business activity are multiple and far reaching. But, without a knowledgeable practitioner and drafter the pitfalls are equally as common and severe. Done correctly, entity formation can provide warranted piece of mind to the business owner and incredible cost savings from both a tax and practical perspective. Below is a quick summary of the more common issues presented in formation and how Five Stone Tax Advisers can help you avoid unexpected or less than ideal outcomes. Building, Billing Then Leaving
The one thing I see most often are well intentioned individuals who have used online forms or entity formation companies to create their entity. In the end, they have a stack of documents to prove that they created an entity; that is all they have. The issue is that when these entity owners are sued or audited, if they have not followed certain rules and formalities that stack of documents proving the creation and existence of an entity is useless. Liability for taxes, torts or contract actions easily flows through to the individual owner in the absence of certain business and bookkeeping practices. The courts and taxing agencies use any number of theories (sometimes referred to as veil piercing or alter ego) to reach the personal assets of the owner. In these cases the entity has failed in its most basic objective: liability shielding. When business owners have a stack of formation documents it gives them a false sense of peace and security. Without good advice from knowledgeable counsel about paying due respect to your entity form, merely having created the entity can do more harm than good. When companies help you build the entity, bill you, and then leave it’s a losing proposition for the business owner.
Tax Considerations
A majority of entities available or useful to your average business owner are known as “flow through” entities. This means simply that income to the entity is not taxed at the entity level. All income “flows through” to the owner or owners of the entity. In the most basic scenario where there is one owner or where all owners split profits and losses equally and all owners have the same basis in the company the accounting is relatively simple and tax results are dictated by each individual member’s or partner’s personal income tax situation. So, superficially, an entity in and of itself is generally not advantageous from a tax perspective. A sole proprietor can take advantage of the same deductions available to members or partners of an entity. But, with an experienced attorney you can utilize conventions for different entity types to maximize deductions or decrease taxable income. You can also avoid some common pitfalls. Below are some of the more common tax issues.
Making an S Corporation Election
From a drafting perspective, most multi member operating agreements refer to partnership tax conventions. These references are common because multi member LLC’s have a default partnership classification at the federal taxation level. However, these references can be disadvantageous or even disastrous if your entity has made an S corporation election and you are under audit. The IRS requests all entity documents including operating agreements in an audit. If your formation documents tend to state that you are a partnership but your requesting corporate tax treatment you have a major problem.
Timing taxable events to coincide strategically with other reportable transactions can lead to tax savings. Some common examples of timing are:
- planning the disposition of an asset to offset gains or empower losses as the case may be in a certain tax year or
- expensing or depreciating a qualifying asset in a way that maximizes tax savings.
Character of income or loss can be equally as important. Some of the more common considerations involve:
- capital and non-capital transactions; and,
- passive and active income.
Employee Benefits
Practical Considerations
Choice of Entity
Some articles or practitioners may ask you to think carefully about what entity is right for you. From my perspective you almost always want to form an LLC. The exceptions are few and far between.
In Texas general partnerships owned directly and solely by natural persons are not considered taxable entities and so are not subject to the franchise tax.[2] In addition, there are no required filings or legal startup costs. Partnerships are automatically formed when two or more people enter into a venture for the purpose of profit unless contract terms dictate otherwise. So, these types of general partnerships avoid paying the Texas franchise tax, there are no Secretary of State filing fees, and they can (but probably should not) avoid legal startup costs. Beyond these advantages (one of which is questionable) there is no obvious reason to form a partnership instead of an LLC. Also, from a liability perspective, in almost any partnership at least some of the partners are fully liable for all debts of the partnership. [3]
C corporations are subject to double taxation. Income to a C corporation is taxed when received by the entity and is taxed again when it leaves the corporation on its way to shareholders. In addition to double taxation meeting all structural requirements for corporations can be daunting; as discussed above, failure to follow certain formalities can lead to loss of liability protection and adverse tax consequences. C corporations can provide an incredible amount of tax advantage opportunities. But, typical business owners who live and breathe on a day to day cash flow basis may not have the financial ability to be fiscally patient; if immediate cash for operating and immediate income for living is essential some of the mechanisms used to delay income recognition or to pay less tax in a C corporation setting are not palatable. In addition, if you are not raising capital from external sources the attractiveness of the C corporation ownership structure for outside stakeholders, like venture capitalists, is not needed.
