What Happens When You Sell a Passive Activity Business or Real Estate?

As you now know, if the passive activity rules apply to your business or real estate then you may not be able to deduct all your losses.  Passive activity losses can only be used to offset passive activity income (they cannot be used as a deduction against your ordinary income).  If you do not have any passive activity income, the loss is suspended and carries forward to the next year until you eventually have passive activity income.  But what happens if you dispose of the passive activity business or real estate before you are entitled to use all of the passive activity losses?

If that is the case, and it is the entire activity that is being disposed of, then special rules apply.  If the disposition is part of a fully taxable transaction (such as a sale), then the losses are recognized in the following order:

1) The current year passive activity losses are first used to offset all passive activity income from other activities for the year;

2) Then, the passive activity losses are deducted against ordinary income.

Lets look at an example to get a better understanding of what this means.

Joe is a limited partner in a small business, and owns one rental property.  Joe is not a real estate professional and does not actively participate in the management of his rental properties. In 2015, the small business will have income of $5,000.  The rental property has a loss of $3,000 prior to its sale during the year.  The property had a tax loss for a number of years prior, and had unused passive activities losses of $30,000.

Because the sale of the property is a taxable event and represents the complete disposition of his ownership interest in that property, Joe is allowed to recognize his prior unused passive activity losses.  First, though, he must offset the current year passive losses of $3,000 against the $5,000 of passive activity income from the small business.  After that, he is entitled to deduct the previously unused passive activity losses of $30,000.

However, the rules are different if the disposition of the business or real estate is instead the result of the owner's death.  In that case, the current year passive losses are still used to offset the current year passive activity income, but only to a certain extent.  They will only be allowed to be used to the extent that the losses exceed the "step-up" in basis that occurs when property is transferred through inheritance.  In other words, the losses are reduced by the amount of basis step-up.  Any unused passive activity losses then disappear- they cannot be used as a deduction against ordinary income.

If you have any questions, please send me an e-mail.

Are Real Estate Professional Affected by the Passive Loss Rules?

Over the past few blog posts we have been discussing what passive activities are, and how they can affect your taxes. Specifically, we discussed how all real estate investments are automatically considered to be passive activities, and that passive activity losses cannot be deducted against ordinary income. Instead, passive activity losses can only be used to offset passive activity income (which is taxed like ordinary income). We also discussed that certain investors who actively participate in the real estate activity are allowed to deduct up to $25,000 of losses as a special allowance, but that the special allowance begins to phase out if the investor has more than $100,000 of income from all sources. But what about real estate professionals? Real estate professionals are not simply investors who may own one or two rental properties, they spend most of their time involved in real estate and their income is typically very dependent on their real estate activities. Are real estate professionals limited to the same $25,000 special allowance that other real estate investors are limited to?

No, the Internal Revenue Code specifies that real estate professionals are exempt from the passive activity rules (for their real estate investments).

Who is a Real Estate Professional?

There are two requirements that must be met in order to qualify as a real estate professional for tax purposes:

1) More than one half (1/2) of the personal services you perform in all trades or businesses must be performed in real estate trades or businesses in which you materially participate (see the material participation rules here). The purpose of this rule is to ensure that only people who spend more time with real estate than other trades or businesses qualify.

2) You must perform more than 750 hours of services during the year in real estate trades or businesses in which you materially participate. This rule prevents casual investors who are not involved in other trades or businesses from claiming to be real estate professionals.

To be clear, there are a number of real estate activities that can qualify- it is not simply limited to rental activities. The Internal Revenue Code specifically lists the following activities that qualify as a real estate trade or business:

• Real property development;
• Redevelopment;
• Construction;
• Reconstruction;
• Acquisition;
• Conversion;
• Rental;
• Operation;
• Management;
• Leasing; and
• Brokerage.

Therefore, if you are a real estate professional, the passive activity rules do not apply to your real estate activities.  You are entitled to deduct those any losses from those activities against your ordinary income.

If you have questions about whether you qualify as a real estate professional, how the passive activity rules operate, or any other tax question please send me an e-mail.

How Do I Know If My Business is a Passive Activity?

In the last post, I discussed the consequences of having your business be classified as a passive activity.  As I mentioned, any trade or business activity in which you do not materially participate is a passive activity to you.  But how do you know if you have materially participated?

Image borrowed from www.123rf.com

Luckily for you, there are 7 tests that answer this question, and you only need to "pass" one of them to avoid the "passive activity" treatment.

The material participation tests are:

1) You participated in the activity for more than 500 hours.  In general, any work you do for the business counts, unless it is the type of work not customarily done by the owner of that type of activity or your main reason for doing that work is simply to reach 500 hours.

