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Texas: The New Hotbed For 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: 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: 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!

 

 

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!

Employer Identification Number (EIN)

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

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.

S Corporation

Is an S Corporation the right entity type for you?

This is a great question to explore when starting a business, or changing your existing business from a Sole Proprietor or General Partnership. It can make a difference in asset protection as well as in taxes. An S Corporation is one of the three popular choices for those incorporating their business. Other choices include Limited Liability Companies (LLCs) and C Corporations.

Business owners can select how they wish to be taxed, and an S Corporation is one of those tax designations that can make a big difference in how much you pay in taxes, and how to handle profits and distribute shares. There are pros and cons to every entity type and it’s important to understand which business model is best for you.

An S Corporation is a corporation that has elected to be taxed as a flow-through entity (similar to an LLC or Limited Partnership). The “S” also refers to an IRS code section. This type of taxation, the S election, allows the shareholders to be taxed only at the individual level only instead of at both the corporate and individual level, thus avoiding the double taxation like the C Corporation.

Of all of the entities, the S Corporation has the tightest restrictions on ownership. There can only be 100 or fewer shareholders (owners), which all must be individuals or their living trusts. Corporations, multi-member LLCs, and non-US residents cannot be S Corporation owners. If the restrictions aren’t followed, the IRS will decide the corporation is C Corp and will double tax it accordingly.

S Corporations can help some service-oriented businesses to avoid being characterized as a Personal Service Corporation, or “PSC” by the IRS. PSCs are C Corporations that are classified by the IRS as providing a service, such as consulting, to the general public.

Now, as you may know, the IRS assesses C Corporations with a pretty low initial rate — 15% on earnings up to $50,000. That’s quite a bit lower than you would pay personally if you were receiving that same $50,000 as salary. And, that 15% rate is also lower than you would pay if your business was an S Corporation. So, to head off the anticipated revenue drain, the IRS closed the loophole by designating C Corporations that provide services as PSCs.

The tax rate for PSC earnings? 35%! That’s probably higher than you would pay through your S Corporation if you took a reasonable salary and the rest as passive income. And, it’s enough, in many cases, to make the difference between going “S” or going “C.” Again, you will work with your CPA, tax and/or legal advisors to determine the best entity for your specific situation.

Advantages Of S Corporations:

  • Limited liability for management and shareholders.
  • An unlimited number of management, no state residency requirements.
  • Distinct, court-recognized existence, which helps protect you from personal liability that can cause you to lose your personal wealth in assets like your home, car, or nest egg.
  • Flow-through taxation: Profits are distributed to the shareholders, who are taxed on profits at their personal level.
  • Good privacy protection, especially in Nevada and Wyoming.
  • Great income-splitting potential for owner/employees. Can take a smaller salary and pay income taxes and regular payroll deductions, then take the remainder of profit as a distribution subject to income tax only.
  • S Corporations are great for businesses that:
              • will provide a service (i.e. consultants);
              • will not have significant start-up costs;
              • will not need to make major equipment purchases before beginning operations; and
              • will make a sizable amount of money without a great deal of expense.

Disadvantages Of S Corporations:

  • At shareholder level, shares are subject to seizure and sale in court proceedings.
    Maximum of 100 shareholders, all of whom must be U.S. residents or resident aliens. Shares must be held directly, except in special circumstances.
  • Owner/employees holding 2% or more of the company’s shares cannot receive tax-free benefits.
  • Because flow-through taxes will be paid at the personal rate, high-income shareholders will pay more taxes on their distributions.
  • Not suitable for estate planning vehicle, as control is ultimately in the hands of the stockholders. In a planned gifting scenario, once majority control passes to children from parents, children can take full control of the company.
  • If tax status is compromised by either non-resident stockholder or stock being placed in corporate entity name, the IRS will revoke status, charge back-taxes for 3 years and impose a further 5-year waiting period to regain tax status.
  • Not suitable to hold appreciating investments. Capital gain on sale of assets will incur higher taxes than with other pass-through entities such as LLCs and Limited Partnerships.
  • Limited to one class of stock only.

What is needed to form a corporation? How does it protect me?

Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, it — the corporation — is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners’ liability is limited to the monies they used to start the corporation, not all of their other personal assets. In the event of a lawsuit it is the company, not the individuals, being sued.

A corporation is organized by one or more shareholders. Depending upon each state’s law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners’ privacy, nominee officers and directors may be utilized. A corporation’s first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including frequently, the company’s attorney.

The articles of incorporation set out the company’s name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.

Can I change entity types?

Yes, if you think you may want to go public at some point in the future, but want initial losses to flow through, consider starting with an S Corporation or a Limited Liability Company. You can always convert to a C Corporation at a later date, after you have taken advantage of flowing through losses. Corporations can make the election at the beginning of its existence or at the beginning of a new tax year.

More benefits to business owners: No self-employment tax!

The big benefit of S Corporation taxation is that S Corporation shareholders do not have to pay self-employment tax on their share of the business’s profits. But they will be taxed on the salary they pay themselves. This is the catch. Before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary) that is subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kick in once the S Corporation is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

More Questions? An Incorporating Specialist can help!

Limited Partnerships – Advantages and Case Study

Advantages of Limited Partnerships

  • LPs allow for pass-through taxation for both the limited partner and the general partner.
  • Limited partners are not held personally responsible for the debts and liabilities of the business, although the GP, if an individual, may be personally responsible.
  • The general partner(s) have full control over all business decisions, which can be useful in family situations where ownership – but not control – has been gifted to children.
  • Estate planning strategies can be achieved with LPs.
  • Limited partners are not responsible for the partnership’s debts beyond the amount of their capital contribution or contribution obligation. So, unless they become actively involved, the limited partners are protected.
  • As a general rule, general partners are personally liable for all partnership debts. But as was mentioned above, there is a way to protect the general partner of a limited partnership. To reduce liability exposure, corporations or LLCs are formed to serve as general partners of the limited partnership. In this way, the liability of the general partner is encapsulated in a limited liability entity.
  • Because by definition limited partners may not participate in management, the general partner maintains complete control. In many cases, the general partner will hold only 2% of the partnership interest but will be able to assert 100% control over the partnership. This feature is valuable in estate planning situations where a parent is gifting or has gifted limited partnership interests to his children. Until such family members are old enough or trusted enough to act responsibly, the senior family members may continue to manage the LP even though only a very small general partnership interest is retained.
  • The ability to restrict the transfer of limited or general partnership interests to outside persons is a valuable feature of the limited partnership. Through a written limited partnership agreement, rights of first refusal, prohibited transfers, and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by limited partnerships.
  • Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner which does not hold a lot of assets.
  • The limited partnership provides a great deal of flexibility. A written partnership agreement can be drafted to tailor the business and family planning requirements of any situation. And there are very few statutory requirements that cannot be changed or eliminated through a well-drafted partnership agreement.
  • Limited partnerships, like general partnerships, are flow-through tax entities.

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Case Study:

When a Limited Partnership is Best

Jim is the proud father of three boys. Aaron, Bob, and Chris are active, athletic, and creative boys almost ready to embark upon their own careers. The problem was that they were sometimes too active, too athletic, and too creative.

At the time Jim came to see me, Aaron was seventeen years old and every one of the seemingly unlimited hormones he had was shouting for attention. He loved the girls, the girls loved him, and his social life was frenetic and chaotic.

Bob was sixteen years old and sports were all that mattered. He played sports, watched sports, and lived and breathed sports.

Chris was fifteen years old and the lead guitarist in a heavy metal band. When they practiced in Jim’s garage the neighbors did not confuse them with the Beatles.

Jim has five valuable real estate holdings that he wants to go to the boys. His wife had passed on several years before and he needed to make some estate planning decisions. But given the boys’ energy level and lack of direction he did not want them controlling or managing the real estate.

Jim knew that if he left the assets in his own name, when he died the IRS would take 55% of his estate, which was valued at over $10 million. And while estate taxes were supposed to be gradually eliminated, Jim knew that Congress played politics in this arena and no certainty was guaranteed. Jim had worked too hard, and had paid income taxes once already before buying the properties, to let the IRS’s estate taxes take away half his assets. But again, he could not let his boys have any sort of control over the assets. While the government could squander 55% of his assets, he knew that his boys could easily top that with a 100% effort.

