In order to preserve the advantages of doing business as a Limited Liability Company, and to comply with the applicable laws in the course of conducting the LLC’s business, there are certain fundamental policies and procedures that must be established and followed. Members must read and observe these policies and procedures to protect the benefits of LLC planning.
The Limited Liability Company (LLC) is a legal entity or “person,” separate from its members, managers, any officers, and employees. One advantage of doing business in the LLC entity form is to prevent LLC obligations from becoming the obligations of its limited members, managers, officers, and employees. To accomplish this goal, it is essential that the separate existence of the LLC be recognized and respected.
Any business done by the LLC should be conducted in the LLCs name to preserve its status as a legal person. Business should not be conducted by the individuals involved in their individual capacity, but only in their business capacity, such as “Member.”
It is important that receipts and disbursements flow through the correct entities. For example, if rent is received by the LLC from a property owned by the LLC, the rent should be deposited in the LLC’s account. Business transactions must always be done through business, not personal, accounts.
Learn about forming a Wyoming LLC here.
If management fees are payable to a Manager or Member, the LLC should write a check from the LLC account to that party. That party should deposit the check into its bank account, and then if it is an entity, write checks to the managers, officers, or Trustees for management fees. Distribution checks should be written to the members (whether trusts, entities, or individuals) as distributions are made. Creating this “paper trail” makes it difficult for anyone to argue that there was no business purpose when in fact the LLC was managed like a business. On the other hand, if this is not done, it can be argued that there was no business purpose, and that the LLC should be disregarded as a separate legal entity.
State law decrees that certain written records must be kept and maintained at the principal or registered office of the LLC. Any member or assignee may make a request of LLC information at any reasonable time and make copies free of charge.
The records must be in written form or able to be reduced to written form. The required records generally include:
A current list that:
States the name of and current address of each Member; and
States the percentage owned by each member; and
States the names of the members of each class or group when two or more types of LLC interest are created.
Copies of the Limited Liability Company’s federal, state, and local tax returns for the most recent six tax years must be kept.
Copies of the LLC agreement, Articles or Certificate of Limited Liability Company, all amendments, restatements, copies of any powers of attorney, and any documents that create classes or groups of members must be kept.
A written statement of the following must be kept:
Cash contributions and agreed value of any other property contributed that the members have agreed to make in the future; and
The time additional contributions are to be made or events requiring additional contributions; and
Events requiring the LLC to be dissolved and its affairs wound up; and
The date each member became a member; and
The books and records of the accounts of the LLC.
Another issue to consider is meticulous maintenance of any Member entity’s records. If an entity is a manager, for example, it is important that books and records be kept up to date, tax returns be properly filed on time, and all state reports filed timely. Since a Manager (if used) is critical to the success of the LLC, it is important that it be properly maintained if it is an entity as well..
The LLC could be subject to federal and state securities laws. It is important for your attorney and CPA to make a determination whether or not they apply. If they do, it is essential that all sales and offers to sell any LLC units are made in compliance with both the federal and state securities laws. Failure to comply can result in serious consequences.
Learn about the benefits of a Wyoming LLC here.
Because of the complexity of the legal requirements relating to disclosure and registration of offering securities, it is most important that legal advice be obtained when any financing plan is developed and prior to any contract with any person concerning the possible sale of any LLC interests. If matters are not properly handled from the outset, opportunities for financing may be legally foreclosed.
The LLC must file an annual federal income tax return on IRS Form 1065. Many states also require annual state income tax returns for entities. Tax accounting is very complex; and the services of a good tax CPA should be seriously considered to prepare the LLC tax returns. When taxable as a partnership, or as a disregarded entity, income, losses, and other tax attributes from the LLC will flow through to the members on a pro rata basis, absent special planning provisions usually referred to as “special allocations.” Different rules may apply if the LLC is taxable as a corporation.
Ideally, a CPA should be involved prior to or immediately following the decision to consider entity planning. The CPA is sensitive to income tax planning and compliance issues, valuation issues, and integration of the entity design into the comprehensive wealth and estate plan.
