Introduction to the Corporate Transparency Act

On January 1, 2024, the new federal Corporate Transparency Act will require the vast majority of small U.S. entities to start filing an online report with the Financial Crimes Enforcement Network (FinCEN) and report beneficial ownership. Existing entities will have until January 1, 2025 to file this report, but entities formed in the new year will need to file within 30 days of formation. Reports with FinCEN are already required for, among other things, foreign accounts, which I discussed in a previous post. However, the CTA is a big deal and represents a complete upheaval of current entity formation and maintenance practice. A number of exceptions to the reporting requirements apply, but generally only include large entities or entities that are otherwise subject to an existing regulatory regime, such as financial institutions. In other words, it is small entities that are being targeted by the CTA, and ultimate individual beneficial ownership is the primary reporting objective.

The reporting requirement is imposed upon the "reporting company" itself, which is any entity formed by filing a document with a state agency. This means that most trusts will not themselves be reporting companies but will likely have complex requirements to provide information about various trust participants if the trust owns a reporting company interest. "Senior officers" of a reporting company are liable for penalties of up to $500 for each day that the violation continues, imprisonment for up to two years, and/or a fine of up to $10,000. Beneficial owners of a reporting company that provide false information or refuse to provide information to the reporting company can also face penalties. A beneficial owner is any individual who exercises "substantial control" over a reporting company or owns or controls at least 25 percent of the ownership interests of the reporting company.

The key pieces of information required of beneficial owners include full legal name, date of birth, physical home address (P.O. Boxes are not allowed), and a copy of the individual's driver's license or passport. If any of this information changes, the reporting company must file a change report. Much of the burden of reporting and keeping track of a beneficial owner's change of information appears to be relieved in large part if the beneficial owner obtains his or her own FinCEN identification number and the reporting company reports that number. Given the detailed personal information that is required to be disclosed and the substantial penalties for noncompliance, we will be hearing much more about the CTA at the start of the new year.

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The Uniform Transfer on Death Security Registration Act

In a prior post, I discussed the trend in probate law whereby nontestamentary arrangements are increasingly favored as ways to transfer property upon death without the need for probate. One such arrangement that I have written about previously is the Uniform Real Property Transfer on Death Act. Another such arrangement is the Uniform Transfer on Death Security Registration Act.

The purpose of the UTODSRA is "to allow the owner of securities to register the title in transfer-on-death (TOD) form," thus providing for a non-probate mechanism for transferring a security upon the death of the owner. Under the act, one or more individuals who own a security can take ownership in "beneficiary form," which simply means that ownership reflects the name of the registered owner(s), followed by the words “transfer on death”, “TOD”, “pay on death”, or “POD,” followed by the name of the beneficiary.

The UTODSRA extends to interests in private companies, including limited liability companies. This can be very beneficial because it is often families of small business owners that have the greatest need for a simple, low-cost alternative to probate.

Many buy-sell agreements restrict ownership of a business to a small group of individuals and provide for the buy-out of an owner upon death. However, depending on the terms of the buy-sell agreement and the owner's individual estate plan, the successor of a deceased business owner may need to go through probate in order to give the manager of the business assurance that the proceeds of the interest buy-out are paid to the right person. The UTODSRA provides one option for streamlining the effectuation of a buy-sell agreement upon the death of a business owner.

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Avoiding a Partnership Tax Return Filing Requirement

According to the IRS, a partnership is a "relationship between two or more persons who join to carry on a trade or business..."  No formal agreement is required; in fact, a partnership can be formed inadvertently, in which case an IRS Form 1065 partnership tax return must be filed.  However, there are a few situations where two or more persons can carry on a trade or business without creating a partnership tax-filing requirement.

If two or more persons have a business relationship that, for tax purposes, constitutes a corporation or trust, obviously such an arrangement is not a partnership. However, a venture that is not a corporation or trust avoids partnership classification if the parties are merely sharing expenses. In addition, a married couple has the option of not filing a partnership tax return if they "materially participate as the only members of a jointly owned and operated business" and file a joint tax return.

