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An LLC is a legal entity recognized by the state government to protect your personal assets in a lawsuit and provide a professional structure for your business. There are a number of advantages to setting up a limited liability company ("LLC"). While every situation is different, there are advantages for owners of a closely-held business, including real estate agents and brokerages and for owners of commercial and residential investment property as well.
Some of these benefits include personal asset protection, a single layer of tax, and flexibility in choosing a tax structure since you can choose how you want to be taxed by the taxing authorities. There are limitations on resident aliens with regard to certain tax structure elections. The LLC is inexpensive to operate and requires little knowledge and time to manage since it is the most similar to the way a person operates a business without an entity (i.e., sole proprietorship). In addition, a LLC can be used in your estate planning as a means of transferring and preserving business wealth to the next generation. The estate planning perspectives of having a LLC are not discussed within this Article.
LLCs came on the horizon about seventeen years ago from the West Coast. They were created by lawyers for lawyers. Corporations, on the other hand, have been around for over 200 years. Corporations have a long lineage of court decisions to support what will happen if a corporation or the owners are sued. Albeit the short legal life of the LLC, they have been very protective of their members personal assets since its inception. Given the number of lawsuits that have been filed against the members, partners, or owners and the court cases report that the LLC’s protected them personally and their personal property.
The average American is involved in seven lawsuits during their lifetime. In our litigious society, landlords are susceptible to lawsuits by tenants living in their properties or their visitors or contractors. If someone falls down on your property while living in your property, and you fail to repair your property timely or to warn the tenants or their visitors regarding problems (e.g., slippery floors/walks), your personal assets are protected.
Rather than subjecting your personal assets to a court judgment; the maximum amount you could lose in a court case is the equity in your property or business entity. One important condition to secure this protection is that you treat your transactions with the LLC at arms-length, and do not treat the LLC as your alter ego (e.g., do not have the entity pay for your hair cuts or pedicures), then a judge will not penetrate the walls of your entity and go after your personal assets. The conclusions herein are assuming that you are not conducting any type of fraud or other tortuous conduct.
If you own a business or rental property, then you have what is called a point of exposure to liability because of the business operation. People who do not have a business can have a point of exposure to non-business liability but these issues are not addressed within this Article.
If a plaintiff sues you and you do not have an entity or walls around your business, then a potential plaintiff can go through the lines surrounding the parameters of your business and get your personal assets, if the plaintiff prevailed in a lawsuit against you.
Lawsuit without an entity – everything is on the table
If a plaintiff sues you and you have the walls up around your LLC business, if the plaintiff prevails against you in a lawsuit, the only assets that the plaintiff can get is the equity in business assets belonging to the entity. Where real estate is concerned, the potential plaintiff can get the equity in the investment property owned by the LLC.
Lawsuit with an entity – the business is walled off or sealed from your personal assets and the potential plaintiff is limited to assets within the LLC if you have conducted the business with it at arms length.
Tax Issues: LLCs versus regular "C" Corporations and "S" Election
Generally, LLCs are taxed as a partnership with income distributed and reported on your individual income tax return. Under certain circumstances, if the income generated by the LLC is from a business operation (e.g., a business that generates a stream of computer product sales) rather than a real estate investment, it may be advantageous to set up a "C" corporation (i.e., a regular corporation which files a Form 1120) and elect for the LLC to be taxed as a corporation rather than as a partnership. Once an election is made to be taxed as a Corporation, US citizen shareholders may make another election to have the corporate LLC be taxed on its income as an "S" corporation where net income flows through to the individual return rather than on a Form 1120S, under an LLC, for Corporations. Legally the entity is a "C" corporation, but for federal and state income taxes, it is taxed as an "S" corporation. The "S" corporation is another type of flow-through or pass-through entity that is required to file an information return. The income from the "S" corporation flows or passes through to the individual owners or shareholders in the same way the owners or members of the LLC have the income flow or pass through to the individual owners or members and both are reported on the individual income tax return or Form 1040. This type of income tax reporting produces a single layer of tax rather than a double layer of taxation.
