Beware Of Income Taxes On Member Contributions To An LLC Taxed As A Partnership

By: Tamara Pow

Before you make a contribution to an LLC in exchange for a membership interest, beware that some member contributions to LLCs are taxable. For a limited liabilty company (“LLC”) taxed as a partnership, the general rule is that members do not recognize any tax gain or loss on their contributions to the LLC in exchange for a membership interest. After the contribution to the LLC, the member will get a basis in her membership interest equal to the basis she had in the contributed property and any pre-contribution gain or loss she had on the property will be allocated to her. However, watch out for these six exceptions to the rule of a member not recognizing gain or loss on a contribution of property to an LLC:

  1. Contribution of Services
    Although the non-recognition rule is true for the contribution of property or cash to an LLC, the contribution of services to an LLC in exchange for a membership interest may be taxable depending on how the LLC agreement is drafted. This is a very complex tax analysis, that I will attempt to simplify here, but if you are considering contributing services to an LLC it is critical that you get the advice of a good lawyer or CPA that understands these complexities. Generally, if the service member receives a capital interest in the LLC (a right to receive money or property on the LLC’s dissolution), the member will immediately recognize ordinary income on the value of the capital interest received in exchange for the services. This recognition may be delayed until any contingency or substantial risk of forfeiture is satisfied. On the other hand, if the service member receives a profits interest, dependent on the LLC’s future profits, this will usually not cause recognition, unless the profits interest brings with it a substantially certain and predictable stream of income, or the member sells it within two years, or the profits interest is in a publicly traded partnership. Either way, an LLC generally recognizes no gain or loss on the issuance (or later vesting) of a membership interest provided in exchange for contributed services.
  2. Disguised Sale
    If the contribution of property to the LLC is really a disguised sale restructured to look like a contribution in exchange for a membership interest, the member transferring the property will recognize gain. For example, if a member transfers property or money to an LLC and, within two years, gets property or money back, the transaction will be treated as a taxable exchange either between the member and the LLC or between the member and another member.
  3. Acquisition of Stock of a Corporate Partner
    An LLC’s acquisition of stock of a corporate member in exchange for property may be taxable.
  4. Contribution of Property subject to Liabilities
    If a member contributes property subject to liabilities and the LLC assumes the liabilities, or takes the property subject to them, the transfer of the property may cause tax recognition for the contributing member. The member is treated as receiving a distribution of cash equal to the amount of the liability assumed, if the member does not have enough basis to cover the deemed distribution, the member will recognize taxable gain.
  5. Investment Company LLC
    If the LLC is classified as an investment company, the contributing member may recognize gain or loss on the contribution of property.
  6. “Boot” Received
    If the contributing member receives some property in addition to the membership interest, this property is known as boot and will be treated as either a distribution from the LLC or a partial sale.

If all the members are contributing cash to an LLC, taxes on contributions are not a concern. However, if members are contributing services or property, or may fall into any of the exceptions above, be sure to check with your tax advisor prior to finalizing the structure and language of your operating agreement.

As an LLC attorney in the Bay Area, Tamara is often asked about the tax consequences LLC members face when making contributions to an LLC. Tamara uses her MBA, California real estate broker’s license and experience in public accounting, to consider all possible tax consequences when choosing the best form of business entity or structuring a member contribution to an LLC.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

LLC Members – Ignoring Self-Employment Taxes When Choosing Your Business Entity Can Be A Costly Mistake

By: Tamara Pow

In addition to income tax considerations on forming a limited liability company (“LLC”) in California and making contributions to the LLC, potential LLC members should keep in mind that income they receive from their LLC may be subject to self-employment tax, and that self-employment tax treatment may be different if the LLC is taxed as a corporation or a partnership.

LLC Taxed as a Corporation

For an LLC taxed as a corporation , if a member is active in the business of the company, payments to the member may be taxed as compensation which is deductible by the corporation and subject to employment taxes. Other amounts, and possibly excessive compensation, will be characterized as a dividend.