Legal and tax advice fees for business planning is usually deductible in the year that the fees are paid. Estate planning fees for certain services may be tax deductible. Fees paid for the organization of the LLC may be amortized over a period of 60 months from the date the LLC is organized. An election under section 709 of the Internal Revenue Code will need to be made on the first federal income of the LLC. These possible deductions should be reviewed with your income tax return preparer.
It may be preferable to create multiple LLCs or other entities to fulfill your objectives. There are three significant issues to consider – risk class of assets, basis of assets, and the diversification rules. Many people who create an LLC actually need more than one entity to accomplish all their goals.
Each asset has its own risk class. For example, marketable securities have almost no risk from a lawsuit standpoint. Marketable securities pose no real risk by just owning them. Real estate on the other hand poses a great risk. People can get physically injured when visiting or using real estate. When someone is hurt on real estate, the owner of the real estate receives a claim or lawsuit for damages. It is easy to see that real estate poses more lawsuit risk to the owner than marketable securities. It is important to try to classify risk classes and to limit liability in any situation to the least amount of assets possible. Different types of real estate pose different levels of risk. How much more risk depends on the real estate, where is it located, and the circumstances of its use. For example farmland poses a different risk level than an apartment building. Learn more about Wyoming LLCs here.
General Rule: Segregate different asset risk classes by using multiple entities. [Note, however, that some state laws do not offer charging order protection to single member LLCs.]
The basis of an asset is the amount paid for that asset or its cost. When you purchase an asset for $100, your cost basis is $100. When you sell that asset, the basis is subtracted from the sale price to determine the capital gain. You then pay taxes on the capital gain. There are factors that can cause the basis to increase (making capital improvements to an asset) or to decrease such as depreciation taken on an asset. When the basis of an asset is adjusted for various increases or decreases we refer to the basis as an adjusted basis.
When a gift of an asset is made to another person your basis, for determining gain on the sale of the asset, will transfer to that person. Thus, when they sell it at a gain they will calculate their capital gains tax by using your basis. But if the person sells the asset at a loss, they will use the lesser of your basis or the fair market value of the asset at the time of the gift, to determine their capital loss. But if a person inherits an asset, they will receive a step up (or down) in basis, equal to fair market value of that asset on the date of death or six months after the date of death in some cases. This means that when inherited property is sold in the future, gain or loss will be calculated by using this new fair market value basis.
When you contribute assets to an LLC, those assets have a basis. If members contribute many different assets in the LLC, each with a different basis, it can become an expensive administrative nightmare for the CPA. The LLCU you receive for contribution of the asset also has a basis of its own. Gifted LLC units transfer the LLCU basis to the gift recipient.
Remember that sales may not occur for years and may include multiple generations of family members. Some assets will receive a step up or down in basis following a member’s death. Some assets will retain the original basis. In some cases, an asset will be mixed with some of the asset receiving the step up in basis and some receiving a step down in basis. This can create complications such as additional accounting expense or increasing the chances of IRS attack.
General Rule: Be careful in mixing assets in an LLC or allowing future contributions of additional assets. Consider use of a different LLC for each basis class. It costs more money initially and a little more administratively to run each year, but can significantly reduce overall cost and complexity.
Transferring assets into an LLC is not usually a taxable event. However, some transfers do trigger an immediate tax. Current law recognizes a taxable event when certain “diversification” occurs with securities, for example. The diversification rules are a trap for the unwary.
The first rule is sometimes called the 80% rule. If marketable securities that are contributed to the LLC make up more than 80% of its asset value, diversification could be a problem. Diversification does not occur if 20% or more of the value of the LLC is made up of real estate. When considering the value, keep in mind that any other discounts or valuation adjustments applying to assets must be considered before trying to satisfy this rule.
If more than 80% of the LLCs assets are stocks and securities, the LLC could be classified as an “investment company”. Transfers to an investment company can result in immediate recognition of gain on the transfer of appreciated securities if the transfer is to:
A regulated investment company; or
A real estate investment trust; or
A corporation, partnership or LLC if more than 80% of the value of its assets are held for investment and are cash, stocks, or securities. Under TRA ‘97, the definition of cash, stocks, and securities was greatly expanded. Stocks and securities include:
Marketable stocks and securities;
All corporate interests;
Evidences of indebtedness;
Forward or futures contracts;
Precious metals; or
Interests in any entity if 90% or more of its assets consist of any of the types of interests described above.
