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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.

How to Set Up Single Member LLCs

You must be very careful when you are the only owner of your LLC. Single member LLCs require extra planning and special language in the operating agreement.

One example: What happens when the single owner/member passes? Who takes over? It may be months before that is sorted out, and your business will falter without a clear leader.

Difficulties of Owning a Single Member LLC

You want the asset protection benefits of a limited liability company. But what if you don’t want any partners? What if you want to be the sole owner of your own LLC?

You can do that with a single owner LLC (sometimes known as a single member LLC).

But you have to be careful.

Before we discuss how to properly set up and use a single owner LLC we must acknowledge a nationwide trend. Courts are starting to deny sole owner LLCs the same protection as multiple member LLCs. The reason has to do with the charging order.

The charging order is a court order providing a judgment creditor (someone who has already won in court and is now trying to collect) a lien on distributions. A chart helps to illustrate:

Illustration showing typical multi-member LLC structure

John was in a car wreck. Moe does not have a claim against XYZ, LLC itself. The wreck had nothing to do with the duplex. Instead, Moe wants to collect against John’s assets, which is a 50% interest in XYZ, LLC. Courts have said it is not fair to Mary, the other 50% owner of XYZ, to let Moe come crashing into the LLC as a new partner. Instead, the courts give Moe a charging order, meaning that if any distributions (think profits) flow from XYZ, LLC to John then Moe is charged with receiving them.

Moe is not a partner, can’t make decisions or demands, and has to wait until John gets paid. If John never gets paid, neither does Moe. The charging order not only protects Mary but is a useful deterrent to frivolous litigation brought against John. Attorneys don’t like to wait around to get paid.

But what if there is only a single owner?

Illustration that shows a single member LLC structure

In this illustration there is no Mary to protect. It’s just John. Is it fair to Moe to only offer the charging order remedy? Or should other remedies be allowed?

How the Court Has Ruled Against LLCs With One Member

In June of 2010, the Florida Supreme Court decided the Olmstead vs. FTC case on these grounds. In a single owner LLC there are no other members to protect. The court allowed the FTC to seize Mr. Olmstead’s membership interests in order to collect. Other states have followed the trend.

Interestingly, even two of the strongest LLC states have denied charging order protection to single owner LLCs in limited circumstances.

In September of 2014, the US District Court in Nevada decided the bankruptcy case of In re: Cleveland.

The court held that the charging order did not protect a single member LLC owner in bankruptcy. Instead, the bankruptcy trustee could step into the shoes of the single owner and manage the LLC. This is not surprising since bankruptcy trustees have unique and far reaching powers, which are routinely upheld by the courts. (But know that, incredibly enough, a bankruptcy trustee can’t get control of the shares of a Nevada corporation. This is a special planning opportunity available to Nevada residents – or those who may become Nevada residents.)

In November of 2014, the Wyoming Supreme Court rendered a surprising verdict in the Greenhunter case.

The court held that the veil of a single owner LLC could be pierced. The issue centered on a Texas company’s use of a Wyoming LLC it solely owned. The LLC was undercapitalized (meaning not enough money was put into it) and it incurred all sorts of obligations. It wasn’t fair for the Texas company for the single owner to hide behind the LLC. The fact that a single owner LLC was involved was a material issue. The court pierced through the LLC and held the Texas company liable for the LLC’s debts.

Even though these are fairly narrow cases, both Nevada and Wyoming have held against single member LLCs. Again, this is the trend.

Luckily there are some things you can do to protect your assets as a single member LLC…

Strategies for Protecting Your Assets

One strategy is to set up a multi-member LLC structured in a way that gives the intended single member all of the decision making power. For example, parents can have adult children over 18 become member(s) or for those under 18 you can use a Uniform Gift to Minors Act designation. You may want to use an irrevocable spendthrift trust for children or others. A local estate planning attorney can help you set these up correctly.

But what is the smallest percentage you have to give up for the second member? Could you give up just 1/100th of 1 percent? Most practitioners feel that the percentage should not be inordinately low and that 5% is a suitable second member holding. So the ideal structure would be that John owns 95% of the LLC and the other 5% is owned by a child (or other family member) and/or an irrevocable trust.