LLC Taxed as a Partnership

For an LLC taxed as a partnership , if a member is active in the business of the company, payments to the member may be self-employment earnings, salary or wages, or simply a distribution based on the member’s percentage interest. A member’s distributive share of LLC income is self-employment income if the business of the company is a trade or business that the member is active in. A member is considered active in the business if she has personal liability for claims against the LLC, has authority to contract on behalf of the LLC, or participated in the LLC’s trade or business for more than 500 hours in a tax year. On the other hand, if the member is not active (like a limited partner) then the income is generally not treated as self-employment income.

For certain professions, including health, law, engineering, architecture, accounting and others, if a member is providing professional services, that member will be considered active and all income from a partnership will be subject to self-employment tax. In California, most professionals are not eligible to practice in a limited liability company, but this rule would apply to a limited liability partnership (“LLP”) as well.

One other California difference to note is that for California state tax withholding purposes, a member of an LLC that is taxed as a partnership cannot be an “employee.”

Self-Employment tax and other individual taxes are one of many tax and other considerations to be taken into account in determining the right form of entity for your business. If you are active in your business, or are planning to practice a profession in a partnership, make sure to discuss these implications with your tax advisor prior to forming a business entity to avoid the hassle and cost of an entity conversion later.

Tamara Pow is an LLC attorney who also has an MBA, a California real estate broker’s license and experience in public accounting. She understands the importance tax planning plays in choosing an LLC as the proper form of entity for business and real estate investments.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Entering Into A Real Estate Loan? Will You Need a Single Purpose Entity?

By: Serge Filatov

The real estate market in the Bay Area and San Jose is booming. With interest rates still low, many real estate investors are taking advantage of cheap debt and either taking out new loans for projects or refinancing existing debt.

One of the common items that I see in commercial real estate loan transactions is the requirement that the borrower be a single purpose entity (an “SPE”) and that it agree to numerous provisions designated to ensure that it remains separate. A single purpose entity is an entity that exists for one purpose. In our context, an SPE is set up for the sole purpose of owning and operating a property, and for no other purpose. By making the entity so narrowly focused, the lender is trying to put protections in place to make sure that the borrower is not pulled into or consolidated with a bankruptcy caused by the problems of affiliates of the borrower.

To ensure a borrower is and remains an SPE, the lender will often impose numerous covenants on the borrower. Below are some examples of the type of covenants a borrower must often agree to:

  • maintain accounts separate from any other person or entity
  • maintain separate books and records from any other person or entity
  • not commingle assets with those of any other person or entity
  • pay for all liabilities out of the borrower’s own funds
  • maintain a sufficient number of employees in light of borrower’s contemplated business
  • not acquire debt or equity of another entity
  • hold itself out at all times as a separate entity
  • maintain adequate capital in light of its contemplated business
  • not create or incur any indebtedness other than the loan and unsecured trade debt or operating expenses

The list can go on and on…

As the borrower, you need to review the SPE language carefully to make sure that it accurately portrays how you will run your business.

For example, will you really maintain a sufficient number of employees to run your business or are those employees really employed by an affiliate? If so, will you need to put in place a services contract between the entities?

If you do not end up operating your business like you have stated, an event of default under the loan can occur and the lender could have recourse against the borrower or any guarantors. Therefore, thinking through these issues is important and a knowledgeable attorney can help you meet the SPE requirements while still allowing you to conduct your business as normal.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Using LLCs For Estate Planning

By: Tamara Pow

Although I do not practice estate planning law, as a limited liability company lawyer (“LLC lawyer”) in San Jose, I have worked with estate planning attorneys to form many LLCs for families that want to include them in their estate plan. Traditionally, the entity of choice for estate planning was the Family Limited Partnership (“FLP”). Once LLCs were introduced in California, attorneys began using an LLC to be the general partner in the Family Limited Partnership. The parents would contribute assets (often income producing real estate) to a Family Limited Partnership in exchange for limited partnership interests which would be gifted to the next generation, and a general partner interest which would be retained by the parents in their wholly owned LLC. This maintained control with the parents, but unlike holding the general partnership interest in their individual names, it provided them with a layer of liability protection as well.