Such an arrangement is known as a "qualified joint venture" and cannot be operated through a state-law entity. However, a husband and wife in a community property state may own and operate a business through a state law entity other than a corporation, such as an LLC, and elect to have that LLC disregarded for federal income tax purposes. The business entity must be owned as community property and have no other owners; if so, no partnership tax return is required. These rules are contained in Rev. Proc. 2002-69.

A final example of partnership-type arrangement that does not give rise to a partnership tax return requirement is co-ownership of real property, other than mineral property, but including rental property. Each co-owner must be a tenant-in-common, and title to the property as a whole may not be vested in a state-law entity. However, each tenant may own their interest in the property through an entity that is disregarded for tax purposes. A number of other requirements are set forth in Rev. Proc. 2002-22 which, if satisfied, will result in no partnership filing requirement.

In summary, a partnership can automatically arise for federal tax purposes even where no entity exists under local law. An arrangement of this kind includes a "syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on..." However, arrangements like those described above avoid partnership classification.

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Flight Department Companies

If you or your client is thinking about owning an aircraft in a limited liability company or other entity, think again. While an individual aircraft owner can operate an aircraft for personal use, this is not the case when that same aircraft is owned by an LLC, even one that is disregarded for tax purposes. The Federal Aviation Administration has consistently viewed these entities as "flight department companies," which require commercial registration. The following is from a Legal Interpretation to James W. Dymond from Rebecca MacPherson, Assistant Chief Counsel, Regulations Division, dated March 9, 2007:

A company whose sole purpose is transportation by air and receives compensation (amounts paid by the Client needed to pay the costs of owning and operating the aircraft) must obtain certification under Part 119… Section 91.501(b)(4) is drafted to permit an individual owner, not a company, to operate an airplane for his own personal transportation and guests without charge. Thus section 91.501(b)(4) cannot be used by a flight department company.

Jeff Wieand, an expert in this area, explains as follows:

Unfortunately, few business lawyers are well versed in arcane FAA rules and regulations, especially ones as counterintuitive as the flight department company trap. Suppose I buy a business jet and own and operate it in my own name. Since I’m flying myself around in my own aircraft, the FAA says I can follow the non-commercial Part 91 Federal Aviation Regulations. Now suppose I create a wholly owned LLC to own and operate my jet, the company’s only business. I may regard the LLC as a kind of alter ego; after all, I’m the sole owner, and it’s doing only what I could do myself—operating the aircraft. But the FAA doesn’t look at it that way. It considers my LLC a completely separate legal entity. Now I’m not flying myself around anymore; the LLC is flying me around. Put differently, my LLC is providing air transportation to a different person—me. And providing air transportation to others for compensation or hire requires, according to the FAA, a commercial certificate, which the LLC doesn’t have.

As this runs somewhat contrary to conventional asset protection wisdom, it is important to be familiar with these and other FAA regulations when dealing with aircraft.

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Self-Employment Taxes for LLC Members

In a previous post, I discussed how members of an LLC taxed as a partnership can avoid being liable for self-employment tax on the net income from the business. With the limited exception of Prop. Reg. 1.1402(a)-2, the subject of that post, clear guidance on this issue has been lacking for decades. This month, the IRS created a stir by taking on the issue anew with Chief Counsel Advice memorandum 201436049. Tony Nitti, writing at Forbes, has a great article that describes the backdrop for this new pronouncement in this way:

"IRC Section 1402, like many provisions of the Code, starts off by setting the general rule– i.e., all trade or business income, including a partner’s distributive share of partnership income, is included in self-employment income–before listing a host of exceptions to that general rule. Specific to this discussion, IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner – other than guaranteed payments – is NOT included in self-employment income."

In general, taxpayers who earn active income owe self employment tax on that income, while taxpayers who invest and earn passive income, such as limited partners in a limited partnership, do not pay self employment tax on those earnings. IRC 1402 was passed before LLCs came into existence, and LLCs have confused the issue because all LLC members are legally akin to limited partners.