Accordingly, in a state that doesn’t protect single owner LLCs, you have an excellent argument for charging order protection. There is a legitimate second member to protect. To further that legitimacy it is useful to have the second member participate in the affairs of the LLC. Attending meetings and making suggestions recorded into the meeting minutes is a good way to show such involvement.

But what if you don’t want to bring in a second member?

There are plenty of good reasons to set up a sole owner LLC. Other owners can bring a loss of privacy and protection. And if you paid 100% for the whole asset, why should you bring in another member anyway? Or, what if you don’t have any children or other family members that you want to bring in?

If a single member LLC is truly the best fit for you, there are three key factors to know and deal with.

1. The Corporate Veil

Many states’ LLC laws do not require annual meetings or written documents. Some see this as a benefit but it is actually a curse.

If you don’t follow the corporate formalities (which now apply to LLCs) a creditor can pierce the veil of protection and reach your personal assts. With a single owner LLC this is especially problematic. Because you are in complete management control it may appear that you aren’t respecting the entity’s separate existence or that you are comingling the LLC’s assets with your own personal assets. Without a clear distinction of the LLC’s separate identity, a creditor could successfully hold you personally responsible for the debts of the LLC (as they did in Wyoming’s Greenhunter case above.) Maintaining proper financial books and records and keeping LLC minutes can help demonstrate a definitive and separate identity for your single owner LLC. You must work with a company which appreciates the importance of this for single owner LLCs.

2. Different State Laws

LLC laws vary from state to state. Some states offer single owner LLCs very little protection. The states of California, Georgia, Florida, Utah, New York, Oregon, Colorado and Kansas, among others, deny the charging order protection to single owner LLCs.

Other states offer single owner LLCs a very high level of protection in traditional circumstances. So we have to pick our state of formation very carefully. In order to deal with this trend against protection, we use the states that do protect single member LLCs.

Wyoming, Nevada, Delaware, South Dakota and Alaska (collectively “the strong states”), have amended their LLC laws to state that the charging order in standard collection matters is the exclusive remedy for judgment creditors – even against single owner LLCs.

So how do we use these state laws to our advantage? Let’s consider an example:

A chart showing a properly structured single member LLC

In this example, John owns a fourplex in Georgia and a duplex in Utah. Each property is held in an in-state LLC (as required to operate in the state). The Georgia and Utah LLCs are in turn held by one Wyoming LLC. (This structure works in every state except California, which requires extra planning. Be sure to take advantage of our free 15-minute consultation if you are operating or residing in California).

I break down potential lawsuits into two different types of attacks: Attack #1, the inside attack and Attack #2, the outside attack.

In Attack #1, the inside attack, a tenant sues over a problem at the fourplex owned by GEORGIA, LLC. They have a claim against the equity inside that LLC. Whether GEORGIA, LLC is a single owner or multi-owner LLC doesn’t matter. The tenant’s claim is against GEORGIA, LLC itself. Importantly, the tenant can’t get at the assets inside UTAH, LLC or WYOMING, LLC. They are shielded since the tenants only claim is against GEORGIA, LLC.

The benefit of this structure comes in Attack #2, the outside attack. If John gets in a car wreck, it has nothing to do with GEORGIA, LLC or UTAH, LLC. But, the car wreck victim would like to get at those properties to collect on the judgment. If John held GEORGIA, LLC and UTAH, LLC directly in his name, the judgment creditor could force a sale of the fourplex and duplex since neither state protects single owner LLCs.

However, since John is the sole owner of WYOMING, LLC he is protected by Wyoming’s strong laws. The attacker can only get at WYOMING, LLC and gets a charging order, which means they have to wait until John gets a distribution and therefore could possibly never get paid. If John doesn’t take any distributions, there’s no way for the attacker (or his attorney) to collect. A strong state LLC offers a real deterrent to litigation, even for single owner LLCs.

3. Operating Agreement

Like bylaws for a corporation, the Operating Agreement is the road map for the LLC. While some states don’t require them, they are an absolute must for proper governance and protection. A single owner LLC operating agreement is very different than a multi-member operating agreement. 

