Twice a year, I host a program on “Legal and Tax Issues for Small Businesses and Their Owners” for a local bar association. Most of the attendees are young lawyers who are just beginning to experience the joys of working with entrepreneurs.
Here are some of their more interesting questions, and the answers I gave during the program.
Q: “After I form a limited liability company (LLC) for a client (so far I’ve done this for owners of residential real estate), what else should I advise them? Do for them?”
A: The short answer is “as much as possible.” Unlike corporations, LLCs are designed to be ‘low maintenance’ – for example, they are not required to have annual meetings. You should always try to “sell” additional services when sending the final LLC document package out to clients. So, for example, your cover letter could say: “If I can assist you in drafting or negotiating any contracts, employment or partnership documents, or handle any other legal or tax matter relating to your LLC, please do not hesitate to call me.”
If your clients are forming LLCs to own second or vacation homes, you should point out that (1) you can prepare their leases with tenants, (2) you can help with mortgage and refinancing paperwork, and (3) you can represent them if the IRS questions any tax savings they claim as a result of putting the property in an LLC.
Q: “What’s the difference between a management (or voting) agreement and an operating agreement for an LLC? Can the terms of the former be folded into the latter?”
A: Most attorneys use the terms “management agreement” and “voting agreement” interchangeably, but when I was first forming LLCs the term “management agreement” was used only in situations where a manager-managed LLC was managed by someone who was not a member of the LLC. I caution clients against trying to spell out in an agreement “who will be doing what” within the business, which is of course what you would do in a traditional management agreement. If they really insist on doing that, then I set them up as “officers” of the LLC with formal job descriptions just as you would do in the bylaws of a corporation.
Q: “What must a C Corporation do to convert to an S Corporation? Are there any time limits? Are there any substantial disadvantages?”
A: A C corporation must file IRS Form 2553 to become an S corporation. It may also have to file an election form at the state level in order to get S corporation treatment for state corporate income taxes. Generally, there are no time limits, but if an S corporation goes back to C corporation status it cannot re-elect S corporation status for three years.
There are some disadvantages to S corporations, specifically: (1) the rules are complicated and you have to keep track of them (for example, all S corporation shareholders must be U.S. citizens or “green card” holders, i.e. permanent residents of the country); (2) S corporations cannot issue preferred shares and so won’t be attractive to venture capitalists and other professional investors; and (3) there are limits on an S corporation’s ability to deduct expenses for “passive” activities such as real estate investment. For more information on the advantages and disadvantages of S corporations, see the “Demystifying the Business Organization” outline which is available as a free download from my website at www.succeedinginyourbusiness.com.
Q: “Are a husband and wife operating a business together with no legal entity documentation a partnership and do they have to file a partnership forms on their tax returns?”
A: Many accountants and CPAs I work with take the position that while a husband and wife engaged in business together are a “partnership,” they do not have to file Form 1065 unless there are other partners (they would file Schedule C, the same as a sole proprietor). I confess I have never found solid authority in the federal Internal Revenue Code for this position, but I simply defer to my client’s accountant when the question comes up.
Q: “How do you transfer a corporation or LLC to a Trust? Is it just a matter of amending the Trust document to include the business entity in the Trust or is there more to it?”
A: The big question is: why are you transferring the corporation or LLC (actually, the owner’s shares) into a trust? If you are doing this to minimize estate and gift taxes, you should consider setting up a “family limited partnership” or “family limited liability company” instead. Just remember the IRS sometimes looks at these as “audit triggers”.
If you are looking at a trust to protect the owner’s shares from attachment by creditors, you will have to set up a “domestic asset protection trust,” preferably in Delaware, Alaska, or Nevada where these trusts are viewed favorably. For an excellent article on these trusts, see http://blog.law.vandrew.com/2011/07/domestic-asset-protection-trusts-worth.html.
Cliff Ennico (www.succeedinginyourbusiness.com), a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books.