Welcome to CPA at Law, helping individuals and small businesses plan for the future and keep what they have.

This is the personal blog of Sterling Olander, a Certified Public Accountant and Utah-licensed attorney. For over seven years, I have assisted clients with estate planning and administration, tax mitigation, tax controversies, small business planning, asset protection, and nonprofit law.

I write about any legal, tax, or technological information that I find interesting or useful in serving my clients. All ideas expressed herein are my own and don't constitute legal or tax advice.

Charging Order Remedies

A charging order is a statutory provision of law that allows a creditor of a company’s owner to take distributions made to the owner by the company. It is a limited remedy designed to protect innocent owners by preventing a creditor from disrupting business activities by seizing or controlling company interests. Because the creditors cannot control the entity, they cannot control when distributions are made, meaning that the creditors get nothing if the business never makes a distribution. Limited partnerships and limited liability company statutes, but not corporation statutes, generally limit a creditor to a charging order.

As an example of how charging order protection works, assume that Jane forms a new Corporation and contributes $10,000. Jane is the Corporation’s 51% owner, and her husband John owns 49%. The Corporation prospers and is worth $10 million some years later. At that time, Jane is driving her personal car negligently and runs over and kills a doctor; she incurs a $10 million judgment. Because her business is formed as a corporation, the estate of the doctor can levy on Jane’s stock, thereby gaining control of the Corporation, and sell its assets in satisfaction of the judgment. This will result in Jane’s loss of employment and in the liquidation of the corporation at a substantially discounted price, with her husband receiving 49% of the discounted proceeds.

However, if Jane had initially organized her business as a limited liability company, the exclusive remedy for the estate of the doctor in most jurisdictions is a charging order. As such, the estate would be entitled to distributions that the LLC makes, but nothing more; it cannot levy on Jane’s LLC interest, fire her, or liquidate her company.

Because limiting a creditor to a charging order is designed to protect the innocent members in a business entity, this limitation may not apply where a limited liability company has only a single member. In fact, a number of courts have held that creditors of the sole member of an LLC are not limited to the charging order remedy and that they may seize the debtor’s LLC interest. Accordingly, a single member LLC by itself cannot be relied upon to provide meaningful asset protection.

File 1120S instead of Schedule C

Schedule C is part of Form 1040 and is used to report income or loss from a business. “Business” means any continuous activity engaged in for income or profit. Schedule C is also used to report statutory employee wages and expenses, income and deductions of certain qualified joint ventures, and certain income shown on Form 1099-K and Form 1099-MISC. There are two important reasons why reporting business income on Form 1120S is better than reporting business income on Schedule C.

First, is audit risk. The IRS continually tracks the “tax gap,” or the amount of tax liability faced by taxpayers that is not paid on time. A huge portion of the tax gap is attributable to Schedule C under-reporting; this is the reason why the IRS audit efforts focus so heavily on Schedule C. Additionally, claiming several years of losses in a row on Schedule C will increase audit risk with the IRS arguing that the “business” is really a “hobby” and that the losses should be disallowed.

Not only does filing Schedule C cause an audit risk, it also results in paying more self-employment taxes than necessary. On Schedule C, all of the net income from the business is subject to self-employment tax, which is normally around 15 percent. Self-employment tax is in addition to income tax.

By forming a business entity and electing to have that business entity taxed under Subchapter S of the Internal Revenue Code, self-employment tax liability can be reduced. A Subchapter S Corporation (S-Corp) is created when an eligible entity, such as a corporation or limited liability company, elects to be treated according to the rules of Subchapter S of the Code and its regulations.

S-Corp net income is reported on form 1120S and flows through to the personal tax return of its owners, avoiding Schedule C and self-employment tax all together. However, S-Corps must pay a reasonable salary to its owners. Salary is subject to payroll taxes, and payroll taxes are virtually identical in amount to self-employment taxes. However, S-Corps do not need to pay all net income as salary, and any net income not paid as salary avoids both self-employment tax and payroll tax.

In order to form an S-Corp and file Form 1120S, advance planning must be undertaken since a business entity should be formed and Form 2553 should be filed to make the S-Election near the beginning of the tax year. Doing so, however, is likely to result in a smaller overall tax liability at year end.

Defective Grantor Trust Overview

Irrevocable trusts are an essential part of sophisticated estate planning. Such trusts are normally used to hold assets that have been gifted or otherwise transferred by a grantor. Assets within irrevocable trusts, including future appreciation, are not included in the grantor’s estate for estate tax purposes.

A standard irrevocable trust is treated as a separate entity for income tax purposes and will be taxed on the income at the trust level. However, if an irrevocable trust is “defective,” the deemed grantor of the trust will be taxed on the income of the trust instead. This means the trust is disregarded for federal income tax purposes; such trusts are known as “grantor trusts.”

An intentionally defective grantor trust can be an effective planning technique for several important reasons. First, as with any irrevocable trust, the assets held within the trust are generally protected from creditors.

Second, since the trust is not a separate taxpayer, a sale to the trust by the grantor is not a recognizable transaction for income tax purposes and no gain will be recognized. Such a sale is often structured as an installment sale with a promissory note that has a self-cancelling feature effective upon the death of the grantor. This results in the balance of the note being excluded from the estate of the grantor; similarly, any increase in the value of the asset will also occur outside of the grantor’s taxable estate.

Third, since income generated by the irrevocable grantor trust is taxed to the grantor, the payment of that tax liability by the grantor is, in effect, a gift-tax free benefit to the trust and ultimately to the trust's beneficiaries. Since the trust is irrevocable, the trust principal will not be included in the taxable estate of the grantor. Therefore, the grantor can transfer assets into the trust by sale without the recognition of an income tax event, not have the trust assets included in his or her gross estate at death, and continue to reduce the value of his or her estate by the income tax payments on the trust income.

Although President Obama's current budget proposal would eliminate the value of using intentionally defective grantor trusts as an estate planning strategy, such trusts currently remain a useful tool.