The Minority Owner Report, Part 1- LLCs and Partnerships

I am by no means a “precog”, nor can always predict when minority ownership in a small business will result in disaster, but my 14 years of experience with small business clients has taught me a great deal about what not to do when structuring a business and offering ownership to employees.

If you are currently a minority owner (<50% interest) in an LLC taxed as a partnership or a traditional partnership, or you are being offered such ownership, you may want to consider running away from the ownership if certain warning signs are present.  Also, I highly recommend having your tax professional and/or lawyer look everything over before you sign anything.  Business ownership is a lot like marriage, so know what you are getting into.

Minority Ownership Warning Signs in LLCs and Partnerships

The entity does not increase guaranteed payments by 5% to cover self-employment tax

When an employee becomes a partner or LLC member, their tax burden increases substantially because of the self-employment tax.  Generally, an employee pays social security and Medicare tax of 7.65% on gross wages, and the employer pays another 7.65%.  However, an active partner or LLC member is considered self-employed and has to pay both the employee and employer portions of social security and Medicare tax, which total 15.3%.  Fortunately, the IRS allows a deduction for one half of the self-employment taxes paid (just like the deduction available to employers), which results in an approximate net rate of 12%.  This means that a employee who becomes a partner or LLC member will incur a tax increase of approximately 5%.

Most companies do the right thing and give an employee transitioning to ownership enough additional income to cover this 5% tax increase.  The most effective means of doing this is to provide the additional income to the new partner or LLC member in the form of an increase to their regular guaranteed payment.  Employees are accustomed to predictable cash flow and regular tax withholdings, so the transition to making quarterly estimated tax payments at a higher tax rate can be difficult.  Additional income that is guaranteed and paid on a regular basis is going to ease that transition and insure that there is a tangible benefit to ownership.

Unfortunately, a surprising number of partnerships and LLCs do not provide additional income to employees transitioning to minority ownership, and often it can result in ownership that is actually a detriment to them as a result of the additional tax.  Usually, future profits are promised when selling ownership to the employees, and in some businesses, this works very well when consistent profits easily eclipse the 5% tax burden.  However, taxable business profits can be very unpredictable due to current accelerated tax depreciation rules and other complications, and in order to distribute profits during the year when they are helpful to the owners, a business has to keep very accurate accounting records.  Owners have to pay estimated tax payments quarterly, so the unpredictability of having to rely on distributions of profits can create a lot of dissension among owners – especially during periods of low profits or losses.  The sad irony for these businesses who are unwilling to pay the additional 5% in income to partners/LLC members is that they often make ownership offers to employees for the sole purpose of keeping them at the company, and often the tax burden on the new owners does the exact opposite after several years of seeing no benefit to ownership.

The entity is providing capital interest ownership in exchange for services

Giving ownership to an employee in exchange for services can actually work very well if structured correctly and all parties are properly informed of the tax ramifications.  However, ideal situations like this rarely happen in the real world, and usually such an arrangement results in a surprise tax bill for the employee receiving ownership.  Avoiding such a disaster requires an understanding of the most common types of interests available in small business organized as LLCs.

Capital Interest – this is the default type of LLC interest, as it is a complete ownership that entitles the holder to a share of profits and losses as well as a share of the proceeds from the sale of the LLC’s assets if the LLC liquidates.  A capital interest is most commonly given to employees brought on for succession planning purposes.

Profits Interest – this interest is like the capital interest, except a profit interest holder does not receive liquidating distributions from the LLC.  In other words, it is only an interest in future profits of the LLC and there is no initial capital balance for the member.  A profits interest is often given to key employees much like stock options are given to employees of corporations.  It is often intended as a form of additional compensation and a method to retain key personnel.

If you receive a capital interest in exchange for services, it is treated as current compensation in an amount equal to the fair market value of the capital interest at the grant date.  The problem is that most small businesses owners organized as LLCs are not aware of this, and rarely do they tell their CPA about such transactions in advance, so it often becomes an ugly year-end or tax-time surprise for the recipient, as they have taxable income to recognize and no cash to pay the tax with.  To make matters worse, most small business owners have no idea what the fair market value of their LLC is, so the transaction becomes very complex can create many problems down the road if not done correctly.  As an employee being offered such an interest, I strongly recommend asking the LLC to involve their CPA and/or lawyer so that the compensation is determined ahead of time.  This will allow you plan accordingly and look into options like the 754 election that can minimize the tax impact.

If you are granted a profits interest in an LLC, no taxable income is recognized as long as the interest satisfies the Revenue Procedure 93-27 safe harbor rules.  Most LLCs that offer a profits interest have already had a CPA and/or lawyer setup it up so that the rules are met, so in most cases it is a good deal for the employee receiving the interest.  However, it is important to get some prior financial statements and/or tax returns so that you can know what to expect, as sometimes start-ups give profit interests and then go several years without any recognized profit.

The entity does not have a method of equalizing expenses

Single-owner businesses have it very easy in the area of expenses, as they can spend how they want without having to justify to other owners or worry about trying to keep things equal.  In multi-owner businesses, there is a constant problem with equalization, as business partners are usually wired differently when it comes to spending and often have different tastes.  One LLC member may be tech savvy with smart phones and tablets and another may still prefer a flip phone and a paper legal pad, so it is crucial for a minority owner that an LLC or partnership have an established method of expense equalization in place.

The most flexible method of expense equalization is to have the operating agreement specifically state that the LLC or partnership will not reimburse partners for certain expenses and that they are required to pay for these expenses.  As long as it is properly setup in this way, each partner or member can deduct their unreimbursed partnership expenses on their own 1040 tax return on Schedule E page 2.  This allows each partner or member to be as lavish or frugal as they want without having to worry about the expenses of the other owners.  Often, meals and entertainment, automobile, travel, and office expenses are treated in this fashion.