2) Your participation was substantially all the participation in the activity of all individuals for the year, including participation of employees.  In other words, if you essentially run the business by yourself you do not have to worry about the number of hours you actually worked.

3) You participated in the activity for more than 100 hours during the year, and you participated at least as much as any other individual.

4) You participate in multiple trade or business activities, each for at least 100 hours, and combined they add up to more than 500 hours.  However, each activity in this grouping must be (if looked at individually) a passive activity.

5) You materially participated in the activity for at least 5 of the last 10 years.

6) You materially participated in a personal service activity for at least 3 years (regardless of how many years ago that was).  For these purposes, personal service activities include activities in the fields of health, law, accounting, or consulting, or any other activity for which your personal skills/services (not capital) is the primary income-producing factor.

7) An evaluation of the "facts and circumstances".  This is the least certain of all the material participation tests because you have to evaluate your situation and make a decision as to whether you materially participated, and hope that the IRS agrees.

If you satisfy any one of these tests, then you materially participated in your trade or business and are entitled to deduct the losses against your other income.

Please keep in mind that your real-estate related activities are considered to be passive activities regardless of whether your materially participated in them.  However, there are two exceptions that we will be discussing in the next blog posts.

If you have any questions about the passive activity rules and how they affect you, please send me an e-mail.

What Do You Mean My Investment is a Passive Activity?

Has anyone ever told you that your investment in a business or in real estate is a passive activity?  Do you know what that means?  Don't worry, most people don't.

Before 1986, investors would create tax shelters for themselves by putting their money into investments that would generate tax losses but no actual economic losses. For example, they may invest in a rental property and then would rent the property to a tenant for an amount equal to the monthly expenses. The investors would then have no net cash inflow or outflow, but would be able to depreciate the property and claim a tax loss.


Congress eventually caught on to the games that investors were playing with the Tax Code as it existed back then, and as a response invented the passive activity rules.

Under the passive activity rules, there are two types of passive activities.  The first type of passive activity are trade or business activities in which you do not materially participate.  In the next blog post we will discuss how this is determined.  The second type of passive activity are rental activities (although there are two exceptions that will be discussed in future blog posts).

The income and gains on passive activities will continue to be taxed just like any other ordinary income and gains. However, the losses on passive activities are not deductible but instead can only be used to offset passive activity income.  The passive activities losses are deferred until they can either offset passive activity income or the underlying investment is completely disposed of (e.g., sold).

In addition to not being able to deduct passive activity losses against your active income, the passive activity income is subject to the 3.8% Medicare Surtax.

Do you think you might have a "passive activity" investment?  If you would like to discuss whether it truly is a passive activity and how that affects your taxes, please send me an e-mail.

S-corp vs. LLC: Allocation of income and losses

As you have now discovered, there are a number of differences between S-corporations and LLCs. S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to follow are far more relaxed.  There are also differences in the taxes and fees that they have to pay to California, and the types of compensation that the owners of each can take. The amount of flexibility you have in allocating income and losses between the owners is also a key difference.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage.  Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation's taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

If you have questions about the tax differences between S-corporations and LLCs, or if you would to talk about the requirements necessary in order to have non-proportional allocations in your LLC, please send me an e-mail.

S-corp vs. LLC: Income

In last week's blog, we discussed how California taxes S-corporations and LLCs differently.  In this blog, we will be discussing the differences in how the owner's compensation is classified.

Image borrowed from
www.nanohealthtechnology.com

The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. While they will be discussed in more detail in a future post, it is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.

On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways.  The first, like LLC members (owners), is through ownership distributions.  These are withdrawals of the business' profits.  The second method, which is not available to LLC members, is through a salary.  In fact, an owner-employee of an S-corporation is required to take a "reasonable salary" before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business.  The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions.  This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business.  You could, for example, take out $20,000.  However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.

An S-corporation's net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.

Regardless of whether your business is structured as an LLC or as an S-corporation, the business's profits are passed through to the owners and subject  to income taxes.  They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.

If you would like to know more about the differences between S-corporations and LLCs and how it can affect your taxes, please send me an e-mail.

S-corp vs. LLC: CA Minimum Taxes

Besides the formalities that S-corporations have to observe, there are a few other differences between S-corporations and LLCs.  One difference that will affect your bank account is how California assesses taxes.

Image borrowed from www.alliancetrustcompany.com

The amount of California taxes that an S-corporation will pay is based upon its net income.  An S-corporation pays the greater of $800 or 1.5% of its net income.