Transfers of non-identical assets can cause diversification, unless the assets are already diversified. This rule is easy to trigger because if one person contributes stock A and another person contributes stock B, these are not identical assets. Thus, gain must be recognized on the transfer. There are some exceptions. For example, by definition, mutual funds are diversified already and therefore the contribution of mutual funds should not cause diversification. The transfer of identical assets, however, does not cause diversification. Therefore, if one or more persons transfer the identical security the anti-diversification rule is not violated.
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The de minimis exception avoids application of the rule when an insignificant contribution is made that would technically trigger the rule. The IRS has accepted a 1% contribution as an insignificant amount, but has rejected an 11% contribution as being insignificant. The area between 1% and 11% is a no-man’s land.
Diversification does not occur if the transferors transfer a diversified portfolio of stocks and securities to the LLC, provided the 25% and 50% tests are met.
A portfolio of assets is treated as diversified if not more than 25% of value of total assets is invested in the stock and securities of any one issuer; and
A portfolio of assets is treated as diversified if not more than 50% of value of total assets is invested in the stock and securities of five or fewer issuers.
The diversification rules are one more factor to help determine how many LLCs or other entities to use in a given case. As a practical matter, careful consideration of the assets being contributed avoids this problem. Trying to do too much with one LLC can create a lot of diversification problems.
Will the contribution diversify the contributing person’s assets? If the contribution does not diversify the contributors’ assets, the investment company taxation rules do not apply.
Diversification results if two or more persons contribute non-identical assets to the LLC.
The same diversification rule may apply to contributions from spouses in non-community property states. In non-community property states, diversification does not result if husband and wife contribute assets jointly owned in the same proportion as their interests in the LLC. Therefore, spouses should transfer title to joint tenancy or tenants in common before transferring the assets to the LLC.
In community property states, spouses may contribute different community property assets as the sole LLC assets. Diversification does not result when husband and wife contribute community property assets, even if those assets are the sole assets used to fund the entity. Thus, when spouses contribute community property assets to fund an LLC, taxation of appreciated assets is rarely an issue.
If one party contributes almost all of the assets to form an LLC other than de minimis contributions by other members, there is no diversification. If an individual contributes assets worth less than 1% of the LLC, the de minimis exception applies. De minimis contributions are not considered for purposes of determining diversification.
If several individuals contribute identical assets to form an LLC, diversification does not occur.
Contributing an already “diversified” portfolio of stocks and securities does not cause diversification. A portfolio is diversified if not more that 25% of the value of the contributed securities is from one issuer; and not more than 50% of the value of the assets are the securities of 5 or fewer issuers.
Mutual funds are diversified by definition. Thus, contributing mutual fund shares to an LLC should not cause diversification.
If the contribution is “stocks and securities” (see below), which are not identical in both type and ratio to the assets already in the LLC, and “marketable securities” comprise over 80% of the value of the LLC, investment company taxation rules will apply. An entity not diversified at its formation can become diversified by later contributions, retroactively creating a taxable event. With other than husbands and wives contributing community property, the contributors should own the assets to be contributed as joint tenants or tenants in common in proportion to their ownership interest in the entity before transferring the assets to the entity.
If the contribution causes diversification, are more than 80% of the assets “stocks and securities?” If so, the entity will be treated as an investment company.
Analyze the assets to be contributed to an LLC. Are they “stocks and securities” as defined by IRC 351(e), which includes:
__ stock or securities of any private or public corporation;
__ forward or future contracts;
__ precious metals;
__ foreign currency;
__ interests in publicly traded partnerships or LLCs;
__ any interest in a REIT, registered investment company, or common trust fund;
__ bonds and personal notes; and
__ interests in any entity if 90% or more of its assets consist of any of the types of interests described above.
If more than 20% of the total value in an LLC is investment real property or other assets that are not classified as “stocks and securities,” the entity will not be treated as an investment company. If possible, contribute at least 20% investment real property to prevent the LLC from being considered an investment company.
Exercise extreme caution when contributing assets to an already funded LLC.