Most tax practitioners agree that, similar to how S-Corps are treated, only part of the distributive share received by members from properly-structured LLCs ought to be subject to self-employment tax, not all of it. However, with CCA 201436049, the IRS took the position that individuals who were members of an LLC that served as a general partner of an investment limited partnership and received a management fee were subject to self employment tax on the entirety of their distributive share.

CCA 201436049 makes reference to Prop. Reg. 1.1402(a)-2 in a footnote, summarizing the three tests for limited partner treatment: "[A]n individual is treated as a limited partner unless the individual: (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership; or (3) participates in the partnership's trade or business for more than 500 hours. [There are] exceptions for certain holders of classes of interest that are identical to those held by limited partners."

With respect to the exceptions: "If the LLC has two classes of members... [and if] at least 20% of the members of the Investor Class do meet all three tests and the managing member is a member of this class," the managing member is treated as a limited partner and his or her distributive share is not subject to self employment tax. John M. Cunningham, "Using LLCs to Protect Family Assets," WealthCounsel CLE, September 14, 2011. The key is to have a properly-drafted operating agreement that clearly creates these distinct classes of membership.

CCA 201436049 stands for the idea that the distributive shares of LLC members who provide services are not wholly exempt from self employment tax simply due to the LLC structure. The proposed regulation, even though not finalized, can probably still be relied upon as a safe harbor. Beyond that, be aware that the IRS appears prepared to argue that more or all of a partnership LLC's distributive shares ought to be subject to self-employment tax.

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Registered Agent Services

Every state in the U.S. offers business owners some form of limitation on liability if they operate through a business entity such as a corporation or LLC. One of the requirements for all business entities is to maintain a "registered agent." A registered agent is a person or other entity within the state where the entity is formed that maintains a physical address within that state. The purpose of a registered agent is to receive service of process on behalf of the business entity. If a registered agent is not identified, a business entity cannot be formed in any state; if an entity ceases to maintain a registered agent, the business will immediately cease to be in good standing with that state.

While almost anyone can be a registered agent, many companies offer this service for a fee.  In my experience, the following complaint about commercial registered agents constantly resurfaces: "I want to cancel my registered agent services, but I keep getting billed or told I have to pay a huge fee to cancel!" Hopefully, this post explains why this situation arises and what to do about it.

This problem is most often faced by someone who has purchased a new business entity, usually an LLC in a different state from where they live, and decides that they don't need the entity any more. Maybe they intended to start a business and it didn't work out, or maybe an advisor recommended setting up an entity or many entities that proved to be overly costly to maintain.

From the registered agent's perspective, as long as the business entity lists it as agent, it is bound to maintain the registered address and be prepared to forward any service of process it receives to the business owner. The only way the registered agent can be relieved of its obligation to provide these services is if (1) the agent resigns, (2) the business owner switches agents, or (3) the entity is dissolved, either voluntarily or involuntarily. With the exception of involuntary, or "administrative," dissolution, each option requires a document to be submitted to the state in which the business entity is formed. This requires time and a fee that is paid to the state, and the registered agent is unlikely to want to take these steps unless compensated by the business owner.

As a specific example, if you own a business entity and LegalZoom.com is your registered agent, the terms of service state, "If you no longer wish to use the Registered Agent Services in any jurisdiction, you must assign another registered agent in that jurisdiction, and must pay all fees related to changing your agent.... If, however, you no longer wish to use the Registered Agent Services because you are discontinuing your business operations (voluntarily or otherwise), you must properly dissolve, cancel, withdraw, or otherwise properly terminate your entity.... If you fail to [do this and submit proof,] you will continue to incur charges for Registered Agent Services until such proof is provided."

To complicate matters further, nearly every business owner must pay an annual fee to the state for every entity they own in order to keep the entity in good standing with the state. If the annual fee to the state is not paid, the entity will go on inactive or default status until all annual fees (including late penalties) are paid. In most states, if an entity is in default, no filings may be made with respect to that entity. After an extended period, at least three years in most states, the entity will be administratively dissolved.

