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Excerpt from:

IS AN LLC RIGHT FOR YOU?

These program materials are intended to be used in conjunction with the NBI seminar entitled 'Is an LLC Right for You?' This seminar is designed and intended to provide an overview of some of the basic issues which may arise. This manual and the related materials are not intended as a substitute or to replace the independent attorney's research, analysis, and assistance. If legal advice or other expert assistance is required for specific circumstances, the services of an independent attorney should be retained.

Course Materials

II. ADVANTAGEOUS USES OF LLCS

C. The LLC as a Valuation "Freeze" Entity

•· Traditional mechanism was recapitalization

•· IRC Section 2701 - 2704 severely restricts freeze if:

1. Intrafamily transfers

2. Subordinate equity interest

3. "Frozen" senior interest with rights retained by transferor

Applicable code sections:

IRC Section 2701 - Transfers of interest in partnerships,

corporations and limited liability companies

IRC Section 2702 - Transfers of interest in trust

IRC Section 2703 - Options or buy-sell agreements

IRC Section 2704 - Certain lapsing rights and restrictions

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D. The LLC as an Estate Planning Vehicle

•· Flexibility of ownership, management and operation

•· All members of LLC enjoy limited liability

•· Freezes the value of business interests for estate tax purposes

•· Owners retain control over management and operations of business

•· Control of business passes to children free of transferal or state tax upon death of parents

•· No limit on classes of membership

•· No restrictions on type of entity that may hold membership interest

•· May reduce estate, gift and transfer taxes (Revenue Ruling 93-12, 1993-1CB 202)

•· May provide lower overall tax cost

•· Provides greater flexibility than subchapter S corporation

•· Unlimited class of stock

•· May make special allocations of income, losses, deductions and credits (Treasury Regulation Section 1.704-1(b)(2)(ii)(a))

•· May obtain step-up in basis upon transfer of Member's interest and/or upon death of member (IRC Sections 743, 754 and 1014)

•· Election to obtain step-up in basis upon transfer of interest

•· Only appreciation arising after death tax value is taxed

•· Transfer of LLC interest not limited to donor's estate (IRS Section 2036(b))

•· Disadvantage of LLC for estate planning is application of gross receipts fee. Delaware LLC eliminates much greater fiduciary duties than California (Delaware 6 Code Sections 108-108; 1101(b))

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E. The LLC as Vehicle to Hold Life Insurance Policies

•· Premiums may be provided in exchange for member interests or as contribution

•· Cross-purchase approach for buy-sell agreement advantageous because insurance proceeds not included in valuation of primary entity

•· Members/owners receive step-up in basis equal to amount paid

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III. TAX ADVANTAGES AND CONSIDERATIONS OF LLC

A. Taxation as Partnerships vs. Taxation as Corporation

1. Taxation as a Corporation

•· Does not apply to single member LLC's (Treasury Regulation Section 301.7701-3(b)(1))

•· Foreign members may be required to withhold taxes at higher marginal rate (IRC Section 1446)

•· Businesses distributing virtually all profits as salaries or other compensation may enjoy lower marginal tax rate

•· May have greater ability to deduct certain employee benefits, such as accident and health insurance and cafeteria plans

•· Income not taxed until distribution actually made

•· Income earned is subject to corporate level tax (IRC Sections 1361-1379; IRS Form 2553)

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2. Taxation as a Partnership

•· May make disproportionate or special allocations of income and deductions (IRC, Subchapter K)

•· No gain or loss on midstream contribution (IRC Sections 351(a) and 721(a))

•· Non-recognition of income upon distributions of appreciated property (IRC

Sections 331, 336, 731(a))

•· Application of IRC Section 743(b) to step up inside basis for benefit of remaining partners (IRC Sections 734(b) and 754)

•· Step-up in inside basis for the benefit of transferee (IRC Sections 743(b) and 754)

•· Inclusion of entity liabilities in basis (IRC Sections 705, 722, 752 and 1366(b)(1)(B))

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3. Disadvantages of Taxation as a Partnership

•· Unexpected income arising from sale of partnership interest (IRC Sections 741, 751 and 752(b))

•· Deemed partnership termination upon sale or exchange of fifty percent or more of partnership interests (IRC Section 708(b)(1)(B))

•· Unexpected basis adjustment upon contribution of encumbered property (IRC

Section 752(b))

•· Adverse tax consequences relating to partnership payments of partner health

and disability insurance premiums

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4. Tax Advantages of LLC's Over Other Entity Choices

•· Ability to select a predetermined to desired tax treatment

•· Provide for tax-free contributions of property in exchange for an interest in the

company

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5. Election Out of Partnership Status

•· LLC may be taxed as a corporation by filing an election within first 75 days of its taxable year (Regulations Sections 301.77-3(c)(1)(ii), 301.7707-3(c)(1)(iii),

307.7701-3(c)(1)(iv) and 301.7701-3(h))

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6. LLC's Flexibility in Allocations of Income and Expense Items

