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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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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Valuation Discounts

One of the primary objectives of estate planning is to arrange for the transfer of wealth to the next generation at the lowest possible cost. For large estates, the most significant cost is the gift and estate tax. These two tax regimes are essentially a single tax imposed on total lifetime gifts plus the value of property transferred at death. As mentioned in a previous post, gifting during lifetime can be part of an estate planning strategy.

For a gifting example, assume a gift tax rate of 40% and a donor who has previously utilized his or her entire tax exemption and who desires to make a gift of $1,000,000 of a $4,000,000 investment in a publicly-traded company.

After making the gift of the $1,000,000 asset, the donor will pay a $400,000 gift tax. Obviously, a key factor in the calculation of the gift tax is the valuation of the stock that is the subject of the gift. In this case, the valuation is straight-forward because the stock is easy to sell and has a ready market.

However, consider the gift of a small, privately-owned family business. In this case, the value of the asset will reflect the fact that there is not a ready market for the business; it is more difficult to sell. In addition, the value of a minority interest in a private business will reflect a lower value if the owner does not have managerial control.

For planning purposes, both the "lack of control" and "lack of marketability" discounts can be effectuated in not only the small, privately-owned family business context, but also for nearly any other asset. For example, suppose that the owner of the $4,000,000 stock investment first transfers the stock into a limited partnership. Subsequently, if the owner transfers a 25% limited partnership interest to a donee, the value of the gift for gift tax purposes will be less than $1,000,000.

This is because there is not a ready market for a privately-owned partnership interest. Furthermore, instead of owning $1,000,000 worth of publicly traded stock outright, the donee merely owns a 25% limited interest in a private partnership. Since the donee lacks managerial control over that interest, it does not matter that the underlying asset is publicly-traded stock; the lack of control discount would apply in addition to the lack of marketability discount.

If the total valuation discount in this case works out to be 30%, this results in a gift valuation of $700,000 instead of $1,000,000. This results in an accompanying gift tax of $280,000 instead of $400,000, an immediate cash savings of $120,000 simply by utilizing the limited partnership.

Source: Valuation, Jonathan C. Lurie and Edwin G. Schuck, Jr., The American Law Institute - American Bar Association Continuing Legal Education, 2008

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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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