I suggested that Jim place the five real estate holdings into five separate limited partnerships.

I further explained to Jim that the beauty of a limited partnership was that all management control was in the hands of the general partner. The limited partners were not allowed to get involved in the business. Their activity was “limited” to being passive owners.

It was explained that the general partner can own as little as 2% of the limited partnership, with the limited partners owning the other 98% of it, and yet the general partner can have 100% control in how the entity was managed. The limited partners, even though they own 98%, cannot be involved. This was a major and unique difference between the limited partnership and the limited liability company or a corporation. If the boys owned 98% of an LLC or a corporation they could vote out their dad, sell the assets, and have a party for the ages. Not so with a limited partnership.

The limited partnership was perfect for Jim. He could not imagine his boys performing any sort of responsible management. At least not then. And at the same time he wanted to get the assets out of his name so he would not pay a huge estate tax. The limited partnership was the best entity for this. The IRS allows discounts when you use a limited partnership for gifting. So instead of annually gifting $14,000 tax free to each boy he could gift $16,000 or more to each boy. Over a period of years, his limited partnership interest in each of the limited partnerships would be reduced and the boys’ interest would be increased. When Jim passes on, his estate tax will be based only on the amount of interest he had left in each limited partnership. If he lives long enough he can gift away his entire interest in all five limited partnerships.

Except for his general partnership interest. By retaining his 2% general partnership interest, Jim can control the entities until the day he dies. While he is hopeful his boys will straighten out, the limited partnership format allows him total control in the event that does not happen.

Jim also liked my advice that each of the five properties be put into five separate limited partnerships. I explained to him that the strategy today is to segregate assets. If someone gets injured at one property and sues, it is better to only have one property exposed. If all five properties were in the same limited partnership, the person suing could go after all five properties to satisfy his claim. By segregating assets into separate entities the person suing can only go after the one property where they were injured.

Jim liked the control and protections afforded by the limited partnership entity and proceeded to form five of them.

Is a Limited Partnership right for you? Get your free 15-minute consultation today!

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.

LLC vs Corporation

LLC vs Corporation

Which is Best?

Choosing the right entity can be one of the most important decisions a business makes. Business owners and investors may find themselves asking which to pick, LLC vs Corporation. To help make your decision a little easier, we’ve compiled a list of helpful comparisons that will teach you the basic differences among entity types.

Who should use which entity?

LLC

LLCs are great for people who want an entity to hold real estate or other appreciating assets. They are a popular choice for investors and entrepreneurs because of the flexible taxation and great asset protection.

Corporation

C Corporations are great for businesses that sell products, have a storefront and have employees. Businesses that offer services may find the taxes of a C Corp to be too high because of specific tax laws applied to Personal Service Corporations (PSC). It’s also advised not to hold appreciating assets in a C Corp because of the tax treatment of asset sales.

S Corporations are a good choice for people who would like the protection and structure of a corporation, but would be classified as a PSC by the IRS. They are also great for businesses that have significant start-up costs because of their flow-through taxation.

Taxes

LLC

LLCs can choose how to be taxed – either as a disregarded single member entity (where the tax reporting flows directly onto the sole owner’s personal return) or as a multiple member partnership. LLCs can also be taxed as an S Corporation or C Corporation. No other entity has this flexibility.

Corporation

C Corporations

A C Corporation has the widest range of deductions and expenses out of all the various entity types. This is especially true in the case of employee fringe benefits. If you own a C Corporation, you can set up medical reimbursement and other employee benefits and deduct the costs associated with running these programs from your corporate taxes. It’s also worth noting that as a C Corporation you pay an initial rate of 15% on earnings up to $50,000.

While you have access to a wide range of deductions and the ability to set up fringe benefits without taxation, the biggest tax disadvantage of C Corporation is the “double-taxation” issue. Double-taxation can occur when a C Corp has a profit at the end of the year that it would like to distribute to its shareholders. The C Corp has paid taxes on the profit, but once it gets distributed to the shareholders, they also have to declare the dividends they receive on their personal tax returns at their own tax rate.

