s longevity and flexibility.

A corporation is born when the Articles of Incorporation are properly filed. The corporate veil provided Shareholders with limited liability and is raised and maintained by management and ownership that treats the corporation like a corporation. As indicated above, a corporation is considered to be a legally distinct entity, capable of incurring its own debts and obligations. This protection is frequently referred to as the corporate veil. When creditors or others seek to obtain a judgement from a court that makes the corporations shareholders, directors or officers personally liable, they are seeking to pierce the corporate veil. This article will focus mostly on maintaining the corporate veil once it has been established, but briefly here are the requirements needed to set it up:

  • File the Articles of Incorporation
  • Hold organizational meetings to empower the corporation to conduct business and provide limited liability.
  • Provide the corporation with competent initial management
  • Issue the corporation’s shares of stock

Maintaining the Veil by Maintaining Corporate Formalities

Performing Annual Filings

Annual filings are required to protect and ensure the longevity of the corporation. In addition to the permits, licenses, or approvals that are unique to the corporation’s business, every corporation must obtain and maintain a corporate charter in good standing. In many states, a corporation must file an annual report, providing the names and addresses of Officers and Directors, and annual fees. If such filings are not completed in a timely fashion, the state may revoke the corporate charter and the corporation will cease to exist. The time, energy, and expense expended organizing the corporation will be wasted if the state revokes the corporate charter. While it may be possible to have the charter reinstated, the best way to maintain the corporate veil and ensure that the corporation serves its purpose is to simply perform annual filings in a timely manner.

Maintaining Internal Formalities

Bylaws adopted by the Directors in their organizational meeting provide the guidelines for the corporation’s future actions and corporate policy. Specifically, the Bylaws should provide the following:
1. Notice requirements for Directors meetings;
2. The minimum number of annual Directors meetings;
3. The date for annual Shareholders meetings;
4. The requirements for special Shareholders meetings;
5. The responsibilities of each Officer and Director; The procedures for removing Officers or Directors;
6. The procedures for Shareholders’ inspection of the corporation’s records; and
8. The name and address of the corporation’s resident agent.

Although they shape the internal operations of the corporation, Bylaws should not be complicated or provide intricate procedures. Necessity determines the extent and detail provided in the corporation’s Bylaws, which may be amended, altered, or repealed by the Board of Directors.

All decisions the corporation makes and all actions the corporation takes should be in compliance with the rules established by the Bylaws. Compliance with the Bylaws indicates that the corporation’s Directors, Officers, and Shareholders treat the corporation as a separate entity with its own rights and limitations. If the Directors, Officers, and Shareholders treat the corporation as a separate entity, courts will be less likely to ignore the division between corporate property and the rights of the individual Directors, Officers, and Shareholders. The corporate veil will be maintained.

As well, in most states it is imperative to have a current resident agent to accept service of process. Failure to have a resident agent in place can lead to arguments that the corporate veil should be pierced.

Maintain a Written Record of Corporate Decisions

Even if a small group of people or a single person controls the corporation, it should conduct meetings and prepare records of such meetings. Shareholders and Directors conduct three types of meetings, which should each be recorded through minutes of meetings. As provided above, immediately following incorporation, organizational meetings should be conducted. During the corporation’s life, regular meetings must be conducted annually pursuant to the corporation’s Bylaws to reflect elections and the corporation’s other decisions. Additionally, a corporation may hold special meetings when called by the Directors or Shareholders. Special meetings are held to discuss urgent items of business or to approve any legal or tax issues. The general procedure for conducting Directors or Shareholders meetings is provided below.

Prior to a meeting of Shareholders, all Shareholders must receive or waive notice of the meeting. Prior to a Directors’ meeting, all Directors must receive or waive notice of the meeting. In meetings of Shareholders or Directors, corporate formalities require voting and an official record of actions taken at the meeting. The official record of actions taken in regular meetings, as well as the organizational meetings, is provided as the minutes of the meeting. Minutes provide a record of the corporation’s resolutions. A resolution is a document that records actions that the Directors or Shareholders “resolve” to take on the corporation’s behalf. The nature and timing of the corporation’s decisions dictate whether a resolution or minutes of a meeting provide an appropriate record of a decision.