For example, if a single owner transfers their interest in the LLC, inadvertent dissolution of the entire LLC can occur. This is not good. Or, again, what if the sole owner passes? Who takes over? Our Single Member Operating Agreement provides for a Successor Manager (a person you pick ahead of time) to step in.

The best way to deal with these issues, as well as others, is to have a specially drafted operating agreement to properly govern your Single Member LLC. Corporate Direct provides such a tailored document for our clients. When it comes to business and investments, you must do it the right way.

Incorporate First – Deduct Second

Should you set up a corporation or LLC before you start trying to deduct expenses? A recent case suggests you should.

Many think that they can deduct all of their start up expenses before formally incorporating a business. But in Carrick v. Commissioner of Internal Revenue (T.C. Summ. Op. 2017-56, July 20, 2017) the Tax Court ruled otherwise.

The Facts of Carrick

The taxpayer had a bachelor’s degree in electrical engineering. For approximately 15 years, he was employed in the oceanographic industry. Before the years in issue, and during 2013 and 2014, he was employed by Remote Ocean Systems (ROS), building underwater equipment such as cameras, lights, thrusters, control devices, and integrative sonar.

During the years in issue, ROS was experiencing financial difficulty. The taxpayer was provided some flexibility in his work schedule, and he began exploring business ventures with other individuals, using the name Trifecta United as an umbrella name for the activities, which he named Local Bidz and Stingray Away.

The Local Bidz activity involved creating a website with features similar to those of the websites of Angie’s List, Yelp, and eBay, which would permit people to bid on hiring contractors for products and repairs. The taxpayer first had the idea for Local Bidz in 2012, and he went “full force in the beginning of 2013,” spending time accumulating data and developing software and the website.

At some point in 2013 the web developer moved to Los Angeles and other individuals left the project. For some unspecified period in 2013, the taxpayer traveled weekly from his home in San Diego to Los Angeles to consult with the web developer. The taxpayer abandoned the Local Bidz activity before the end of 2013. Sometime in 2014, the taxpayer began the Stingray Away activity, which involved researching and developing a device to prevent surfers and swimmers from being injured by stingrays.

The taxpayer initially noticed that sonar devices might affect the behavior of sharks and other species, so he conducted research at beaches in La Jolla, where swimmers and surfers often were stung and bitten by stingrays. The taxpayer did not fully develop any devices nor list any devices for sale in 2014. He had had no gross receipts during 2013 or 2014 from either the Local Bidz activity or the Stingray Away activity.

The Decision in Carrick

In Carrick, the taxpayer asserted that his reported expenses were deductible as ordinary and necessary business expenses relating to the activities of Local Bidz and Stingray Away. The Tax Court noted that 26 U.S.C. § 162(a) provides the general rule that a deduction is allowed for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” The Tax Court stated that it was clear that the taxpayer was not “carrying on” a trade or business in 2013 or 2014 when the expenditures for the Local Bidz and Stingray Away activities were made.

Carrying on a trade or business requires more than preparatory work such as initial research or solicitation of potential customers; a business must have actually commenced. Expenses paid after a decision has been made to start a business, but before the business commences, are generally not deductible as ordinary and necessary business expenses. These preparatory expenses are capital expenditures.

The Tax Court pointed out that, while the taxpayer may have been conducting research in 2013 with respect to Local Bidz, or in 2014 with respect to Stingray Away, neither activity reached the point of actually commencing. There was neither sales activity nor evidence of the offering of products or services to the public. The taxpayer was still in the very early stages of research and development in each of these activities.

The Tax Court observed that there was nothing in the record indicating that the taxpayer had commenced any business activity as a sole proprietor. The taxpayer had not set up a formal business entity. Therefore, the Tax Court concluded that the taxpayer was not “carrying on” a trade or business in 2013 or 2014. See, 26 U.S.C. § 162(a); Frank, supra, 20 T.C. at 513-14 (1953); Shea, supra, T.C. Memo. 2000-179, 2000 WL 688593, at *5n. 10; Christian, supra, T.C. Memo. 1995-12, 1995 WL 9151, at *5.