You may also want to consider an S Corporation if your company’s primary product is services to the public, as you will be taxed as a PSC with an initial rate of 35% instead of the 15%. The IRS does this to stop people from using a corporation to pay less in taxes for what is essentially a salary.

S Corporations

S Corporations are what is called a flow-through entity (similar to an LLC). Unlike a C Corporation, an S Corporation pays no tax on the corporate level. The shareholders only have to pay taxes on the individual level. This can be beneficial in some cases, but shareholders who make a high income from distributions will pay higher taxes. As far as benefits are concerned, S Corps may still write off the cost of benefits, but shareholders who control more than 2% of the entity must pay taxes on the benefits they receive.

S Corporations are commonly used to avoid the PSC tax rate set by the IRS. A corporation is considered to be a Personal Service Corporations (PSC) by the IRS if more than 20% of the corporation’s compensation cost for its activities of performing personal services is for personal services performed by employee-owners and the employee-owner owns 10% or more of the stock. Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.

Since an S Corporation is a flow-through entity and shareholders pay taxes on the individual level, a modest salary with passive income may mean lower taxation. To determine what’s best for you and your business, you should always talk with your CPA or legal advisor.

Shareholders and Owners

LLC

An LLC does not issue shares, but it can have multiple owners (called members) who all share a percentage of the company.

Corporation

C Corporations

C Corporations allow for an unlimited number of shareholders, there is no limitation on who can hold shares and no restrictions on what types of shares can be held (such as preferred vs. common). A C Corp is perfect for a company looking to go public.

S Corporations

S Corporations are a bit more restricting. All shareholders of an S Corp must be Individuals (not entities) and they must be U.S. citizens. The company can only have 100 shares issued, and the shares can only be of one type.

Asset Protection

LLC

A key feature of the LLC is charging order protection. In strong states like Nevada or Wyoming, if the owner of a business gets sued, an attacker can only get a charging order (a lien to the distributions of the LLC). If there are no distributions, the attacker gets nothing. The charging order in most cases is contingent on the entity having at least two owners, but Nevada and Wyoming have protections for the single member LLC.

It should be noted that in some states, like California, Georgia and New York, the court may still order a sale of the businesses assets.

Corporation

A Corporation is an entirely separate and independent legal entity from its owners (or shareholders) and there is a separation between ownership and management. As such, the management and shareholders of a Corporation generally are protected from personal liability for the Corporation’s liabilities and obligations. Although shareholders of a Corporation may be liable for the amount they have invested in the Corporation, their own personal assets usually are protected. This limited liability feature also applies to directors, officers, and employees of a C Corporation.

However, there is an issue in the asset protection of a Corporation. If you own shares in a corporation and are sued personally (i.e. after a car wreck), a judgment creditor can reach your shares in the corporation. If you are the majority owner, the attacker now controls your business by virtue of share control. Nevada is the only state that extends charging order protection (as in an LLC) to corporate shares.

Foreign Investors

LLC

In general, whether you’re a foreign real estate investor or one in the U.S., the limited liability company is the best entity. The LLC is great for both asset protection and has flow-through taxation, and they are affordable to set up and maintain. Since they have flexible taxation, they can be set up for easier taxation management too. Often Canadians will use an LLC taxed as a C Corporation for ease of use, and Australians use them as-is for real estate investment of their retirement monies. It’s always best to consult your accountant about which taxation system would best fit your business.

Corporation

C Corporations

C Corporations are a good to foreign owners for the same reasons stated in the sections above, but It may be more popular with countries that have similar taxation. For example, most Canadians prefer to use a C Corporation because the taxation of a C Corporation most closely resembles that of their home country. When the systems are closely related, it makes them easier to manage.

S Corporations

S Corporations are the only U.S. entity that cannot be used by a foreign investor.

 

Questions?

Determining which entity is right for you can be challenging. You want to ensure that you are getting set up properly right from the start.

If you need help figuring out what entity is right for your business, set up a free 15-minute consultation with an Incorporating Specialist.