An alternative in most states to conducting actual meetings and preparing minutes for those meetings is for the corporation to authorize action by written consent. This is the quickest and easiest way to document formal corporate action. Directors and/or Shareholders sign a document that contains the language of the corporation’s decision or resolution. By signing the document, the Directors and/or Shareholders approve the decision or resolution. To ensure that an action by written consent is adequately documented, all Directors and/or Shareholders must sign the consent form. The corporation should keep signed consent forms in the corporate minute book.

By conducting the necessary meetings and preparing adequate records, a corporation provides documentation to protect the corporate veil. Should a creditor seek to pierce the corporate veil at a later date, the corporation’s records will serve as evidence of its separate existence. In addition, maintaining proper records may help to avoid future miscommunications and misunderstandings within the corporation.

Although many people believe that preparing annual meeting minutes is difficult, the minor inconvenience is greatly outweighed by the potential problems that failing to prepare such records could cause. If necessary, a service provider may prepare the required minutes for the corporation for a reasonable fee. Our firm charges $150 per year to prepare minutes. You may call toll free 1-800-700-1430 for more information.

Provide the World with Corporate Notice

Whenever the corporation enters into a contract or engages in any business activity whatsoever, it must do so clearly as a corporation. Individual Officers or Directors may be subject to personal liability if they act on the corporation’s behalf, but fail to clearly indicate that they are acting in their capacity as the corporation’s Officer or Director. To avoid creditors or others from piercing the corporate veil and attacking individual members of the corporation’s management or Shareholders, it must be clear that the corporation, and not an individual, is acting. Business cards, letterhead, invoices, company checks, brochures, etc … must identify the corporation. The full name of the corporation should be provided (not XYZ, but XYZ, Inc.). All contracts and correspondences signed by Directors or Officers for the corporation should be signed with reference to their corporate designation. If the corporation takes steps to ensure that others know that the corporation, and not an individual Officer or Director is acting, the corporate veil will be more resistant to attack.

Avoid Under-Capitalization

Although most jurisdictions will not allow creditors to pierce the corporate veil solely because the corporation had insufficient assets, the risk of veil piercing provides reason to ensure that the corporation is sufficiently capitalized. California and few other states have relied on under¬capitalization in piercing corporate veils. A corporation should have sufficient resources to meet its short-term obligations whether it is just starting, is part of a cooperative project, or is merely one element in a greater corporate strategy. If the corporation is undercapitalized, a creditor may argue, and a court could accept the argument, that the corporation exists simply to help its owners shelter their assets. As is discussed further below, this may be enough reason for a court to pierce the corporate veil and find personal liability for Officers, Directors, and/or Shareholders.

Maintain the Distinction between Corporate and Personal Assets

A common but fatal mistake for developing corporations occurs when its management and/or Shareholders fail to maintain the distinction between corporate and personal assets. Whether arising from loans from the corporation to individuals, shared bank accounts, shared tax returns, or individual use of corporation property, failure to separate corporate assets from personal assets negates the corporation’s separate identity. To prevent creditors from piercing the corporate veil, the corporation must maintain a separate bank account, file separate tax returns, and use corporate assets only for corporate purposes.

The corporation should not be used as a lender for its Officers, Directors or Shareholders. An air of impropriety is created when a corporation loans money to members of management, even if management genuinely intends to repay the loan. The infamous chain of corporate scandals in spring and summer 2002 highlighted the dangers involved in loaning to management, as such loans were often cited in allegations that a Director or Officer breached their fiduciary duties. The best way for the corporation to avoid potential problems is to refuse to lend money to its Directors and Officers.

Regardless of their personal interest or role in the corporation, nobody should treat the corporation’s property as personal property. By clearly distinguishing between corporate and personal assets, the corporation may indicate and retain its separate identity. By reporting and maintaining the corporate assets separately from management’s or Shareholders’ personal assets, the corporation will reduce the potential for successful lawsuits against Officers, Directors, and individual Shareholders.