Brief Discussion

If you’re preparing to open a new business, then you need to make certain that you understand the tax rules. It is crucial that you offer the product or service to the public and that you begin sales activity, because start-up expenditures, i.e., expenditures paid before a business begins, are not deductible in the years they are actually incurred. Instead, they are capital expenditures, which generally must be amortized over a 15-year period, once business begins, meaning gradually write off the cost over 15 years. See, 26 U.S.C. § 195. Thus, in order for an expenditure to be an ordinary and necessary trade or business expense, it must be related to more than a preparatory expenditure.

So, if the taxpayer in Carrick had opened his business first, then he might have been able to deduct his expenditures in the years they were actually incurred, instead of amortizing them over a 15-period.

Conclusion

The moral of the story is: Open your business first, and deduct later.

What’s new in 2021?

Let’s start with the good…

California Raises their Homestead Exemption

The homestead exemption is an excellent creditor protection strategy for personal residences.

It all started in Texas when they were an independent republic from 1836 to 1846 and in need of settlers. Texas passed a law whereby creditors could not reach the equity of your homestead (your farm, ranch or dwelling). It worked like a charm and other U.S. states followed suit,

While the homestead amounts in Texas as well as Florida, Kansas, and Oklahoma are unlimited, other states have their own dollar limit. In Arizona, for example, the amount of equity you can protect is $150,000. So, if your home is worth $500,000 and you have a first deed of trust securing your mortgage of $350,000 there is $150,000 in equity exposed. By filing the homestead exemption form with the county recorder’s office (a process that may vary state to state) you have set aside the $150,000 in equity for your benefit as against a later creditor.

California’s homestead has been kept at a low and confusing amount for many years. A single home owner could protect $50,000 while an elderly married couple could protect $175,000 in equity. But those dollar amounts didn’t reflect the high cost of California real estate. A $50,000 homestead in some high rent areas may not protect a backyard Tuff Shed. So California, after years of inaction, did the right thing. They raised the homestead amount and indexed it for inflation.

The new homestead has a baseline amount of $300,000 but can go as high as $600,000 in counties with expensive real estate. Assume a couple is burdened by credit cards and car loan debt but they’ve built up equity in their home. Before, with the lowered homestead amount, they could lose their home to foreclosure. Now with the $600,000 in protection (and rising every year with inflation) the couple could go through a Chapter 13 bankruptcy and keep their home.

Homesteads offer significant protections to homeowners. It is good to see California recognize that.

And we’ll end with the not so good…

Congress and Corporate Transparency: A New Burden for Small Businesses

The Federal government wants to know who owns your business. In December, 2020 Congress passed the Corporate Transparency Act (CTA). Before this bill companies did not have an obligation to report their true owners to the feds. As long as the company paid their taxes there wasn’t an issue.

But within the federal bureaucracy and law enforcement circles there are people who just need to know more. Arguing that shareholder anonymity allowed bad people to engage in financial crimes, including – sound the alarms – money laundering and terrorist financing, the CTA passed both houses. Instead of requiring the states, which govern corporate formation, to collect such information, beneficial ownership data on every corporation and LLC must now be reported every year to the U.S. Department of Treasury’s Financial Crimes Enforcement Network (FinCEN).

Opponents argued that such information could be easily gained and misused. Proponents countered with hubris, stating that all the sensitive data would be stored on private networks away from public scrutiny. Their assurances of confidentiality occurred the same week as the identification of the massive Solar Winds hack, the Pearl Harbor of cyber-attacks, in which the Russians gained God access to thousands of federal websites and networks.

But never mind that. Law enforcement’s desire to know who owns every corporation, LLC, LP and other state-chartered entity is clearly written into the legislation. FinCEN must keep the names and addresses confidential (servers willing) except when:

  1. Federal Agencies involved law enforcement, intelligence and national security want it;
  2. State and local agencies involved in criminal or civil investigations after obtaining a court order want it;
  3. Foreign intelligence agencies want it; and
  4. Other federal regulatory agencies including the IRS want it.