An LLC, on the other hand, pays $800 of California taxes and may be assessed an LLC fee based upon its revenue.  The table below shows the LLC fee for the various revenue ranges.

Revenue	LLC Fee
$0 - $249,999	$0
$250,000 - $499,999	$900
$500,000 - $999,999	$2,500
$1,000,000 - $4,999,999	$6,000
$5,000,000 +	$11,790

Therefore, whether an S-corporation or an LLC makes more sense for your business (based purely on the amount of taxes you will pay to California) depends on what you expect you revenues to look like compared to your net income.  Lets look at a few examples.

Example 1

You expect your business to have $600,000 of revenue but only $60,000 of net profit.  In this case, it makes more sense to operate as an S-corporation.  As an S-corporation you would be paying $900 in taxes to California ($60,000 x 1.5%).  However, as an LLC you would pay $3,300 ($800 of taxes plus a $2,500 LLC fee).

Example 2

You expect your business to have $900,000 of revenue and $300,000 of net profit.  In this example, it makes more sense to operate your business as an LLC.  As an LLC, you will be paying $3,300 to California ($800 of taxes play a $2,500 LLC fee).  However, as an S-corporation you would be paying $4,500 in California taxes ($300,000 x 1.5%).

If you would like a further understanding of the tax differences between LLCs and S-corporations, please send me an e-mail.

Can You Own an LLC By Yourself?

Sometimes the number of owners a business has affects what types of entities it is allowed to operate as.  While a corporation can have one or more owners (shareholders), a partnership by definition must have two or more owners.  An LLC can be thought of as a hybrid between corporations and partnerships, so can it have only a single owner (member)?  It depends.

Image borrowed from www.corporatedirect.com

The federal government's position changes depending upon how an LLC elects to be taxed.  LLCs have the option to be taxed as either a corporation or a partnership, but the default rule is that LLCs are taxed as partnerships.  If a single-member LLC elects to be taxed as a corporation, then the federal government will recognize the LLC as a corporation. However, if a single-member LLC elects to be taxed as a partnership, then the federal government will treat the LLC as a "disregarded entity".

The federal government essentially creates a legal fiction that the disregarded entity does not exist. It looks through the disregarded entity and attributes all of the entity's actions to its owner.  The owner is required to report the entity's income on its own tax return.

California, however, does not treat a single-member LLC any differently than any other LLC.  The LLC is required to file its own tax return for California.  In addition, because LLCs are created under state law, a single-member LLC has all of the same legal protections that any other LLC would have, such as limited liability protection.  If you would like a better understanding of a single-member LLC's legal rights, I would recommend talking to a business law attorney.

If you have any questions regarding how a sigle-member LLC is taxed, please send me an e-mail.

Is an LLC the Right Choice for You?

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

Image borrowed from bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a "minimum tax" and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 "Articles of Organization of a Limited Liability Company (LLC)".  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to "pierce the corporate veil" and remove your LLC's limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing them in detail in future posts.  In the meantime, if you have any questions about LLCs please send me an e-mail.

Built-in Gains Tax

If you have been operating your business as a corporation but are now contemplating making the S Election, make sure you speak to a tax advisor about how the Built-in Gains Tax could potentially impact you.

As I discussed in the blog post "Is an S-Corporation Right for You?", an S corporation has all the traditional benefits of a C-Corporation (or what you typically think of as a corporation) including limited liability protection, but like a partnership the owners only have to pay income taxes on the distributed profits once.

The S Election could be made right after the business is incorporated, in which case you do not have to worry about the Built-in Gains Tax. However, the election can also be made years after the corporation has been formed.  In that event, it is important that you understand when the Built-in Gains Tax is triggered and how it operates because it could impact the business decisions you would otherwise make.

The Built-in Gains Tax may also apply if an S-corporation ever acquires assets from a C-corporation in a tax-free transaction.

The purpose of the Built-in Gains Tax is to prevent the shareholders of a C-corporation from converting to an S-corporation with the intend of avoid the tax consequences that would otherwise apply in a liquidation.  In other words, the Built-In Gains Tax is intended to prevent owners of a C-corporation from avoiding the taxes they would otherwise have to pay when shutting down or selling off all or part of their business by converting to an S-corporation.

Essentially, when converting to an S-corporation, the corporation must look at the assets it owned prior to the S Election taking effect and determine if those assets have appreciated in value (a formal appraisal is highly recommended).  If they have, the amount of appreciation on each asset will be known as the net unrealized built-in gain.  If the S-corporation then, within the applicable time period, sells that asset, the corporation (not the shareholders) must pay the Built-in Gains Tax, which is equal to the top marginal corporate tax rate (currently 35%), on the net unrealized built-in gain.