Cautiously Distribute Corporate Profits

Whether a corporation distributes its profits through dividends paid to shareholders or compensation paid to employees, the corporation’s distribution of profits may provide a basis for creditors to pierce the corporate veil. The veil that limits the liability of Shareholders, Directors, and Officers also creates limitations on the corporation’s ability to pay such corporate actors from the corporation’s profits. If the corporation fails to obey established rules for the distribution of corporate profits, a creditor may use such failure as an indication that the corporate actors are not treating the corporation as a separate legal entity. To reduce creditors’ ability to pierce the corporate veil, the corporation must exercise caution in distributing its profits.

Every state authorizes a corporation’s Board of Directors to issue dividends to its Shareholders. However, the Directors’ decision to declare dividends may result in substantial fines assessed against the individual Directors if the dividend is found to be illegal. Dividends from surplus cannot exceed limits established by reference to the corporation’s assets. “Nimble” dividends, or dividends paid from profits, may be issued when the corporation’s surplus is insufficient. However, such dividends may only be paid when such payment does not impair the capital representing preferred stock. Directors must determine whether the corporation has sufficient funds legally available to pay dividends to protect themselves from potential liability. To avoid liability arising from the issuance of dividends, corporations should consult with legal counsel before deciding to issue dividends.

Keep a Separate Bank Account

A corporate veil will be pierced in cases where the company founders use a personal bank account for business affairs. You cannot consistently pay business expenses from a personal account and, conversely, you cannot pay personal expenses from a company bank account. Failure to follow these simple guidelines can be catastrophic, so as soon as you incorporate obtain an EIN (Employer Identification Number) from the IRS and use it to open a corporate bank account.

Prepare a Separate Tax Return

Because you have obtained an EIN for your entity you must now file a separate tax return with the IRS. Fear not, this is your chance to take all the deductions you may be entitled to take. But failure to file a separate return can lead to claims that you are not following corporate formalities. So file – and take advantage of the tax benefits you are entitled to in the first place.

Many developing corporations do not have sufficient assets or profits to distribute dividends to Shareholders, but they must compensate Officers, Directors, or other employees for their services. Especially in start-up businesses, the compensation a corporation pays to Officers, Directors, and other employees may determine the corporation’s ability to succeed. Equity compensation (using shares of the corporation’s stock, stock options, or other alternative forms of compensation) may be attractive. Compensation based in part on the corporation’s profits may also be appealing. However, all forms of compensation should be based primarily upon the market value of the employee’s services. The Internal Revenue Service may scrutinize excessive compensation paid to Directors, Officers, or employees and decide to tax excessive compensation as dividends.
Corporations that over-compensate their employees may create liability for the Directors based on Shareholders’ claims of mismanagement, breach of fiduciary duties, self-dealing, or waste of corporate assets. Through a derivative action, the Shareholders may regain control of the corporation and its assets. The corporation may then assert legal claims against former Directors, creating personal liability for such Directors. To avoid potential liability based on employee compensation and excessive tax liability, Directors must ensure that compensation paid by the corporation is reasonable.

All decisions regarding the distribution of a corporation’s profits or compensation for employees is subject to the discretion of the Board of Directors. However, to avoid potential liability for the corporation and for themselves, Directors must carefully consider the effects of every use of the corporation’s assets. Caution and the advice of legal counsel may be necessary to prevent the Board’s distribution decisions from creating unwanted liability.

State Differences

Some states are more likely to pierce the corporate veil than others. As well, in some states veild piercing cases are brought more often. The top five states in order of most cases filed are:

  1. New York,
  2. California,
  3. Texas,
  4. Ohio and
  5. Pennsylvania.

As you would expect, the filings reflect population density. But they also reflect the states in which the strategy may be successful.

On a national basis, nearly 50% of veil piercing cases were successful, which is all the more reason to be cautious when dealing with corporate formalities.