As such this confidential information can be expected to be used by both governments and dark web hackers. By 2023, every business entity at the time of its formation and on an annual basis thereafter must report its beneficial owners’:

  1. Full legal name;
  2. Date of birth;
  3. Current residential or business street address; and
  4. Unique identifying number from a U.S. passport, state drivers license or similar state issued ID.

The complete disclosure requirements, including the meaning of ‘beneficial owner’, will be further fleshed out by future regulations.

Corporate Direct will keep you informed of these new rules and will attempt to assist you with filing your FinCEN report. Failing to properly file will carry penalties of up to $10,000.00 and two years in prison. So while not welcoming this new reporting burden, we will work with you to stay on the safe side of it.

Distributing LLC Money

You’ve set up your LLC. Now it’s time to make money, and flow the profits into your bank account. It’s time to think about how you will be distributing LLC Money between bank accounts. In the example we’ll use in this article, you have transferred title in a real estate rental property (a duplex) into your new LLC, which is called XYZ, LLC. You have also, as is required to follow the corporate formalities, set up a bank account in the name of XYZ, LLC. You haven’t hired a property management company yet as you are going to try managing the property yourself.

In the first month, your two duplex tenants pay the rent on time. You are thinking to yourself: “This is good. This is how it’s supposed to work.” You deposit the rent checks, which are properly made out to XYZ, LLC, into the new XYZ, LLC bank account. You have a mortgage and trash pick-up payment to make, so you write two checks against the new LLC bank account to cover those obligations.

Glory be, after those payments, at the end of the month you have a profit! What do you do?

You could pull some of the money out, transferring it from XYZ, LLC to your personal account, knowing that you’ll have to pay taxes on a portion of it at some point. More likely, you may leave the money in XYZ, LLC and build up a reserve of cash to be able to cover any unforeseen issues. Some owners may leave the money in the LLC account until near the end of the year. After speaking with their CPA to understand how much income is sheltered by depreciation and how much tax they’ll owe they will pull enough money out of XYZ, LLC to pay their tax obligation, if any, as well as take a profits distribution for themselves at the end of the year.

Things are working well and you decide to invest in another rental property, a fourplex. You’ve heard that by putting your new fourplex into XYZ, LLC you are creating a target rich LLC. If a tenant at the duplex sues XYZ, LLC for a faulty condition they could not only reach the equity in the duplex but also in the new fourplex. They have a claim against the LLC and on an inside attack they can get what is inside XYZ, LLC, which would be both the duplex and fourplex. You don’t want to do that.

So you set up ABC, LLC to take title to the fourplex. Following what you did with XYZ, LLC you set up a new LLC bank account for ABC, LLC and deposit tenant checks made out to that LLC into the new ABC, LLC bank account.

Along the way you come to appreciate that the state in which ABC, LLC and XYZ, LLC were formed offers weak asset protection for the outside attack. The inside attack, where a tenant sues the LLC directly, offers the same protection in all states. But the outside attack where, for example, a car wreck victim has a personal claim against you and is suing from the outside to get at your assets, varies from state to state. California, New York and Utah are weak states. The car wreck victim and their attorneys can get at your valuable real estate to satisfy a claim. Wyoming, Nevada and Delaware are strong states featuring charging order protection, which is briefly described in this short video. For more detail, see my book, Loopholes of Real Estate.

LoopholesRE Sutton.Front Cover.Final .HiRes .2019
For now, we want you to focus on distributing LLC money through this new structure. As before, the new holding LLC we form in Wyoming opens its own bank account under the name Padre, LLC.
How to Properly use LLC Bank Accounts

 The profits you generate from the two title holding LLCs on the top line will, whenever you want, be distributed to the new Wyoming holding LLC. We don’t want to directly distribute to your personal bank account moneys from XYZ, LLC and ABC, LLC because you don’t personally own them anymore. Instead, you own Padre, LLC, which in turn owns XYZ, LLC and ABC, LLC. So the money flows from XYZ, LLC and ABC, LLC to Padre, LLC. Whenever you want to take a distribution you will take it from Padre, LLC, which is the entity you directly own. XYZ, LLC and ABC, LLC are technically owned by Padre, LLC and not you. But that is good, because it provides excellent asset protection when a strong state is used. As well, Padre, LLC is a good place to hold money because it is asset protected in Wyoming. If you hold the money in your personal bank account you are not as protected.

