LLC Checklist

LLCs are ubiquitous in planning but there are a myriad of tax issues and complications in spite of their common use. Consider:

Not an LLC

LLCs can provide the individual members significant personal protection from liability claims even if they are active in the business. Practitioners should be alert to client investment and other endeavors that remain held in personal name rather than in LLC format. While the advantages of using LLCs over personal holding of many types of business endeavors or investment assets is obvious, many clients still have these held in their personal name. If, in preparing any Schedule C or E, practitioners identify rental real estate, even a small home based business that is not in LLC format, communicate the importance of addressing this to the client. Practitioners might even consider, to protect themselves, putting this recommendation and warning in writing. The fact that a client is a manager of the LLC should not taint this protection. This is quite different than the partnership context. If a limited partnership is formed, the general partner, unless an entity, will have full exposure to claims.

Importantly, and few clients understand this, if a limited partner becomes involved in active management of the partnership he or she will have personal liability.

Check the box

An LLC can opt to be classified under the check-the-box Regulations as either a partnership, an association taxable as a corporation or a disregarded entity. Practitioners should be mindful that these decisions have significant consequences apart from only the income tax issues. While there is a tendency to have LLCs structured as single member disregarded entities to avoid the cost to the client of filing an additional tax return, this will lessen significantly the protection the LLC will provide the client from lawsuits.

If the LLC instead is a multiple member entity, under many state laws that will provide valuable “charging order” protection in that a claimant will only be able to receive the limited economic rights to the members interest in satisfaction of a claim. If instead the client opts to be treated as an association taxable as a corporation in order to elect S corporation status, practitioners should warn the clients, perhaps even in writing, to make certain that their estate plans properly address the S corporation characterization. IRC Sec. 1361(a). Commonly used bypass trusts that are the cornerstone of many estate plans (even with the availability of portability) will not generally qualify to hold S corporation stock unless Electing Small Business Trust (ESBT) or Qualified Subchapter S Trust (QSST) provisions are added.

Certificate

LLCs are formed under state law by filing a certificate with the appropriate state agency. Practitioners should obtain a copy of the filed certificate that reflects the actual date of formation for their permanent files. This certificate will confirm the correct legal name for the entity, the exact date of formation, which is essential for tax compliance purposes. The certificate is usually a short and relatively simple to read document which every practitioner should read. Some certificates might limit the scope of the business the LLC can conduct. That might be significant if the LLC is engaged in an activity that is different than what was initially contemplated. The certificate may also establish whether or not the LLC is member managed or manager managed. If you have someone signing the return as a manager and the certificate says it is member managed (not manager managed) you have an issue to address.

Transferability

LLCs are governed by state law. Most state LLC laws are “default statutes.” If the owners (members) provide for a particular matter in the legal document governing the LLC, the operating agreement, then that operating agreement will govern. If the operating agreement doesn’t exist, or if it exists but is silent on a particular point, then the state law, by default, will govern as to that matter. LLCs should therefore have a governing operating agreement. A critical issue to address in the operating agreement is the transferability of membership interests. Most closely held or family business or investment LLCs are intended to stay within the small closely held group or family. State law should not be relied upon to restrict the transfer of ownership interests and an operating agreement expressly addressing this vital point should exist and be signed. The only way for practitioners to know for certain is to have a copy of the current operating agreement in their permanent file.

K-1s

LLC operating agreements will specify who owns what interests. However simplistic and obvious it sounds, it is not uncommon for practitioners to file Forms 1065 and issuing K-1s with percentages that differ from the operating agreement. Every practitioner filing a return for any LLC should have a copy of the operating agreement and as a routine part of each year’s tax preparation confirm that the ownership percentage is identical to that reported on the return. In addition, some attorneys issue membership interest certificates for LLCs. These are analogous to stock certificates. Practitioners should make certain every tax filing that the ownership percentages are identical for all three sources: certificates, operating agreement and K-1s.