•· Applicable to LLC's that have elected to be taxed as a partnership (IRC, Subchapter K, IRC Sections 702)(a) and 706(a))

•· Ability to specially allocate tax items such as income and loss (IRC Section 704(b) and Treasury Regulations Section 1.704-1(b)(1)(i))

•· Property contributed by member to LLC must account for differences between basis of property contributed to LLC and property's value at time of contribution (IRC Section 704(c))

•· Special rules apply to membership interest created by gift to allocation of LLC income between donor and donee (IRC Section 704(e)(2))

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7. Safe Harbor Provisions

•· LLC Operating Agreement must satisfy basic requirements for economic effect (IRC Section 704(b) and Treasury Regulations Section 1.704-2(e)(1))

•· In year that nonrecourse deductions first arise, allocations must be reasonably consistent with valid allocations of other LLC items (Treasury Regulation 1.704-2(e)(2))

•· LLC Operating Agreement must contain "minimum charge back" provisions (Treasury Relations Sections 1.704-2(f)(c) and 1.704-2(e)(3))

•· All other material allocations and capital account adjustments must be valid (IRC Sections 704(b)(c); Treasury Regulations Section 1.704-2(e)(4))

•· Inclusion in Operating Agreement that:

a) LLC will maintain capital accounts for its members in strict compliance with tax rules

b) Partnership will make liquidating distributions in accordance with capital accounts

c) Partners in liquidation who have deficits in their capital accounts will restore those deficits to the LLC

d) LLC will make minimum charge backs with respect to their interest in LLC nonrecourse debt

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E. Self Employment Taxes

•· Amounts paid to members of corporate LLC may be deductible as salary (Treasury Regulations Section 1.162-8)

•· Amounts paid to members of partnership LLC may be treated as net earnings from self-employment, salary or wages, or distributable share of partnership income (IRC, Subchapter K)

•· A member's distributive share of LLC income is self-employment income, unless member is limited partner (Regulations Section 1.1402(a)-2(d); IRC Section 1402(a)(13))

Exceptions:

a) If activities of LLC involved services in the fields of health, law,

engineering, architecture, accounting, actuarial science or

consulting, individual who provided services would not be

treated as limited partner (Proposed Regulations Sections

1.1402(a)-2(h)(5); 1.1402(a-2(h)(6)(iii))

b) A member that holds more than one class of interests of the

LLC could be treated as a limited partner (Pro. Regulations

1.1402(a)-2(h)(3); 1.1402(a)-2(h)(6)(iv))

c) A member owning only one class of partnership interest who is

disqualified as a limited partner (Prop. Regulations Section

1.1402(a)-2(h)(4))

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F. Federal "Check-the-Box" Regulations

•· Allows unincorporated entities to choose to be taxed as either partnership, sole proprietorship, or corporation (Regulations Sections 301.7707-1 -3017701-3)

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G. State and Local Tax Issues

•· Gross receipts fee is single greatest disadvantage for use of California LLC

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1. California Tax

•· Conforms with federal law with respect to income taxation of partnership (California Revenue and Taxation Code Sections 17851, 17851.5)

•· Imposes taxes and fees on LLC's at the entity level, with an annual franchise tax of $800 and a statutory fee for any year in which total income is $250,000 or more (California Revenue and Taxation Code Sections 17941(a)-(b), 23153(d)(1))

•· "Total income" for purposes of gross receipts fee refers to income from outside California as well as within, and income of members of the LLC's "commonly controlled group" (Revenue and Taxation Code Sections 25100 and 25105(b))

•· Gross receipts fee for annual gross receipts amounting to $250,000 or more are:

a) $900 for annual total income of $250,000 to $499,999

b) $2,500 for annual total income of $500,000 to $999,999

c) $6,000 for annual total income of $1,000,000 to $4,999,999

d) $11,790 for annual total income of $5,000,000 or more

(Revenue and Taxation Code Section 17942(a))

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2. Nonresident Member's Tax

•· Nonresident member who fails to consent to California tax jurisdiction must pay tax attributable to nonconsenting member's distributive share of LLC income (Revenue and Taxation Code Section 18633.5(e))

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3. Recent Developments

•· Constitutionality of California Annual Gross Receipts Fee is being challenged by Northwest Energetic Services, a Washington State LLC

•· LLC's registered to do business must currently pay annual fee based upon worldwide income, not just California-source income (Revenue and Taxation Code Section 17942)

•· Protective claim should be filed if LLC has income or receipts from outside California or if LLC paid increased annual fee because California source income was less than all sources of income

•· Franchise Tax Board has dedicated fax number (916-845-9796) and mailing address (P.O. Box 942867, Sacramento, CA, 94267-8888) for filing protective claims pursuant to Northwest decision, and also accepts FTB Form 568 if filing claim letter

•· Foreign LLC's with a California resident manager that transacts business in California must register with California Secretary of State or face penalties of $20 for each day of unregistered activity in California, are unable to bring or defend a lawsuit in California, and are taxed as a general partnership and unlimited liability for all members for acts committed in California (Corp. Code Sections 1700(ap) and 17456)