Rental income from your real estate interests can be taxed at your individual tax rate. If a single person owns the entity, then the entity can be "disregarded" and the income is reported on Schedule E (Schedule C depending on the type of business activity) as part of your Form 1040 on your individual income tax return.
If you hold your rental property as a partner in a partnership, the partnership reports its income and expenses on an information return called a Form 1065 and your share of the profit or loss is reported on your individual income tax return on Schedule E via a Form K-1 once the partnership information return is completed, which is distributed by the LLC after reporting its net income.
Generally, married couples are required to file an information return for their investment properties, if the property is jointly owned. However, after a recent change in the federal income tax rules and depending on your state property rules, couples can elect to file their jointly owned real estate rental or business income on their individual income tax on Schedule E. Many, however, choose to file the information return or Form 1065 to keep the business information separate from their individual taxes.
If you have a multi-member business with several members (i.e., more than one member) other than a married couple, you must use the Form 1065 to compute your share of the taxable income from the business. However, you must file an information return to report the partnership activities each year.
All income passes out to the individual partners whether you receive the money from the LLC or not. In other words, a pass-through entity passes all of its income and expenses out to its members or partners each year and the individual members or partners are taxed on the net income or loss on their individual income tax return.
Annual or Bi-Annual State Filing or Charter Fees
In most jurisdictions, LLC members need to pay a filing fee or charter fee each year for the privilege of having the entity in existence. For example, each year Maryland charges Three Hundred Dollars ($300.00) filing fee for those entities in existence on January of a given year. Business trusts are not required to pay the filing fee at this point. Virginia assesses a Fifty Dollars ($50.00) annual filing fee per year while California charges Eight Hundred Dollars ($800.00) a year for its annual fee for LLCs. If you fail to pay these filing or charter fees, then the State or Commonwealth can revoke your charter (i.e., forfeit your business charter and your business entity will no longer exist). These fees change so such rates refer to the rate in effect per year. The District of Columbia requires a form to be filed every other year so there are differences between the jurisdictions. Generally, the State jurisdiction will send out the assessments to make sure you have updated your business address and paid their fees. If you don't pay the assessment, you will loose the protection of your LLC or business entity.
Deduction of passive losses produced from owning real estate
There are different types of income: investment, active income, or passive income. Except for certain real estate-related businesses (discussed herein below), income from real estate rentals is considered passive rather than active income. Generally, passive losses can only offset passive income and cannot be used to offset active income (e.g., salary) or portfolio income (e.g., interest income). However, if your modified adjusted gross income is less than $100,000, then you are allowed to use losses of up to $25,000 to offset your active income, if you have "materially participated" in the management of the real estate property. However, if your modified adjusted gross income is between $100,000 and $150,000, then you can use a reduced amount of the loss limitation amount to offset your income (e.g., between $25,000 and $0 in losses). If your modified adjusted gross income is more than $150,000, then you cannot use any loses.
If you are a Realtor, you can use more of the investment losses, usually resulting from depreciation of your investment properties. If you are a real estate agent ("Agent"), a LLC can provide pass-through of losses in excess of passive income. The IRS tax code has carved out an exception allowing real estate professionals to offset up to Twenty-Five Thousand Dollars ($25,000) of active (e.g., salary) or investment income with losses generated in real estate rentals where the owner actively participates. Agents with modified adjusted gross income of One Hundred Fifty Thousand Dollars ($150,000) or more will not be able to offset their active or investment income with the rental activity loss unless the real estate agent works more than seven hundred fifty (750) hours during the year in real estate-related businesses in which you materially participate. The tax law also allows such deductions where a majority of the time and money is derived [more than eighty (80%) of the personal services performed during the year are performed in real estate trades or businesses] from businesses in the real estate industry.
It is advisable to have a LLC rather than a corporation when dealing with commercial or residential real estate. Yet, it is advisable to have a Corporation to operate or handle businesses with other types or streams of income. Corporation have other benefits to their establishment such as being able to deduct keyman life insurance policy premiums that can not be deducted from pass-through entities but these corporate gems are not discussed within this Article.