LegalZoom.com maintains a registered office in Nevada, and all other states, so that it can serve as a registered agent. (As an interesting side note, on October 1, 2013, a new Nevada law went into effect requiring any registered agent with 10 or more represented entities to register with the Secretary of State, which LegalZoom.com has not yet done. This means that all of its represented entities are on administrative hold and will be unable to file annual reports until LegalZoom fixes the problem. If your entity is charged late fees in Nevada because you couldn't file your annual report, LegalZoom should be responsible for those late fees).

Continuing the Nevada example, entities in that state must pay $325 to the state each year (not including registered agent fees, which normally range from $100-$200). If a business fails to file the necessary reports, a $175 late fee per year is imposed. What this means is that if someone set up a Nevada entity, never did anything with it, forgot to file annual report for two years and wants to stop being billed $100-$200 each year for registered agent services, they must first bring the entity back into good standing (which would cost at least $1,000 in state fees alone), then pay the $100 fee to the state to dissolve the entity, and only then will the registered agent be released from its obligations and be able to close the account (perhaps only after receiving payment for the past years of registered agent services). That can add up quickly for a business that never did anything but briefly exist.

If you have a business entity but haven't done anything with it, didn't keep it in good standing, and want to close it down, my best advice is this: Ask your registered agent to resign as your agent. There will be a fee for this, but it will be significantly less because a registered agent can usually resign from entities that are not in good standing. In other words, if you were to dissolve the entity yourself, most states would require you to first pay all past due annual fees and late fees and then pay to formally dissolve; if your registered agent simply resigns its position, most states do not require the entity to be in good standing. This is by far the easiest and cheapest option, and most registered agent companies don't offer to do this up front, so you have to ask and try and negotiate.

If this doesn't work, and you happen to have a personal relationship with your registered agent, you may be able to simply let them know you are abandoning the entity and letting it administratively dissolve and they may cancel your account and stop billing you. Usually, this is not an option, however. Your only other viable option is to pay the state to bring your entity back into good standing if it isn't, and file Articles of Dissolution. Provide proof to your registered agent and then ask if they will give you a break on any past-due agent fees.

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Federal Tax Classifications for Business Entities

For federal tax classification purposes, a business is classified as either a "business entity," which is any entity recognized for federal tax purposes; or a "disregarded entity," which is any entity not recognized or treated separate from its owner for tax purposes. The most common federal tax business entities include a C-Corporation, S-Corporation, and Partnership. Various rules under the Internal Revenue Code determine how a business is treated for federal tax purposes.

The default tax classification for a corporate entity is a C-Corporation. Alternatively, a corporation can elect to be taxed as an S-Corporation by filing Form 2553 with the IRS and meeting certain requirements.

A single-member limited liability company is the only state-formed entity eligible to be classified as a disregarded entity; this is the default classification. The one exception is where a business is owned equally by a husband and wife in a community property state; this business can also be treated as a disregarded entity. A single-member LLC can also elect to be taxed as a C-Corporation by filing Form 8832 with the IRS; alternatively, it can elect to be taxed as an S-Corporation by filing Form 2553.

The default tax classification for non-corporate, multi-member legal entities (including LLCs and state-law partnerships) is a partnership. A multi-member business may elect to be taxed as a C-Corporation or an S-Corporation in the same manner as a single-member LLC. One of the prerequisites for S-Corporation status is a single class of interest, disregarding differences in voting rights; multi-member LLCs with one class of interest or general partnerships can meet the requirements to be treated as an S-Corporation.

The following chart summarizes these rules:

               State-Law Entity

	Corporation	Single-Member LLC	Multi-Member Eligible Entity
Disregarded	No	Yes	No*
Partnership (Form 1065)	No	No	Yes
C-Corporation (Form 1120)	Yes	Yes	Yes
S-Corporation (Form 1120S)	Yes	Yes	Yes**

*A business owned equally by a husband and wife in a community property state can be treated as a disregarded entity.
**Only certain entities, such as multi-member LLCs with one class of interest and general partnerships, can qualify for S-Corporation status.