The applicable time period is currently 10 years, but shorter time periods apply to conversions that occurred in prior years.  If the S Election took effect in 2009 or 2010, then the applicable time period is 7 years.  If the S Election took effect in 2011, 2012, or 2013, the applicable time period is 5 years. It is always possible that new legislation will be enacted shortening the applicable time period again, so please talk to a trusted advisor if you are concerned about how the Built-in Gains Tax might affect you.

If you have questions about the Built-in Gains Tax, please send me an e-mail.

Is an S-Corporation Right for You?

You like the idea of forming a corporation because you want the limited liability protection, but the high cost of being taxed twice on the same income is very unappealing.  So then you thought about operating your business as a partnership so that your share of the business income will flow through to you, but the risk of being sued due to the actions of others is just too great.  A limited partnership doesn't work for you either because you want to be the one actively managing your business, not just an investor.  What other options are available to you?  One option is an S-corporation.

Image borrowed from Pacific
Associates Corporation

Every S corporation starts off as a C corporation, or what you may think of as a "regular corporation."  Then, the corporation will make an election, commonly referred to as an S Election, to be taxed under Subchapter S of the Internal Revenue Code. Basically, what this means to you is that taxes are paid at the owner-level rather than at the business-entity level, just like with partnerships.  But unlike partnerships, because an S-corporation is still a corporation it has the benefit of limited liability protection.

The S Election is made by filing Form 2553 with the Internal Revenue Service.  Once the election is made with the IRS, S corporation status is automatically recognized by California.  The election may be filed anytime during the year prior to when the election is to take effect, or within the first 2 months and 15 days of the year in which the election is to take effect.

However, there are restrictions on what corporations can be S-corporations.  First, the corporation must be incorporated within the United States.  Next, all the shareholders (owners) must be either individuals, estates, and certain types of trusts.  An S corporation may not have partnerships, corporations, or non-resident aliens as shareholders.  Additionally, an S corporation may not have more than 100 shareholders, and there can only be one type of stock issued.  The reason there can only be one class of stock issued is that all the shareholders must have the same rights in the corporation.  Finally, an S-corporation is not allowed to engage in certain types of business, such as finance or insurance.  If any of these restrictions are violated, the S-corporation status will be revoked.

S corporations have to comply with the same formalities that their C corporation counterparts do. Some of these formalities are:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

However, this is not an exhaustive list and you should talk to a corporate law attorney to see what other formalities have to be observed.

In future blog posts, we will discuss in more detail the distinctive characteristics of S-corporations and specifically how they differ from other types of entities.

If you would like to talk about the unique tax rules that govern S-corporations and how they may impact your business, please send me an e-mail.

What is a Limited Partnership?

How is a limited partnership different from a general partnership?

In the last blog post, What is a Partnership?, I gave you an overview of general partnerships and some of the advantages and disadvantages of using that type of business entity.  In an attempt to make partnerships a more beneficial business structure, limited partnerships were created.

In a general partnership, every partner is a "general partner."  That means that each partner can be held personally liable for not only his or her own actions, but for the actions of the partnership as a whole, the other partners, and the partnership's employees.

In a limited partnership, there must be at least one general partner but there are also limited partners.  Limited partners have limited liability (see Limited Liability Protection) so they can only be held personally liable for their own actions.

In exchange for having limited liability protection, the limited partners are not allowed to take any active role in the management of the partnership.  I would advise talking to a business attorney about what activities specifically qualify as management activities.

Why would a General Partner want to be in a Limited Partnership?

At first, it does not seem like there would be any advantages to a general partner to being in a limited partnership.  The general partner is still fully liable for the actions of the others, just as in a general partnership.

However, there are two main benefits to this arrangement for general partners.  The first is that it makes it easier for general partners to raise funds for the business through investors.  Many investors would not be interested in becoming a partner with full personal liability for the actions of the other partners.  The second benefit is that this arrangement leaves the general partners in full control of the daily operations of the business and all major business-related decisions.

What are the other benefits of Limited Partnerships?

Limited partnerships, like general partnerships, are pass-through entities for tax purposes meaning that they are not subject to double taxation (see Would You Rather Be Taxed Once or Twice?).  Also, the limited partners only have the amount that they invested in the business at risk.  Creditors cannot attempt to seize their personal assets, and as previously mentioned they are not personally liable for the actions of others in the business.

What are the negatives of Limited Partnerships?

While the limited partners being barred from participating in the management of the business may be a benefit to the general partners, it can be frustrating for the limited partners.  The limited partners invested their money in the business and may have strong opinions about how the business should be run.  However, if they become involved in the management of the business they lose their limited partner status and their limited liability protection.

