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Texas: The New Hotbed For Business?

by | Sep 1, 2023 | ARTICLES, Charging Order, Corporate Direct, Start a Business

Texas: The New Hotbed For Business?

By: Ted Sutton, Esq.

 

In the business realm, Texas has become the lone star that is burning brighter. And it may become a top state for business in the near future.

 

They say that everything’s larger in Texas. This also includes a larger demand to form a business in the Lone Star State. Forming a business in Texas has become a popular alternative to other larger states like California and New York. Given its thriving economy and a favorable tax climate, Texas has seen an increase in new LLC formations.

 

These formations may increase further. Under the recently-passed Senate Bill 2314, Texas now recognizes the charging order as the exclusive remedy for both single-member and multi-member LLCs.

 

The charging order apples when an LLC member is personally sued and loses in court. But in order for the lawsuit winner to collect anything from the LLC, they must wait until any distributions are made from it. So, if no distributions are made, then the winner doesn’t collect anything from the LLC. This is true, even if the loser is the only member of the LLC. This new law takes effect on September 1, 2023.

 

This new law overrules Devoll v. Demonbreaun, a 2016 Texas Court of Appeals case[1]. Devoll held that the charging order was not the exclusive remedy, even if it was charged against an LLC’s membership interest. This new Senate Bill changes this outcome. Now Texas LLC owners are better protected in the event they are personally sued.

 

On top of this, Texas has also just formed the Texas Business Court. Similar to the Delaware Court of Chancery, this new court system will handle corporate disputes and complex litigation matters. Texas will eventually set up these courts in Austin, Dallas, Fort Worth, Houston, and San Antonio. This court will help expedite lawsuits and provide case law to resolve these disputes. But most importantly, this will attract even more business to the state. These new courts are set to start on September 1, 2024.

 

Another thing Texas has is its large population and rapid population growth. Currently, Texas is the second largest state with 30 million people. And since 2010, Texas has had the third-fastest growth of any state at a whopping 20%. Given these recent trends, it could take that top spot in the not-too-distant future.

 

Could Texas overtake Delaware and Wyoming as the best state for businesses? Only time will tell. However, these recent developments show that it may be possible.

_______________________________

[1] Devoll v. Demonbreun, No. 04-14-00331-CV (Tex. App. Aug. 31, 2016).

 

 

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Section 1202

by | Feb 13, 2023 | Corporation, Start a Business

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.

Multi-Member LLCs: Structure and Issues

by | Oct 17, 2022 | Forming an LLC, Start a Business

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!

 

 

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Design Your Asset Protection Plan

by | Jul 20, 2022 | Asset Protection, entity types, Start a Business

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!

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Employer Identification Number (EIN)

by | Feb 14, 2022 | Corporate Direct, Start a Business

EIN stands for Employer Identification Number. The IRS requires that you have such a number when you incorporate or form an LLC. Think of an EIN as a Social Security number for your business. You will file all your tax returns using this number and you will need this number to open a bank account for the business.

Once you’ve filed your incorporation papers and they’ve been approved by the Secretary of State, your corporation needs to file for an Employer Identification Number, or EIN. An EIN is a permanent number assigned to your business, which is used for official corporate business such as opening bank accounts and paying taxes.

How Do I Get an EIN?

You can apply for the EIN yourself on the IRS.gov website for free; however, some people find this confusing and/or do not wish to spend the time doing it themselves. If this is the case for you, Corporate Direct can obtain one for you for a small service fee. Whichever way you choose, know that it required for your business.

The IRS allows businesses to apply for an EIN either online, by phone, fax or mail. If applying online, the EIN is assigned immediately upon completion of the interview-style application that walks you through type of business, identity of business, authentication, addresses, details and confirmation of the new EIN number.

Even though receiving the number is immediate, it can take up to two weeks to be added into the IRS database and until it is added, the number can’t be used for filing returns. In order to avoid any issues, be sure to obtain your EIN as soon as possible. 

C Corporation

by | Jan 5, 2022 | Corporate Direct, Corporation, entity types, Start a Business

What is a C Corporation?

illustration of a storefrontCorporations have been used for over 500 years to limit owners’ liability and thus encourage business investment and risk taking. Their use for this purpose continues to this day. 

You will hear about both C Corporations and S Corporations. Both are corporations with charters granted by the state of organization. You can organize in Nevada for the best asset protection laws, for example, and qualify to do business in California. In that case, you will have one corporation paying annual fees in two states (which many people do). While we like and often use S Corporations, we keenly appreciate the advantages of C Corporations. They certainly have their merit and a place in your entity structure strategy.

The C and the S refer to IRS Code Sections. C corps feature a double taxation – one tax at the company level and another tax on profits distributed to shareholders. This double tax is why many people consider S corps, which has only one level of tax. But there are restrictions on ownership of S corps, where as there are no such limits on C corps.

Here is a quick list of C Corporation advantages:

  • They can have an unlimited amount of shareholders, from anywhere in the world.
  • For Nevada and Wyoming corporations, officers and directors can reside anywhere in the world. This can be a boon for foreign investors. 
  • They can have several different classes of shares.
  • They have the widest range of deductions and expenses allowed by the IRS (more on this below).
  • They are the most widely recognized business entity in the world, and are the premier entity for going public.
  • In Nevada and Wyoming, nominee (or stand-in) officers and directors can be utilized, adding extra levels of privacy.
Image Link to download full c-corporation guide pdf

Tax Advantage: Wide Range of Deductions and Expenses

A C Corporation has the widest range of deductions and expenses allowed by the IRS, especially in the area of employee fringe benefits. A C Corporation can set up medical reimbursement and other employee benefits, and deduct the costs of running these programs, including all premiums paid. The employees, including you as the owner/shareholder, will also not pay taxes on the value of those benefits.

This is not the case in a flow-through entity, such as an S Corporation, LLC or LP. In each of those cases the entity may write off the costs of the benefits, but any employee/shareholder who owns more than 2% of the entity will pay taxes on the value of their benefits received. So, if having the maximum deductions and all of the employee fringe benefits on a tax-free basis is important to you, a C-Corp may be your entity choice.

Which type of business works well as a C Corp?

C Corporations are great for a business that sells products, has a storefront and employees, and may or may not have a warehouse where it keeps its inventory. C-Corps don’t work well with businesses that want to hold appreciating assets, such as real estate, because of the tax treatment on the sale of these assets.

Tax Disadvantage: Double Taxation Issues

The most often-cited disadvantage of using a C-Corp is the “double-taxation” issue. Double-taxation happens when a C-Corp has a profit left over at the end of the year and wants to distribute it to the shareholders as a dividend. The C-Corp has already paid taxes on that profit, but once it distributes the profit to its shareholders, those shareholders will have to declare the dividends they receive as income on their personal tax returns, and pay taxes again, at their own personal rates.

How to Avoid the Double-Taxation Scenario

There are many things you can do to avoid the double-taxation scenario:

  • Structure the C-Corp so that there are no profits left over – use all of the write-offs and deductions allowed by the IRS to reduce the C-Corp’s net income.
  • Offer great benefit plans!
  • Pay higher salaries to yourself and the other owner/employees than you would if you were using a flow-through entity such as an S-Corp. Yes, you will have to pay payroll taxes and personal income taxes on those monies, but you would pay personal taxes on dividends paid to you anyway. And it may be that in the big picture, the savings on one side outweigh the additional taxes paid on the other side.

The decision as to what entity is best for you really does, in so many cases, hinge on taxes, and that is why, with any corporate-related decision, you are wise to seek the advice and assistance of a good CPA.

Corporate Direct along with your CPA can help you decide which corporation is best for you.

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