Ease of Operation and Management
Most people prefer the LLC because it the most similar to the way a person operates business individually as a sole proprietorship. While every business should have its own employer identification number ("EIN") and its own bank account. Establishing a separate bank account is one of the ways to help establish the entity as not being used as your alter ego.
People always ask me, "How much money can I take out of my business?" Well if you have a LLC, you could take one hundred (100%) percent of the income out of the business bank account and transfer it to your personal bank account. It is wise, however, to operate through the entity for all business transactions. In other words, you probably want to leave enough money in the entity to pay for its expenses (e.g., mortgage payments, rent, and repairs).
What most professional fail to tell their Clients
People forget or are not properly instructed by their professionals to have all client and customer contracts in the name of their LLC rather than their personal names. All repairs, remodeling, contractor contracts, etc should be in the name of the entity and not in your personal name. Once you open your entity’s bank account, you should pay all bills and expenses, including mortgages, directly out of the LLC. Make sure all leases are in the name of your LLC and not in your personal name. Make sure that you do all your personal business outside the LLC in your personal bank accounts and not in the business bank account. Since you can transfer all the business income to your personal account, owners should not do any personal business in the business bank account. To the contrary, if the LLC needs money, you can loan it the money or contribute money to it so that you can give the contractor a LLC check as payment rather than giving out a personal check. Make sure you keep all your records and receipts for the LLC if the Internal Revenue Service needs to see proof of payment.
Real estate agents and brokers should protect their real estate business
If you are a real estate sales person, you should sign a contract with your broker in the name of your LLC and not have the broker pay you in your personal name. Once the paperwork is signed, the broker can pay your commissions directly to your LLC. Real estate agents can register the name of their LLC on the real estate agent license (the same is true for real estate brokerage firms) rather than have their real estate or broker’s license in their personal name.
Compare to the "C" Corporation
Assuming you have a business that sells patented products, it is probably best to place this stream of business income and its activities in a "C" Corporation (a regular "C" corporation). If the business activity has to conduct real estate activities, you would be best served with a LLC. If you and your tax professional decide it is best to have a "C" Corporation, then you can elect to be taxed as an S Corporation for federal and state taxation purposes. Please note, assuming all the members are American citizens, LLC members can also elect to have their entity taxed as corporation and then elect to be taxed as S Corporation (which means that there is a single layer of taxation at the individual level).
If you set up a "C" or "S" corporation, you will not be able to take all the money out of the corporation with paying out such moneys as wages or bonuses paid to you unless the corporation loans money to you as a shareholder. Borrowed moneys have to be repaid with interest imputed at the federal rate of interest. C or S corporations are required to withhold moneys on wages but the corporation does not have to pay the self employment taxes. These taxes are shared by the corporation and the individual rather than being paid wholly by the individual as when a LLC pays out its income which triggers self employment taxes at the individual level.
Corporations have other requirements such as keeping minutes and resolutions on every major business decision it makes and conducting annual meetings. It is very important that you keep these records but if you have failed to keep them up to date you can always go back and reconstruct them. The IRS, as well as the shareholders, has the right to inspect these records and make sure that they are accurate and up to date. LLCs do not have to make resolutions or minutes except for extraordinary issues such as a sale of the entity or name changes.
Because members of an LLC are treated as self-employed, members are not required to pay federal unemployment or state unemployment taxes ("FUTA" and "SUTA") on payroll withholdings, distributions or guaranteed payments. One caveat to this statement is if the LLC has elected to be taxed as a corporation rather than as a partnership, then FUTA and SUTA taxes would be required. Payroll withholdings, FUTA, and SUTA taxes are required on all other employees of the LLC.
Another important tax issue that warrants notice about the LLC taxed as a partnership is if you have employees (other than the partners or members themselves), and if the Company goes bankrupt and there are unpaid payroll taxes the Internal Revenue Service can go through the entity directly to the partners or members for the payment of the payroll taxes. Another resolution is to always pay your employee payroll taxes when they are due. This is not the case for a Corporation. However, there can be a one hundred percent (100%) officer’s liability under the tax code for failure to pay the payroll taxes where an officer has the right to make the decision to pay or not to pay and there are unpaid payroll taxes.