Some people will complain that in the structure example above, a total of three bank accounts is not needed. Two points are critical here. First, it is useful to know that with online banking and fairly low minimum balance requirements the use of three separate accounts is neither burdensome nor expensive. Second, and more importantly, by not using separate bank accounts you run the risk of a creditor seeking to pierce the veil of your entity. You must not commingle money between personal and separate business accounts. There must be a clear line of money flows from duplex tenants into XYZ, LLC, from that entity into Padre, LLC and from the Wyoming holding LLC into your personal bank account. You cannot skip a step and risk being held personally liable for a claim.

Again, distributing LLC money correctly is not going to be a burden. And even if it was it is required for you to maintain your asset protection edge, so just do it. Work with your CPA on the timing of distributions and payment of taxes and all will be fine.

Besides, it’s how everyone else does it anyway.

California Does Something Right (Temporarily) for Small Business

California’s minimum tax on business entities is $800.00 per year. The California Franchise Tax is the highest in the nation and also comes with corporate income tax and personal income tax. California traditionally is a tough state to own a small business due to all the taxation and ever-changing business regulations. Interestingly, corporations have been exempted from that high fee for their first year of business since 1998. However, only 75% of about 100,000 new corporations that are formed each year claim the exemption because of complicated tax filing requirements. And don’t forget, California demands you pay the business entity tax if you are “doing business” in California. Many people mistakenly believe that if they don’t specifically have a California LLC then this tax does not apply, but that is not the case. The definition of “doing business” in California is extremely broad. You are subject to this tax if you (among other things):
  • Engage in any transaction for the purpose of financial gain within California. (Even if you don’t live there.)
  • Are organized or commercially domiciled in California
  • Your California sales, property or payroll exceeds certain amounts.
With regard to exceeding certain sales amounts, it gets even muddier. There is a law that exempts certain companies outside of California from the tax even if they are making sales in California which is described by the Franchise Tax Board as follows:
Public Law 86-272 potentially applies to companies located outside of California whose only in-state activity is the solicitation of sale of tangible personal property to California customers. Businesses that qualify for the protections of Public Law 86-272 are exempt from state taxes that are based on your net income. These entities, however, still may be considered to be doing business in California and may be liable for filing and paying the applicable amounts.

Such broad explanations and definitions can make it extremely difficult for business owners to discern whether or not they must pay this tax. As well, there are ongoing battles in court in order to try to stifle the Franchise Tax Board’s broad interpretations. So even before the Coronavirus, these taxes have had the effect of discouraging business in the state.

But for now, everyone can go ahead and take a deep breath (albeit temporarily) when they form an LLC in California. California is changing its taxation policy to waive the $800.00 mandatory franchise tax for the first year on all new entities. LLCs, limited partnerships and limited liability partnerships that register in the years 2021, 2022 and 2023 will not have to pay the $800.00 in their first year of business. Through this change the state would be reducing the General Fund Revenue for California by about $50 Million dollars in 2020-21 and $100 Million dollars in 2021-22 and out years. The goal of the new legislation is “to help and reduce costs for first year California small business.” The legislation further notes that “…these taxes may stifle economic growth and job creation and may inhibit the formation of many small businesses.”  Which ironically, may have some new business owners holding off to open a new entity to avoid paying the 2020 franchise tax, thereby stalling the California economy even more until 2021 when the tax exemption will be placed. California traditionally has about 250,000 LLCs, partnerships and sole proprietorships formed each year. Now, to try and keep economic growth from stalling, the $800.00 fee is temporarily waived on the first year for these entities along with corporations. (Hopefully without the cumbersome tax filing requirements.) The cost of doing any sort of business in California is very high. Waiving the $800.00 fee for an LLC’s first year is a good start. But why not make the waiver permanent? Corporations are excluded from the fee for the first year, and have been for years. Allowing LLC’s and other entities a similar permanent first year exemption would be wise policy.

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