Gifting of limited partnership interests is more attractive than outright gifting of the underlying asset for two reasons: First, the donor can retain control in the form of the general partnership interest. Second, the gifted limited partnership interest can get a valuation discount for terms in the partnership agreement such as lack of control and lack of marketability of the interest. In other words, a parent can gift her child 50% of a property worth $1,000,000, making the gift worth $500,000; or a parent can gift her child a 50% limited partnership interest in a partnership that owns the $1,000,000 property, making the gift worth approximately $350,000 because the partnership interest is not a controlling interest and cannot be easily transferred. LLCs are entitled to this same valuation discount so long as the transferee has limited rights.

Over time, estate planning attorneys have become more comfortable with using Family Limited Liability Companies in place of Family Limited Partnerships, rather than just as their general partners. Using one entity instead of two can sometimes reduce the amount of California franchise taxes paid by the family to maintain the entities and can simplify the annual reporting requirements for the family. Also, the transfer of assets to a Family LLC can avoid the potential of a gift occurring when parents transfer assets to an FLP and take limited partnership interests but give the next generation the general partnership interest (the IRS sees this as a transfer of control resulting in a gift without valuation discounts). This same argument against valuation discounts does not apply to LLCs because the transfer of assets to an LLC with one class of members does not involve the same disproportionate transfer of control.

There are many more business and real estate considerations to an operating LLC than just the estate planning considerations. A good LLC attorney is critical to drafting an operating agreement for the LLC that will both satisfy the family’s estate planning intentions and satisfy its business protection needs, management needs and other tax requirements. A trust and estates attorney can set up trusts for the members to hold the LLC interests and work with the LLC attorney to make sure the ownership and control succession plan dictated by the operating agreement is in line with the succession plan for the family.

As an LLC attorney with an MBA, a California real estate broker’s license and experience in public accounting, I cannot overemphasize the importance good planning plays in choosing an LLC, LP or corporation as the proper form of entity for business and real estate investments, including those involved in family estate planning.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Business Contracts – Beware of Third Party Beneficiaries -They May Not Be Missing Persons

By: Robert Hawn

As a business attorney with a Silicon Valley practice, I create a lot of contracts for many different kinds of companies. It never gets boring! One of the issues we sometimes worry about is whether there are any other parties that might have rights under these contracts. This concept, which lawyers refer to as a “third party beneficiary right,” is often disclaimed in the agreement. Job done, right? Well maybe not.

In January of this year, a Ninth Circuit Court of Appeals looked at whether third party rights exist where they have been expressly disclaimed in an agreement and decided that, the facts need to be examined further. Whether this case will expand third party rights, or will just be limited to its particular facts, remains to be seen. It does, however, caution business people to make sure of the deals they cut so that only the parties with whom they deal with in the contract will be the parties they have to deal with in court if the deal goes sideways.

For you fans of 80s Rock, this case involved the lead singer of the band, Missing Persons. The facts, however, are not just a simple case of walking in L.A., so pay attention.

Dale Bozzio, the lead singer of the band, brought suit against Capitol Records, and its corporate parent, EMI, to collect royalties based on what was argued to be a mischaracterization of the source of the record company’s revenue for the band. Like many bands, Missing Persons had created a “loan-out corporation.” This is a corporation that is used to cut deals with, among others, record companies. Under the contract, Bozzio, along with her other band mates, agreed that they would not bring any claims for royalties individually against the record company, but only against the loan out corporation. Problem was, the corporation was suspended when the band broke up and therefor had no standing to sue. So, a lower court looked at the contract and said no corporation, no lawsuit, and besides you agreed not to sue, so go away. Bummer. Bozzio appealed.

The Ninth Circuit looked a bit closer at the contract, and said not so fast. To make a long song into radio format, the Ninth Circuit looked at some other parts of the law and the contract and said that Bozzio could have her day in court. They were swayed by prior case law that seemed to imply that the fact that the corporation could not sue did not necessarily mean that someone claiming third party beneficiary rights under that corporation could not sue. They were also swayed by a clause, presumably created to protect the record company, that said that if the loan out corporation could not provide Bozzio’s services, that she would provide them directly. In addition, the Agreement provided for royalty payments individually under certain circumstances, which allowed the court to conclude that the record company may have accepted the concept of individual rights for Bozzio under the agreement, and that her standing as a third party beneficiary of the loan out corporation’s rights against the record company existed, notwithstanding her promise not to sue the record company directly.