Also, keep in mind that all moneys earned by the LLC flow-through or pass-through to the members or partners and require the payment of self employment taxes for the LLC income on the members or partners individual tax return.
In addition, certain tax attributes (e.g., charitable contributions and keyman insurance) pass through directly to the partners or members on the K-1 form at the end of the year for deduction on the partners or members individual tax returns rather than filtering through the net income of the LLC.
Benefits Provided through the LLC
Consider using your business entity as a means of providing certain tax benefits or so-called employee benefits such as retirement plans, medical or keyman insurance or medical reimbursement plan expense reimbursements for the members or partners. Whereas a regular "C" corporation can deduct these expenses before calculating its taxable income right on their corporate tax return, the LLC members or partners deduct these expenses on their individual income tax return. If you are interested in enrolling in any of these employee benefit plans, Ms. Arnett can give you the name of several insurance and medical reimbursement plan professionals that set up these benefit plans. Ms. Arnett or your tax professional can explain further the full details of these employee benefit plans.
Another benefit provided by establishing an entity with its own EIN, is the creation of a separate entity credit profile. Once you have the EIN, it takes about two (2) years to establish a new business credit profile. Banks generally will require new business owners to co-sign or sign as a surety for the new business during the first two (2) years. The bank will usually require your personal assets to back the loan when they grant the business loans until the business has sufficient assets and earnings records to support its own debt.
Business owners should also remember to get a DUNS number. A DUNS number refers to the number you receive when you register with Dun and Bradstreet ("D&B"), an agency that rate business credit. Similar to they way Experian and Equifax rate your personal credit, D&B rate business credit. If your business has a loan, you are automatically rated by D&B. It is hard for a small business to get a really high rating unless your small business has a lot of assets. A "B" rating is normal for a small business with limited assets.
Business and Tax Succession Strategies
Most people work hard to establish their business. You are the driving force and inspiration behind your business, so what happens to your business is important. Most owners want their business to continue to thrive when they are no longer a part of it, whether it's in the hands of family members or a new owner. Thus, it is not only necessary to have a strategy to continue to develop and grow your business, but it is important to have a succession plan to secure the future of your business. A succession plan is a strategy which determines the best way for you to exit your business while ensuring the business continues. The plan determines who will take the leadership and or ownership of the business when you leave. There are two option to consider when developing a succession plan. One approach is to keep the business in the family or to sell your business interests either before or after you leave the business. If you want to keep a family in the business, then you need to consider the legal and tax obligations as well as the impact on family relationships, if any. Alternatively, you can consider selling minority shares to employees or others outside the business. If you sell interests to others, then you should consider the use of by-sell agreement for a corporation with shareholders/stockholders or through the use of a operating agreement if you have a partnership. Even if a business person is not considering the future, a business and succession plan will ensure the profitability of the business in its current condition. It is good to have a plan to maximize the value of the business and review it annually, including budgeting issues. A valuation of the business is essential to this process to know what the business is worth during the time of planning and at the time of a business interest change triggering event. These agreement ensure the smooth transition of a business after a potentially disruptive event, such as an owner's retirement, incapacity or death. Without such a plan, the future of the business is left to chance. Planning allows the maximization of profitability and lays a foundation for continued success. The plan you develop and the level of detail will depend you and your preferences. Among other things your plan, business and succession plan, will depend on your objectives, family situation, financial position, health, age and the ages of potential heirs. A plan should be realistic, workable and developed with input from individuals or groups with an interest or share in the business. You should speak with your business and tax advisors such as your lawyer, accountant and financial advisors. It is best if all of these professionals work together with you in establishing your plan. The plan should integrate with your estate plan and be updated if there are changes. You will want to break the tasks down and work on them separately, but concomitantly. You will need a time table for completion and schedule key milestones along the way to keep you and or your successors on track towards completion and later transition.
In addition, an owner should consider placing real estate investments in a family limited partnership. Depending on your specific situation, this may provide a better wealth transfer vehicle than through the estate process. Another consideration is the sale of a family business to the next generation outright or through the use of a Trust (IDGT).
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Asset Protection and Business Strategies