DAVID J. WILLIS ATTORNEY
Copyright © 2015. All rights reserved worldwide.
AN INTRODUCTION TO LLC TAX ISSUES
by David J. Willis, J.D., LL.M.
This article is strictly an introduction to LLC tax issues that offers general information and is not intended to substitute for a thorough evaluation of your tax circumstances by a CPA. Consult your tax advisor before relying on any of the information presented here.
Obtaining an EIN
The quickest way to secure an EIN is from the IRS website (www.irs.gov). Alternatively, one may complete the IRS hard-copy SS-4 form and mail or fax it to Internal Revenue Service, Attn: EIN Operation, Cincinnati, OH 45999 (fax number 859-669-5760). An EIN may be also be obtained by calling (800) 829-4933 between 7:00 a.m. and 10:00 p.m. Monday through Friday. Note that the EIN application requests that the applicant list a “responsible party” along with that party’s social security number.
Each series of a Texas series LLC is permitted (but not required) to have its own EIN, assumed name, and bank account. Texas banks are new to series entities and an investor may have to explain to the bank officer what he or she is doing. If the bank is hesitant, direct them to Sec. 101.601(20)(b) of the BOC: “A series established in accordance with Subsection (a) may carry on any business, purpose, or activity, whether or not for profit, that is not prohibited by Sec. 2.003.”
Federal Tax Returns
The LLC will have to file its own annual federal income tax return unless the company and its series are treated for federal income tax purposes as a “disregarded entity.” A “disregarded entity” is disregarded as an entity that is separate from its owner for federal income tax purposes. Under the IRS default rules for entity classification (IRS Reg §301.7701-3(b)), a single-member LLC is automatically disregarded and a multi-member LLC is automatically taxed as a partnership. In a case where a natural person (Form 1040 filer) is the only LLC member, the activities of the disregarded entity are reported on the taxpayer’s Form 1040 – Schedule C. In a community property state (e.g., Texas), a husband and wife who wholly own an LLC as community property have the option of either receiving disregarded or partnership treatment (IRS Rev. Proc. 2002-69).
Alternatively, your CPA may assist you in filing the entity classification election to receive tax treatment other than that provided by the default rules (accomplished by means of Form 8832). The other option for a single-member LLC is being classified as an association taxable as a “C” corporation (in which case the entity would file Form 1120 - a “U.S. Corporation Income Tax Return”); or an “S” corporation (in which case the entity would file Form 1120S – a “U.S. Corporation Income Tax Return for an S Corporation”). A multi-member LLC may also elect to be classified as an association taxable as a “C” or an “S” Corp. Unless there is a compelling business reason to elect “C” corporation status that is well researched, this status should not be elected. In general, according to IRS regulations, once an entity has made its tax election, an election may not be changed for 60 months.
So should your entity make an S Corp. election rather stick with the default position of a disregarded entity? It depends. Dallas CPA Angie Sebeniecher advises as follows: “If the IRS considers the client as dealer (doing this business for their livelihood), then their business income is subject to self-employment tax. The S Corp election can be used to minimize that. If classified as a dealer, none of the gains are considered capital gains. It's all considered ordinary income, subject to the tax rate the individual is in, plus self-employment tax. I usually recommend this for people flipping property on a regular basis.” Consult your CPA for advice relating to your specific circumstances.
Series IRS Returns
Must a series file its own tax return? Not usually, but it depends. If a series has its own EIN, activities different from other series, and/or a different membership structure, a separate annual federal income tax return may have to be filed for both the series LLC organization itself and for the individual series. Let your CPA know that the U.S. Treasury Department has proposed regulations (Sept. 14, 2010 at 26 CFR Part 301) which state that the IRS will treat individual series as separate entities - each of which may elect “pass through” tax treatment if the established criteria are met. The Journal of Accountancy, states that “the tax treatment of the series will then be governed by the check-the-box regulations (Treas. Reg. §§ 301.7701-1 through 301.7701-3) . . . The IRS decided that the factors supporting separate entity status for series outweigh the factors in favor of disregarding series as entities . . . They specifically looked at the fact that the rights, duties, and powers of members associated with a series are direct and specifically identified. They also noted that individual series may have separate business purposes and investment objectives. The IRS concluded that these factors are sufficient to treat domestic series as entities formed under local law.” (www.journalofaccountancy.com/Web/20103328.htm). Among other things, this means that individual series will have their own K-1.