So what is the takeaway? First, just excluding a person as a third party beneficiary might not do the trick. You need to look and see if there are any other provisions affecting those shareholders that might allow them to assert rights sufficient to allow them to sue you. This case is particularly interesting because a clause that was, in my opinion, created to help the record company (i.e., the clause that allowed the record company to get Bozzio’s services when the loan out corporation would not provide them) was used against the record company. Second, and probably most important, you need to keep in mind that the law in this area is fuzzy and fact dependent, and you have to consider these types of rights as you evaluate the risk of any deal.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Limited Liability Companies, California Real Property And Property Taxes

By: Tamara Pow

As a real estate attorney in Silicon Valley, I represent a lot of real estate investors that hold their properties in LLCs. One of the biggest and most expensive mistakes LLC members can make when transferring property to or from an LLC is triggering a reassessment of their real property, yet this complex area of taxation is often not well understood by real estate owners or even accountants or attorneys that do not specialize in this area. The general rule is that any transfer of real estate is an event causing both transfer taxes and the reassessment of the property for property taxes. The role of the tax advisor, whether a CPA or real estate or business entity attorney, is to either prepare the client for this eventuality in advance so they can decide whether or not to proceed, or to structure the transaction to fall into one of the exceptions.

A contribution of real property to an LLC on the formation of an LLC is a change of ownership, triggering reassessment for California property tax purposes, unless all of the following three circumstances apply :

  1. The transfer is between legal entities or between one or more individuals and an entity;
  2. The transfer is solely a change in the method of holding title; and
  3. The proportional interests in the property (directly or through the entity) remain the same before and after the transfer.

This means that one or more owners of real property can transfer the real property to an LLC and take membership interests in the LLC in the same percentages in which they previously owned the property directly and there will be no change in ownership, and therefore no reassessment for property tax purposes and no transfer taxes. Be very careful with percentages – they must be identical. I recently had to argue a case with the Santa Clara County Tax Assessor’s Office in which an attorney helped two co-owners of real estate transfer their property to an LLC. One owned one-third of the property, which was noted on the deed as 33 1/3%, and the other owned two thirds of the property, noted on the deed as 66 2/3%. However, when the attorney drafted the LLC operating agreement, he rounded the percentage interests to give the first owner 33% and the second owner 67%. The result was that the property was reassessed and the partners could not claim that the indirect ownership percentages were identical before and after the transfer to the LLC.

Even though the contribution to the LLC may not be a change of ownership, the property could still be reassessed later as a result of a member’s transfer of an interest in the LLC resulting in either a change in ownership or a change in control. A change of ownership results when more than 50% of the total interests in the LLC are transferred by the original co-owners. A change in control results whenever a person or entity obtains direct or indirect ownership of more than 50% of the total membership interests in the LLC. One of the many reasons experienced real estate attorneys encourage their clients to take title to property from the beginning in the name of the LLC (rather than taking title in their own names and then transferring to an LLC) is to avoid the change of ownership risk.

If title to the property is being transferred by deed, the County receives a “PCOR” or preliminary change of ownership report form whereby the transferee reports the new ownership and claims any exclusions from reassessment. If LLC membership interests are being transferred, the property remains titled in the LLC, so no deed or PCOR is filed. Instead, the members are required to file a change of ownership of real property form with the State Board of Equalization within 90 days of any change of more than 50% of the original co-owners (cumulatively – in one or more transaction) or any change in control. Failure to timely file the Form BOE-100 can result in a significant penalty. For more information on the change of ownership form go to the BOE website .

Once a property has been reassessed it is usually impossible to reverse unless a mistake was made, and it is difficult and expensive to argue for a reversal even for a mistake. Before transferring real property into an LLC or from an LLC out to its members, and before transferring membership interests in an LLC, be sure to consider the potential property tax implications.

I am one of the very few LLC attorneys that has an MBA, my real estate broker’s license and experience in public accounting. I therefore understand the importance tax planning plays in choosing an LLC as the proper form of entity for business and real estate investments.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.