Another disadvantage to limited partnerships is that the passive activity rules may affect the limited partners ability to deduct business losses.  The passive activity rules will be the subject of a future blog post.

If you would like to learn more about the tax implications of using the limited partnership structure for your business, or the tax implications of any other business decisions, please send me an e-mail.

What is a Partnership?

A partnership is the easiest type of business entity to form.  So easy in fact that partnerships are occasionally unintentionally formed.

A partnership is formed when two or more people engage in a business enterprise for profit. Partnerships are the only type of business entity that do not require any form of paperwork to be filed as part of its formation.

For purposes of this post, when I refer to a "partnership" I mean a general partnership. Limited partnerships will be discussed in the next post.

Although not required to form a partnership, I would recommend talking to a business transactions attorney anytime you are considering going into business with another person.

In some ways, a partnership is the opposite of a corporation (see What is a Corporation?).  Whereas there is a legal fiction that a corporation is a separate and distinct person, a partnership can be viewed more as an aggregate of all the partners.  For example, property can be owned in the partnership's name but really that means that each partner owns a portion of that property.

Also, as previously mentioned, a partnership does not have to follow any type of formalities to be formed.  It is created simply by two or more people engaging in a business enterprise for profit.  It can be a very informal arrangement.  There are no requirements that even a partnership agreement be created, although for practical purposes it is very useful to have a partnership agreement in place.

While partnerships are required to file tax returns, it is simply an "informational" tax return.  The partnership itself does not pay any taxes, and thus unlike a corporation it is not subject to double taxation.  The partnership's taxable income instead flows through to its individual partners who are responsible for reporting the income on their individual tax returns and paying tax on their share of the partnership's income.  The purpose of the partnership tax return is simply to notify the IRS and the relevant state tax collection agencies of the amount of income that the individual partners should be reporting on their tax returns.

The informational tax return that a partnership files is Form 1065.  Form 1065 will show all of the business' revenue, expenses, gains, losses, and tax credits that get passed through to the partners. Each partner, and the relevant tax collection agencies, will then be provided with a Form K-1.  The purpose of the K-1 is to inform the partner of how much income, losses, and other tax attributes have to be reported on the partner's individual tax return and the nature of the income and losses.

There are several disadvantages to operating your business as a partnership.  The first is that your partners must consent to you transferring your ownership interests in the partnership to someone else. Because the defining characteristic of a partnership is that there are two or more people choosing to work together in a business enterprise, it is impossible to have a partnership if the other person refuses to be engaged in a business enterprise with another person.  Therefore, if you want to sell your ownership interest in a partnership to another person your partners have to agree to it.

Another disadvantage of partnerships is that you are jointly and severally liable for the actions of the partnership, yourself, your partners, and your employees.  Effectively, this means that your partner, while conducting business for the partnership, could cause injury to another person and you could end up being the one sued for it even though you had nothing to do with the situation other than being a partner in a partnership.

If you would like a referral to a business transactions attorney or would like more information on how partnerships and other forms of businesses entities are taxed, please send me an e-mail.

Triple Taxation?!?!

In the last blog post, Would You Rather Be Taxed Once or Twice?, we discussed that the major disadvantage of corporations is that its profits are taxed twice: once at the corporate level, and once at the shareholder level.   But what if a corporation owns another corporation?  Would the income from the second corporation be subject to triple taxation?

Image borrowed from hudsonvalleynewsnetwork.com

The answer is... maybe and to a certain extent.

Does that clarify things?

In order to lessen the potential impact of triple taxation, within the Internal Revenue Code there is a corporate tax deduction known as the "dividends received deduction."

What the dividends received deductions does is allow a corporate shareholder to deduct from its income a certain percentage of the dividends it receives from other corporations that it owns based upon its ownership percentage.

If a corporate shareholder owns less than 20% of another corporation, it is entitled to deduct from its income 70% of the dividends it receives from that corporation.  If the corporate shareholder owns between 20% and 80% of another corporation, then it is entitled to deduct 80% of the dividends it receives from that corporation.  Finally, it a corporation owns greater than 80% of another corporation, it is entitled to deduct 100% of the dividends it receives from that corporation.

There are several limitations placed upon the dividends received deduction, including the: taxable income limitation, the holding period limitation, and the debt-financed dividends received limitation.