State of Formation

LLCs are almost always formed in the state where the client resides and the practitioner practices, but this is not always the case nor always advisable. As estate planning has become sophisticated, more and more clients are setting up trusts in states like Alaska, Delaware, Nevada and South Dakota to achieve better tax and asset protection results. These trusts are no longer the purview of only the super-wealthy and are really appropriate for many clients. If a client has a trust in one of those states and that trust owns interests in an LLC for which you are arranging an income tax return, there may be significant advantages to the client of having that LLC authorized to do business in the state where the trust was formed, or preferably, organized from inception in that state and then authorized to do business in the state where the client resides (or where, for example, real estate or a business interest is located). Practitioners should be alert to filing requirements in these other states. If a practitioner notes that an LLC is owned in part or all by such a trust and is not authorized to do business in the state where the trust-member is located, bring it to the attention of the client or the client’s attorney.

Tax Rate Differentials

When planning for new entities practitioners should consider the possible impact of the new 3.8% Medicare tax on passive investment income that is to become law in 2013. IRC Sec. 1411.

Investment income includes gross income from interest, dividends, annuities, rents and royalties and net capital gains. This tax is imposed on net investment income or modified adjusted gross income (MAGI) over $250,000 ($125,000 for married filing separate, and $200,000 for single taxpayers). For LLCs, if the member in question is not a material participant as defined under the passive loss limitation rules under IRC Sec. 469), the LLC income would be deemed passive income to that member. There is also the possibility of higher marginal income tax rates on wealthy taxpayers. While LLCs as a pass through entity have enjoyed an income tax advantage over the corporate form, this may not continue to hold true in all cases. However, before considering a change in format, practitioners should carefully weigh the advantages of flexibility, simplicity and asset protection (see comments on charging order protection above) which LLCs afford clients. Also, the tax pendulum has swung back and forth several times and it may continue to do so in later years.

Conversion of Corporation to LLC

LLCs offer many advantages over corporate form and some clients that still hold assets or business operations in corporate format might wish to convert to an LLC. However, to do so would require the liquidation of the corporation. This could be achieved mechanically as follows: (1) The corporation forms an LLC; (2) The corporation contributes all of its assets, subject to any of its liabilities to the LLC in exchange for LLC membership interests; (3) The corporation liquidates distributing the only asset it holds, LLC membership interests to its shareholders. Many state laws will permit the filing of a certificate to accomplish this conversion process without the formal transfer of title to assets to the LLC from the corporation. The tax cost on liquidation and distribution may be prohibitive. An S corporation would face a similar tax. IRC Sec. 1371(a). But in an S corporation the gain recognized flows through to the individual shareholders who can increase their basis in their S corporation stock. IRC Sec. 1367. Because of these potential issues practitioners will sometimes use an approach known by various names like “the withering vine.” In this arrangement a new LLC is formed and new business is conducted in the new LLC. Meanwhile business in the old corporation is allowed to wither and eventually disappear. Practitioners should exercise caution in this type of plan. The IRS and even claimants may assert that the corporation actually transferred its goodwill to its shareholders who then in turn transferred the goodwill to the new LLC. This would effectively reconstruct the transaction to the approach described above with a commensurate tax result.

Conversion of Partnership to LLC

It can be advantageous to convert an existing partnership to an LLC to achieve the better liability protection an LLC offers. For example a general partner if not an entity has unlimited personal liability. Also if the partnership is a limited liability partnership it may expose members to unlimited contractual liability (e.g., on a lease). The partnership could liquidate distributing its assets into the new LLC. This could constitute a termination of the partnership. IRC Sec. 708(b). However, it appears that the IRS will treat the contribution of assets by the partnership to the LLC as tax free. IRC Sec. 721. See generally Rev. Rul. 84-52, 1984-1 C.B. 157, Rev. Rule 95-37, 1995-1 C.B. 130. If this approach is used then the partnership should not be treated as terminated, and no liquidation should be deemed to have occurred. Instead, the LLC could be treated as a continuation of the partnership.

Another approach can be achieved mechanically as follows: (1) The partnership forms an LLC; (2) The partnership contributes all of its assets, subject to any of its liabilities to the LLC in exchange for LLC membership interests; (3) The partnership liquidates distributing the only asset it holds, LLC membership interests to its partners. The costs involved in this conversion process probably will have to be capitalized and will not qualify for amortization under Code Section 709. INDOPCO v. Comr., 112 S. Ct. 1039 (1992).