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IV. COMPLIANCE UNDER STATE AND FEDERAL LAW

D. Property Transfers

1. Property Taxes

•· Transfer of real property to an LLC constitutes change in ownership triggering reassessment for California property tax purposes unless designated exception available (Revenue and Taxation Code Sections 60-62)

•· Most common exceptions are if:

(a) Transfer of real property is between separate legal entities or

between an individual to a legal entity

(b) Transfer results solely in a change in title

(c) Proportional interest in the ownership of property remains the

same after transfer

(Revenue and Taxation Code Section 62(a)(2) and 18 California Code of Regulations Section 462.180)

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2. Documentary Transfer Tax

•· Cities and counties may impose tax on each deed or other instrument transferring real property (Revenue and Taxation Code Sections 11901-11934)

•· Documentary transfer tax will not propose on a transfer of real property when transfer is between one or more individuals and a legal entity, provided the transfer results solely in a change of holding title to the real property and the proportional ownership interest in the real property and in the entity by the same immediately after transfer (Revenue & Taxation Code Section 11925(d))

•· County tax rate is $1.10 per $1,000 (.11%) excluding amount of any note secured by deed of trust

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3. Sales and Use Taxes

•· Transfer of substantially all property of a business is exempt from sales and use tax if real or ultimate ownership of properties is substantially similar before and after transfer (Revenue & Taxation Code Sections 6006.5(b) and 6367)

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E. Dissolution and Winding Up

1. Statutory Dissolution Events

•· Provides that an LLC is dissolved and its affairs wound up upon occurrence of one of the following (Corporations Code Section 17350):

a) At the time specified in the Articles (Corp. Code Sections 17051(c)(3),

17350(a))

b) On event specified in the Articles or Operating Agreement (Corp. Code

Section 17350(a))

c) By majority vote (Corp. Code Sections 17350(a) and 17005(b)(3))

d) On decree of judicial dissolution (Corp. Code Sections 17351 -

17351(a)(3); 17350(c))

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2. Effect of Dissolution

•· On agreements, an LLC's dissolution will have no effect upon the validating of existing agreements or on its obligation to perform them (Corp. Code Section 17354(a))

•· On creditors, obligations of an LLC to its creditors are unchanged by dissolution (Corp. Code Sections 17352(b) and 17354(b))

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3. Continuation after Dissolution

•· A Certificate of Dissolution may be retroactively voided even after it has been filed and must state that one of the following circumstances has occurred (Corp. Code Section 17357):

a) Remaining members have unanimously voted to continue business

b) Dissolution was made under Corporations Code Section 17350(b) and

each member who consented to dissolution has agreed in writing to

revoke their vote agreeing to the dissolution

c) The LLC was not, in fact, dissolved

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4. Winding Up of LLC

•· Once dissolution occurs, managers or members are obligated to file a Certificate of Dissolution (Corp. Code Section 17356(a)(1))

•· In the event of a dispute, if judicial supervision is necessary, the court will designate the individual responsible for winding up (Corp. Code Section 17352(b))

•· Individual in charge of winding up must:

a) File Certificate of Dissolution (Corp. Code Section 17356(a))

b) Obtain Tax Clearance Certificate

c) Send written notice of winding up by mail to all known creditors

and claimants who appear on the records of business (Corp.

Code Section 17352(a))

d) Ensure that all LLC debts have been paid or adequately

provided for (Corp. Code Section 17353(c))

e) A statement of tax liability assumption for the dissolved LLC

must be submitted when Certificate of Dissolution is filed (Corp.

Code Section 17356(b)(2)(B))

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5. Filing Certificate of Cancellation

•· A certificate of cancellation must be filed when winding up is completed (Corp. Code Section 173565(b)(1))

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F. SINGLE-MEMBER LLC'S

•· An LLC with one member may elect to have LLC taxed as corporation (Reg. Section 301.7701-3(b)(1))

•· If no election is filed and member is an individual, LLC is taxed as sole proprietorship

•· If LLC owned by corporation, is treated as a division of parent corporation and income or loss is reported on tax return of corporate parent

•· Classification of LLC is not affected by any change in the number of members of the entity (Reg. Section 301.7701-3(f)(1))

•· Treatment of single-member LLC membership interest issued to husband and wife in community property states such as California characterize the LLC has having either one member or two, with single-member LLC disregarded for federal income tax purposes, and two-member LLC treated as a partnership (Revenue Procedures 2202-69 and 2002-2 CB 831)

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G. FOREIGN LLCS

•· If LLC has two or more members and one member is personally liable for all debts, LLC is classified as a partnership (Regulations Section 301.7707-3(b)(2)(i)(A))

•· If all LLC members have limited liability, then LLC is classified as a corporation (Regulations Section 301.7701-3(b)(2)(i)(B))

•· If foreign LLC has a single member, then classified as a sole proprietorship (Regulations Section 301.7701-3(b)(2)(i)(C))

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