Under the taxable income limitation, the amount of the dividend received deduction cannot exceed a certain percentage of the corporation's taxable income.  For corporations that would be entitled to a 70% dividends received deduction, the amount of the deduction cannot be greater than 70% of the corporation's taxable income.  Likewise, for corporations that would be entitled to an 80% dividends received deduction, the amount of the deduction cannot be greater than 80% of the corporation's income.  However, there is no such restriction for corporations that would be entitled to a 100% dividends received deduction.  Also, the taxable income limitation does not apply if the dividends received deduction either creates or increases a corporation's net operating loss.

Under the holding period limitation, a corporate shareholder must hold the shares of the distributing corporation's stock for a period of more than 45 days.

Under the debt-financed dividends received limitation, the deduction  is disallowed if debt was used to finance the purchase of the other corporation's stock.  Therefore, if a percentage of the stock was purchased using debt, then the dividends received deduction is reduced by that percentage.

If you would like to learn more about the dividend received deduction, please feel free to send me an e-mail.

Would You Rather Be Taxed Once or Twice?

Would you rather pay taxes on the same income once or twice?

I am going to make a wild guess that 99.9% of you do not want to pay any more taxes than necessary, so you would prefer not to pay taxes on the same income twice.

If you read my one of my previous posts, What is a Corporation?, you know that the biggest downside to structuring your business as a corporation is that it is subject to double taxation. You also know that there are benefits to structuring your business as a corporation that may make it worthwhile to you to be subjected to double taxation. In this blog post, I will attempt to give you a more thorough understanding of what double taxation means so that you can make an informed decision.

Being subject to double taxation means that income earned by a corporation is taxed at the corporate level and then again when it is distributed to the shareholders.

To better understand what this means, lets look at an example.  For purposes of this example, lets say that both the corporate and individual tax rate is 15%, there are no state taxes, and there are no personal deductions, exemptions, or credits (or anything that really allows for tax planning).

Alex is the sole shareholder of ABC Inc.  In 2015, ABC Inc. earns a net profit of $100,000.  Because ABC Inc. is a corporation, it has to pay $15,000 in federal taxes.  This leaves ABC. Inc. $85,000 which it distributes to Alex.  Alex then has to recognize that $85,000 as dividend income and pay $12,750 more taxes on it.  This leaves Alex with only $72,250 of the original $100,000.

On the other hand, what if ABC Inc. was not subject to corporate taxes but instead all of its income flowed through to Alex?  In that case, Alex would pay $15,000 in federal taxes and be left with $85,000 instead of only $72,250.

A major reason why many business owners decide to structure their businesses as S-corporations, partnerships, or limited liability companies (LLCs) is that these can be taxed as "flow through" entities.  That means that the income flows through the business entity and is only taxed at the owner level.  There are restrictions and other drawbacks to these "flow through" entities that will be discussed in future blog posts, but the single level of taxation is a benefit that should not be ignored when you decide on what type of entity is right for your business.

If you have any questions about how various types of business entities are taxes, please feel free to send me an e-mail.

Protect Your Liability Shield!

You set up your business and made sure that you have limited liability protection.  That means you do not have to worry about someone suing you personally for something that happened through your business, right?  Wrong!

Picture borrowed from the Indiana Business Law Blog

(www.michaelsmithlaw.com)

Plaintiffs will try to get around your liability shield through a legal concept known as "piercing the corporate veil." You will want to talk to a business attorney to get a thorough understanding of this, but this blog post will attempt to give you an overview.

Essentially, a plaintiff will attempt to sue you personally instead of suing your business by claiming that your business is really your "alter ego" and not truly its own separate entity.  This tactic is known as "piercing the corporate veil."  Courts will look at a number of different factors to determine whether or not to pierce the corporate veil and allow the plaintiff to proceed to sue a business owner personally.  These factors, and how they are interpreted, vary significantly from state to state as case law in each state continues to evolve.  Therefore, I would again like to emphasize that you should talk to a business attorney to make sure that you are operating your business in a way that will protect your liability shield under the state laws that your business is operating under.

One factor that courts will generally consider is whether the corporation or limited liability company (LLC) engaged in fraudulent behavior.  This should be common sense; you cannot expect to use your business to defraud others and then expect to escape personal civil liability just because it was done through a corporation or LLC.

Another major factor that courts will generally consider is whether the business followed the required formalities.  In California, this primarily applies to corporations because the formalities for LLCs tend to be relaxed.  As I mentioned in a prior post, What is a Corporation?, these formalities generally include, but are not limited to:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

The general concept is that if you want your business to be treated as a separate legal entity by others, then you have to treat it as a separate legal entity yourself.  That means that even if you are the sole shareholder in the corporation, you must hold a Board meeting at least once a year (and maintain minutes of the meeting) to make major decisions for the corporation.  It is not enough that you make the decision because you are not the corporation- the Board must be the one to make the decision (even if you are the only Board member).