The second best method is devising a special allocation where certain expenses are allocated 100% to certain owners against their guaranteed payments.  This can be elaborate or just a simple calculation done with the tax return preparation, but either way – LLCs and partnerships are extremely flexible in this area.  Just make sure the allocation is decided on well in advance, as it is much more difficult to agree on after expenses have already been paid.

That’s it for LLCs and partnerships.  In Part 2, I will concentrate on minority ownership issues in S corporations.

Advertisements

Attention S Corporation and LLC Procrastinators

There is less than a month until the final extended deadline for 2011 S corporation and LLC tax returns, and it is crucial you file on time to avoid late filing penalties.  If you have not sent in your 2011 data to your CPA or tax preparer, you might want to work on it this weekend instead of enjoying the summer weather (or lack thereof if you are in Portland this morning).

I have written numerous posts about the S corporation late filing penalty that can only be abated if you have no prior late filing history, and the partnership penalty that the IRS has recently been making more difficult to abate.  If you have never read up on this topic or had to deal with this issue, please take a few minutes and click on the links above to read about the penalties, as they can amount to thousands of dollars in unnecessary, non-deductible costs for your business.

Even though there are automatic abatement procedures in place for entities taxed as partnerships, you should not assume that if it has worked for you in prior years that it will work in the future.  Last year, the IRS made changes to their internal procedures with regard to how they dealt with late filed partnership returns, and I had many abatements challenged or denied that had been approved in prior years.  You can read about some specific problems on my TaxQueries.com post, but I believe the IRS will continue making it more and more difficult for partnership filers that continue to file late each year.

Make finishing your 2011 accounting work a priority this weekend!  Not only will your tax preparer appreciate it, but not having potential penalties hanging over you is even better.

 

LLC vs. S-Corporation, Round 1

When setting up a business and deciding on entity type, most people are looking for 1) liability protection and 2) tax savings – specifically lowering self-employment tax liability.  For small businesses, the two best options are the LLC or the S-Corporation, and many tax or legal professionals seem to advocate for one team or the other so it is hard to know what entity is truly best for your business.  Well, I am not your advisor and I have been on both teams, so hopefully I can provide you with some balanced information and after a couple rounds, hopefully we will have a winner for your business…

Will the business own appreciating property like real estate?

If your business has anything to do with real estate rentals or owning and managing commercial or residential property, then LLC is the early winner.  This is vitally important – you should never put real estate into a corporation.  If a CPA or tax practitioner recommends this for a new small business, I would consider it malpractice.

Basically, if you put real property into an S-Corporation, then you are going to have a taxable event if you transfer it out of the corporation in the future and you will pay tax based on the fair market value of the property at that time.  I could tell you some horror stories on this issue, but trust me – if you have a residential or commercial property, put it in an LLC.
LLCs are perfect for real estate as you can move the property in and out of the entity without any taxable events.  Plus, they are much easier to setup, administer, and report for tax purposes.  Even better, if you have one owner, you can use the single-member LLC for your real estate and then the tax reporting is simplified so that you only have to complete a Schedule E as part of your personal return.

How many owners will the business have?

This is another important question to look at upfront, as it can result in a knock out in round one.  If you will be the sole owner of the business, then your options are limited to the following:

Single-member LLC (SMLLC)

The only LLC offering for the single-owner business is a great option for easy setup, administration, and tax reporting; however, it is going to cost you in the form of self-employment tax.  To the IRS, The SMLLC is no different than a sole proprietorship – in fact, the SMLLC is reported on Schedule C just like a sole proprietorship.  Unfortunately, this means that you will pay self-employment tax (15.4%) on the entire amount of your net taxable earnings.  This can really add up – especially if you are a consultant with few expenses and/or minimal capital asset needs.  After a few years of paying a hefty tax bill, most business owners are willing to put up with some extra administration and tax prep costs in exchange for a much lower tax bill via use of the S-Corporation while paying themselves a reasonable wage.

S-Corporation

The big winner for single-owner businesses is clearly the S-Corporation as most business owners can end up saving thousands.  With an S-Corporation, you do not pay self-employment tax on the earnings, BUT the owner must pay himself a “reasonable” salary, which means you are paying payroll taxes on the Federal and state level.  Usually, if you sit down with a CPA and lay this all out, they should be able to give you a ballpark of your tax savings each year; however, there are costs related with this:

  • Legal costs – it is not cheap to setup, but I would never suggest a D.I.Y for an S-Corporation.  Get it setup right and avoid legal problems later.
  • Accounting Fees – keeping your accounting data on a spreadsheet may not cut it anymore – especially if you use a lot of credit cards and loans.  Be prepared to pay a bookkeeper or an accountant to get your books setup right so that the tax preparation goes smoothly.
  • Tax Prep fees – S-Corporation returns require much more work and typically range from $750 – $2000 or higher depending on complication.  Plus, you now have to file quarterly payroll tax returns and payroll to process, which can run you about $95/quarter even with one employee using ADP, Paychex, of your CPA.

If your savings are still substantial after factoring in these costs, then you should definitely go with the S-Corporation, but make sure you have a good lawyer and a good CPA that you like as you will be talking to them frequently for the first few years.

Well, round 1 is in the bag and we are tied at 1 a piece.  In round 2 we will deal with issues for businesses with more than owner.

Just remember – never choose an entity for your business without consulting a CPA and lawyer as every situation and business is unique.  Give me a call at 503.224.8844 if you need a CPA or a lawyer to help you with your new business.