The IRS offers a helpful online Tax Workshop for new businesses designed to help small business owners learn their tax rights and responsibilities. Go to www.irs.gov/businesses/small/article.
Texas Franchise Taxes
As for Texas franchise tax, the Comptroller of Public Accounts sends a notice to new filers of the date on which the first state franchise tax report is due (May 15th). It will also show the LLC’s state taxpayer number (which is different from the file number at the Secretary of State’s office). The letter will also ask that you “please complete an online Franchise Tax Accountability Questionnaire with 30 days.”
A Texas franchise tax return must be filed with the Comptroller even if the company has no income. It is due by May 15th of the year following formation. Many new companies are eligible to file the No Tax Due Information Report (Form 05-163) if the LLC is a passive entity as defined in Tax Code Sec. 171.0003; if it has annualized income less than the statutory threshold ($600,000); if the company has zero Texas gross receipts; or if the company is a real estate investment trust (REIT) as defined by Tax Code Sec. 171.0001(c)(4). If your company does not fall into one of these categories, one will likely be filing the EZ Computation Report (Form 05-169).
For owners of more than one Texas registered entity, it will likely be necessary to include an Affiliate Schedule (Form 05-166). There is $50 fee for filing late.
The Comptroller´s Public Information Report
The annual filing of a Texas Franchise Tax Public Information Report (the “PIR” found on Form 05-102) is required by the Comptroller. It is due by May 15th of the year following formation. It is a simple form. The PIR requires disclosure of the names of each current “officer, director, or member” of the LLC. This is different from the Certificate of Formation which called for the names of the initial managers, not members. Since LLC’s do not have directors, that is not an issue; however, one needs to supply the name of any person or entity who is a member, a managing member, or a non-member manager. This of course has implications for any anonymity strategy an investor may have.
Visit the Comptroller’s website at www.window.state.tx.us. to acquaint yourself with information and resources available. Their phone number is (800) 252-1381.
Failure to Pay Franchise Taxes
Failure to pay Texas franchise tax will result in the company’s right to transact business, as well as the right to sue and defend itself in Texas courts, being forfeited. If the company’s right to transact business is lost, then the company’s officers, directors, partners, members or owners may become liable for debts of the entity, including taxes, penalties and interest, which are incurred after the due date of the report and/or payment (See Tax Code Ann. Sections 171.251, 171.2515, 171.252, and 171.256). For future reference, to determine if the company is in good standing with the Texas Comptroller, go to www.ecpa.cpa.state.tx.us/coa/index.html or call (800) 252-1381.
There is no annual filing required at the Secretary of State’s office.
Banking with a Series LLC
Lawyers hear lots of questions, comments, and complaints in this area. Firstly, the series concept is new to most Texas banks; and secondly, lenders generally have become so difficult to work with that it is nearly impossible to know with certainty what they will require, either for purposes of opening an account or obtaining a loan. A physician client of ours was even asked for a copy of his medical school diploma.
Tax vs. Legal Considerations in Asset Protection
One should distinguish between asset protection generally, and asset protection structures specifically, that are approached from a legal vs. a tax point of view.
An asset protection lawyer is primarily focused on likely courtroom outcomes—specifically avoiding adverse ones, since a large judgment can be an extinction event (unlike a slightly higher tax bill). Focusing on avoiding liability and lawsuits, and the protection of non-exempt assets in the event of a judgment . . . that is what an asset protection lawyer does.
Approaching entity formation and deal structuring from a purely tax-driven perspective is a different avenue entirely, often employed by CPAs who may have no experience in a courtroom and lack knowledge concerning the vulnerability of assets. A narrow tax-driven approach may not always be entirely consistent with the legal approach.
In some cases, the legal and tax perspectives coincide. In others, an investor may have to decide where his or her emphasis is going to be: saving on taxes vs. maximizing protections on the legal side. It is often not feasible to maximize both sets of considerations.
This article has been intentionally brief. Even though basic tax information has been presented, it is not a substitute for ongoing advice and guidance from a good CPA. All new series LLC owners should consult a CPA concerning the best way to handle the new company for federal and state tax purposes. Certain tax benefits may be available but are not automatic.
Information in this article is proved for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well since we are not tax practicioners and do not offer tax advice. This firm does not represent you (i.e., no attorney-client relationship is established) unless and until it is retained and expressly agrees in writing to do so.
Copyright © 2015 by David J. Willis. All rights reserved worldwide. Reproduction or re-use of any this material for any purpose without prior written permission and full attribution is strictly prohibited. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, http://www.LoneStarLandLaw.com.