Likewise, you must be sure to not commingle funds. Have a separate bank account for your business (corporation, S-corporation, or LLC), and only pay business expenses out of that bank account.  If you put all of your personal funds and business funds in the same bank account, it strongly indicates to a court that you do not consider your business to be its own separate entity.  Similarly, if you pay personal expenses out of your business bank account, such as your mortgage, it gives a court the impression that it is just another personal account.

Another major factor that courts will evaluate when determining whether to allow a plaintiff to pierce the corporate veil is whether the business is undercapitalized.  This means that when you are first contributing money to the new business it must be a reasonable amount.  For example, if you expect your business to have $5,000 of operational expenses a month, an initial capitalization of $1,000 does not appear to be reasonable.

Finally, a factor that will be considered is the amount of control you are able to exert over the business.  For example, if you are the sole owner of the business you are fully in control of the business, and it would be easier for a plaintiff to argue that the business is really just an extension of yourself, your "alter ego".  On the other hand, if you are one of 100 co-owners each owning 1% of the business, it would be very difficult for a plaintiff to argue that the business is your alter ego.

So, as you see forming an entity that has limited liability protection is great, but you must protect your liability shield.  That means you must maintain all the required formalities, including maintaining separate bank accounts and not commingling funds, and you must adequately capitalize your business.

I would strongly recommending talking to an attorney to determine what specifically your business will have to do to protect your liability shield.  If you would like a referral, please send me an e-mail.

Limited Liability Protection

It has been promised for the last few blog posts, and at long last it is here: a detailed discussion of limited liability protection!

While this will be a more detailed discussion of limited liability protection, it is not possible to cover everything and all situations in one blog post.  I strongly recommend that you talk to a business attorney to learn more about this topic.

One of the main advantages of the corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) is limited liability protection.

What protection limited liability provides varies from state to state, so we will focus on California law.  As the name implies, the protection offered is limited to certain types of liabilities.  It primarily applies to protection from personal liability for the entity's debts and protection from personal liability for the actions of co-owners or employees of the business.

So what type of liability is not covered?  Personal liability for your own actions.  If you, for example, personally injure another person you are the one potentially liable.  While I would recommend having insurance anyways, this is another reason to look into purchasing insurance.

Lets go back to what is covered.  Limited liability protection means that you are not personally liable for the entity's debts.  So, for example, let's say that Jason has a corporation, ABC Inc.  ABC Inc.  has been in business for a number of years, but recently business hasn't been good for ABC Inc.  It borrowed $100,000 from XYZ Lending, but burned through its cash and no longer has any money left to repay XYZ Lending.  ABC Inc. has $20,000 worth of other assets.  XYZ Lending can sue ABC Inc. to seize the $20,000 worth of other assets, but cannot go after Jason's personal assets.  Unfortunately for XYZ Lending, they are unable to recover the remaining $80,000.

As previously mentioned, limited liability protection also means that the business owner is protected from personal liability for the actions of his or her co-owners and employees.  Let's look at another example.  Steven owns Delivery, Inc., a successful package delivery corporation.  Delivery, Inc. has hired several drivers to deliver packages.  One day, Rob, one of Delivery, Inc.'s drivers ran a red light while delivering packages and hit a pedestrian.  That pedestrian sued Delivery, Inc. for $500,000.  Delivery, Inc. only has $200,000 in cash and other assets, so the pedestrian is only able to seize that $200,000 worth of assets and cannot go after Steven's personal assets.  On the other hand, if Steven had decided to run the business as a sole proprietorship instead of forming a corporation he could have been held personally liable and had his personal assets seized due to the reckless behavior of his employee.

As you can see limited liability protection is a great benefit to business owners.  However, plaintiffs will try to get around this liability shield by "piercing the corporate veil."  I will explain that legal concept, and how you can maintain your liability shield, in the next blog post.

If you would like a referral to a great business transactions attorney, or you would like to talk to me about your tax situation please send me an e-mail.

What is a Corporation?

Your friends keep telling you that you should incorporate your business, but you brush them off. You own a small business; corporations are giant entities like GE and Apple.

The truth is, you can incorporate your business regardless of its size.  The question is instead whether it makes sense for you and your business to incorporate.

Picture borrowed from www.cgglobal.com

You have to answer that question for yourself, perhaps with the help of a trusted adviser, but in order to make an informed decision you need to have a general understanding of what a corporation is and what the tax implications are to incorporating your business.