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Self-Employment Tax Avoidance for LLC Members

In addition to the income tax, sole proprietors and partners in a partnership must pay self-employment tax on net self-employment earnings. This tax is imposed on "active" trade or business income, as opposed to "passive" income from rents, interest, dividends, capital gains, and income of a limited partner in a partnership.

Corporations pay tax at the corporate level and accordingly, corporate net income is not subject to self-employment tax. As I wrote previously, S-Corporation earnings flow through to the individual shareholders' personal income tax returns and also avoids self-employment tax. A special set of rules applies to income generated by LLCs taxed as partnerships.

These rules come from Prop. Reg. 1.1402(a)-2(h)(2). Technically, these regulations are not binding since the IRS has not issued final regulations, but they are the only administrative guidance available, "they can be relied on to avoid a penalty under IRC section 6406(f), and there is judicial precedence, in Elkins [81 T.C. 669 (1983)], [to] reasonably conclude that the courts will sustain the position of a taxpayer who relies on proposed regulations." Janet Meade, Minimizing Self-Employment Tax of LLC Managing Members, The CPA Journal, June 2006.

Under the proposed regulations, an individual will be treated as a limited partner (and thus avoid self-employment tax) unless "the individual (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership's trade or business for more than 500 hours during the taxable year." Individuals who provide health, law, engineering, architecture, accounting, actuarial science, or consulting services cannot take advantage of this rule.

Even if members of the LLC don't meet all of the above tests, self-employment taxes can still be avoided with respect to "amounts that are demonstrably returns on capital invested in the partnership." In general, in order to take advantage of the exceptions to the general rule, the LLC should be manager-managed and the operating agreement should provide for two classes of members, a managing class and an investor class.

The investor class will be treated as limited partners and the managing class will be treated as general partners for self-employment tax purposes. Members of the managing class can avoid self-employment tax on a portion of their share of the partnership's net income if their interests are bifurcated between the managing class and investor class interests. In other words, the "application of the SE tax to LLC members under the proposed regulations depends not only upon their formal status as members or managing-members but also on their level of participation in the entity" (Meade).

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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.

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Personal Residence LLC and Trust Tax Considerations

Some asset protection attorneys recommend placing personal residences into entities, while others prefer trusts. While both have their pros and cons, no decision should be made without ensuring that the federal tax benefits of owning a personal residence are maintained.

The Internal Revenue Code provides a significant tax advantage to taxpayers who own a personal residence. First is the interest deduction of as much as $1 million of acquisition indebtedness and up to $100,000 of home equity indebtedness on a qualified personal residence. Taxpayers who do not hold legal title to a residence but who can establish they are the equitable owners of the property are entitled to deduct mortgage interest paid by them with respect to the property. Transferring a personal residence into an asset protected entity should not affect this deduction as long as the taxpayer remains the equitable owner of the property.

Second, and more important, IRC § 121 provides for an exclusion from taxable income of $250,000 ($500,000 for married couples) worth of gain on the sale of a personal residence. This exclusion may be claimed every two years as long as the taxpayers owned and used the property as their principal residence for two out of the previous five years prior to the sale.

Treas. Reg. § 1.121-1(c)(3)(i) provides that if a taxpayer owns his or her residence in a trust, as long as the taxpayer is treated as the owner of the trust, he or she is treated as owning the residence for purposes of satisfying the two-year ownership requirement. Treas. Reg. § 1.121-1(c)(3)(ii) provides that if an individual taxpayer owns his or her residence in an entity, as long as the entity has the taxpayer as its sole owner and is disregarded for federal tax purposes, he or she is treated as owning the residence for purposes of satisfying the two-year requirement.

One other possibility exists in community property states where a married couple owns the limited liability company 50-50, as the entity can elect to be taxed as a disregarded entity under Rev. Proc. 2002-69. The couple will be able to own their residence in the LLC and satisfy the two-year requirement.

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