LLC’s combine the advantages of flow through taxation and the liability protection of a corporation without the daunting structural requirements. In addition, LLC’s can make S corporation elections to provide additional tax savings.
Single Purpose Vehicles (SPV’s)
This topic is somewhat complex but with the increasing amount of real estate transactions and investments, especially in Texas, it is no longer (or at least should not be) obscure. Any entity formation practitioner should at least recognize the issues.
Real estate investors will form entities for one transaction then dissolve after consummation. This is a way to limit liability exposure. From my perspective the wisdom of the practice is questionable. State law in Texas allows the use of series transactions within one LLC. Series transactions allow LLC owners to isolate liability on a transaction by transaction basis. Considering that statutory allowance and the great respect afforded to the LLC form in the state of Texas by law and the courts alike the more provident practice may be to avoid dissolution after each transaction and to rather isolate liability within your existing LLC structure by utilizing the statutory series allowance. If an LLC owner is sued and they have since dissolved the LLC involved in the transaction giving rise to the suit there is a chance that, by virtue of equitable principals, a court may allow the claimant to collect damages from the dissolved LLC owner’s personal assets. From a judicial perspective, an aggrieved claimant is left with no ability to collect on a rightful claim because the only liable entity (the dissolved LLC) no longer exists.[4] In the alternative the entity remains and owners are protected by the predictable statutory and judicial framework of LLC liability. With the use of the series allowance liability is further isolated to the assets, if any, of the particular series. Even in the absence of insurance and assets the courts have upheld the limited liability of the LLC.
Predictability upon Disputes and Dissolution
Disagreements are inevitable. Partners and members begin all ventures with optimism and hope. The everyday stress of business can erode and sometimes disintegrate initial relationships. The results of disagreement and dissolution can be chaotic, time consuming and costly. Careful drafting can lend predictability to these unfortunate events. A good agreement can save owners a significant amount of time and money. It is best to reach consensus on handling these issues before problems arise while excitement and emotion is at a minimum.
Are You Selling a Security?
If your LLC will be or is manager managed and you have members who are not managers you may be selling securities. A sale of securities must be registered with the Securities and Exchange Commission and your local state securities board unless an exemption for such registration exists. And, even if such an exemption does exist you generally have to file for approval of the exemption. Failure to register the sale of a security can result in heavy fines and complete unwinding of the transaction. An entity formation practitioner should recognize this issue and advise on avoiding the costly consequences of a securities violation. Amongst other solutions, a knowledgeable practitioner can help a business owner avoid the issue altogether by setting parameters for all members or partners requiring activity in the venture and true, active dedication to the venture for profit.
Professional Associations
Certain licensed professionals are prohibited from forming typical partnerships or LLC’s. Instead they must form LLP’s or PLLC’s. The difference between these professional associations and their non-professional counterparts is individual liability for tortious conduct – namely, malpractice. An individual, such as an attorney or doctor, cannot shield themselves from personal liability for malpractice as a matter of public policy. The entities themselves are still liable to the extent of the entity property for the negligence of the individual members or partners but in addition the individual members or partners are also personally liable for any malpractice. But, in most situations the individual members or partners are not personally liable for any other claims against the entity not involving their own personal malpractice. Understanding when these entity forms are required and the consequences of negligence in these settings is essential to successful preparation. An experienced practitioner can aid professionals during formation.
Final Thoughts
When knowledgeable practitioners form an entity and advise the business owner from a tax and legal perspective on a continuous basis the resulting peace of mind is warranted and the resulting tax and practical savings can be substantial. Companies offer document preparation and entity filing service to business owners at a low cost. While the initial savings appears advantageous the cost to the business owner in the long run from non-compliance with applicable regulations, protracted dispute resolution, non-recognition of tax opportunities or complete failure of the entity in one of its most basic purposes – personal asset protection – eliminates the initial incentive to organize cheaply. Even the issues addressed in this article are far from all-encompassing and the legal and tax landscape changes almost daily. The advice of an experienced attorney will cause a slight increase to startup costs but the business owner’s confidence moving forward and careful planning to avoid numerous, costly pitfalls are priceless.
Five Stone Tax Advisers is a leading provider of tailor-made solutions for business owners and anyone considering entity formation. Our Legal Advisory Services Division is dedicated to helping individuals navigate all practical and tax related issues during and after the entity formation process. Our associates have multi-faceted backgrounds in business and tax issues leading to the most complete solutions.
[1] Even the election process can be complex especially if seeking retroactive designation.
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