The goal of this blog post is to give you an overview of what a corporation is.  I strongly recommend talking to a business transactions attorney if you are considering forming a corporation as there are many important details not discussed here.

As opposed to a sole proprietorship, a corporation is a legal entity that is separate and distinct from you as its owner (shareholder).  There is, essentially, a legal fiction that a corporation is its own person.  What exactly that means has been the subject of many Supreme Court cases and continues to evolve, but for purposes of our discussion it means that the corporation can: enter into contracts, purchase assets, loan and borrow money, sue or be sued, and pay taxes.

Corporations are organized under state law, and must recognize certain formalities.  These vary to some degree from state to state, and for purposes of this discussion I will be discussing the formalities that California corporations are subject to.  Again, this is a very general discussion and I strongly recommend discussing this with a business transactions attorney.   Some of the formalities include:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

This is not an exhaustive list of the corporate formalities that must be followed by a California corporation.

As mentioned in my previous post, Why Form a Business Entity?, one of the primary benefits of forming a corporation is that it has limited liability protection.  Because of the importance of limited liability, it will be discussed in the next blog post.  For now, the general rule is that your financial risk is limited to the amount of your investment.

Another benefit of the corporate form of business ownership is that your ownership interests can, relative to other forms of business ownership, be easily transferred to another individual.  Your ownership interest in the corporation is represented through shares of stock, and generally there are no restrictions on you in transferring your ownership of the stock to another person.  To be clear, this does not necessarily mean that there is an active market for your stock, but once there is a buyer the sale process is much simpler than, for example, the sale of a partnership interest.

However, one of the main drawbacks to the corporate form of business ownership is double-taxation. As I mentioned, a corporation is a separate legal entity that is subject to taxation.  That means that any income that the corporation earns will be taxed first at the corporate level.  If that income is then distributed to the shareholders, it may be taxed again at the individual level (the taxation of distributions will be discussed further in a future blog post).

It is possible to for a shareholder to take money out of the corporation and only have it be subject to one level of taxation if that owner is also an employee.  An owner-employee is paid wages or a salary, and that is W-2 income to the owner-employee but a valid deduction to the corporation. However, as W-2 income it is subject to payroll taxes.  Any additional distributions (i.e., money taken out of the corporation that is not run through payroll) is again taxable at the corporate and individual level.

This hopefully will give you a general understanding of what a corporation is, what formalities it is subjected to, and some of its benefits and drawbacks.  If you are interested in a referral to a business transactions attorney or if you have any questions about the tax implications of corporate ownership, please send me an e-mail.

Why Form a Business Entity?

Congratulations!  You decided to turn your passion into a business, and you are doing everything you can to make sure that it is a success.  You've heard people talk about incorporating their business or forming a partnership or LLC, and now you are wondering if that is the right thing for your business.

Table borrowed from www.strategicofficesupport.com

The answer is...maybe.  It is a cliche, but every business and every business owner is different and has different needs that must be considered.

However, there are some factors that impact this decision.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity's assets (i.e., not your personal assets) are at risk of loss.  For example, let's say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are a number of different tax implications, not the least of which is whether or not you are then considered "self employed" and subject to the self-employment tax, that are outside of the scope of this blog post.  The important thing to remember is that there are a number of tax implications to how you choose to structure your business.  I would recommend talking to a CPA to discuss the specific impact that operating your business as a sole proprietorship versus a partnership, corporation, S-corporation, or LLC will have on your tax situation.

The final factor to consider when deciding to operate your business as a sole proprietor or as a separate business entity is the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS- they are all the time- but many tax professionals believe that sole proprietors are audited more frequently.  Of course you will be filing your taxes properly, but an IRS audit can be expensive for taxpayers even if the IRS does not make any changes to your tax return.

I highly recommend talking to a business transactions attorney about whether forming a separate entity for your business makes sense for you.  Please also feel free to e-mail me if you have any questions about the tax implications of how you structure your business.

What Type of Business Entity is Right for My Business?

Are you considering starting your own business?

According to data released from the U.S. Small Business Administration, hundreds of thousands of businesses are created  in the United States every year.  Every one of these new business owners must decide whether they want to operate as a sole proprietorship or whether they would prefer to operate the business as a separate entity.  Then, they have to decide what type of business entity best serves their needs.

Over the following weeks, I will assist you in answering these critical questions by discussing the factors that business owners should consider in determining whether they should form an entity, and the differences that exist between corporations, S-corporations, partnerships, and limited liability companies (LLCs).

If you are currently going through this process, I would be happy to talk to you about the tax implications of forming a business and to refer you to a business transaction attorney to answer any legal questions you may have.  Just send me an e-mail.