Editor’s note: This is part 15 of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
A global trend in deregulating and automating legal services is offering consumers of legal services automated, inexpensive LLC formation options. In all areas of life, an inexpensive price usually comes with high costs that are unforeseen. Unfortunately, none of the inexpensive LLC services has a complete rubric for guiding people through the ever-changing state and federal legal issues that must be navigated during an LLC’s formation. The many misunderstood and overlooked facets of LLCs cause big problems in the form of tax non-compliance, unexpected tax assessments, audits, federal rule and regulations violations and a lack of asset protection.
Professionals like dentists, doctors, lawyers, architects and designers form LLCs in the state where they practice and then file an S corporation election (small corporation election) because they are told that doing so will save on federal employment taxes. These professionals might assume they can easily figure out the legal side of business. This can create numerous unintended consequences.
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Example. A dentist files an LLC to set up a new office for their expanding dental practice. The dentist is inspired to name the practice Riverside Dental and is happy when the state website for the LLC filing shows that the name is available. Once the LLC is filed with the state, the dentist calls the bookkeeper and asks them to file an S corporation election because the dentist remembers that they did this with their previous office to save on employment taxes. The dentist then purchases equipment in the LLC with a federal S corporation election, and the dentist then purchases an office and deeds the office into the S corporation.
Several years later, the dentist receives a cease-and-desist notice claiming that by using the name Riverside Dental, the dentist has violated the federally filed trademark of another dentist. The dentist sends a brusque letter explaining that they filed the LLC several years ago and secured the name Riverside Dental, so the other dentist can jump off of a bridge. Soon thereafter, the dentist finds that they are being sued for federal trademark infringement, and the other dentist is claiming that the first dentist must pay treble damages to the trademark owner. The dentist is shocked that the state permitted the LLC filing when it caused a violation of federal trademark laws, and they hire an attorney to reach a settlement with the federal trademark owner.
Unfortunately, the trademark infringement settlement payment is so large that the dentist takes on a new dentist partner, who contributes cash into the S corporation to pay off the settlement. The dentist is shocked again at the end of the year when they discover that they owe both capital gains taxes and depreciation recapture taxes on the contributions made by the new dentist. The dentist speaks with a tax attorney, who explains that if the dentist’s Riverside Dental office had been taxed as a partnership, no tax would be owed, but S corporations work very differently when it comes to new contributions of capital.
Rustin advises clients on tax, business and estate planning matters. He serves as an adjunct professor, frequent speaker and is current or former chair of professional associations. A prolific author, he has published many technical and popular articles on estate and business issues, as well as drafting and advising legislators in developing numerous statutes pertaining to trust and estate and business planning, creditor exemption planning and digital asset (blockchain) trusts and blockchain entities known as decentralized autonomous organizations.
LLCs are so easy to file in most states that people are usually unaware of the layer cake of applicable state and federal laws. LLCs are a creation of state law, but the state will not look out for the federal regulatory and tax problems inherent to them. Another very common use of LLCs is to hold real estate, and in my law practice, I regularly need to unwind LLC catastrophes for landlords. Although real estate-holding LLCs have many complexities and nuances, many of the problems I encounter are a result of misunderstandings about the fundamental principles of LLCs.
Here a few of the most common real estate LLC issues that I regularly encounter:
LLC ownership risk. Listing a person as the owner of the LLC, rather than a trust (or trusts), leaves the LLC vulnerable to attack by the personal creditors of the LLC owner. As an example, although the LLC will protect the real estate owner from the tenants (outside liability risk), if the LLC is owned by a person directly, then the person’s personal creditors can recover against the LLC as an asset belonging to the LLC owner (inside liability risk). Trusts remove the LLC from the risks of the LLC owner.
Cross-liability risk. Holding multiple real properties all together in just one LLC subjects all the properties to cross-liability risk. A problem with one property will impact all properties. Property insurance is very important, but there are endless exceptions in any property insurance policy that can cause the property insurance to fail, leaving the real estate susceptible to creditors.
Real estate non-deduction risk. Real estate-holding LLCs must be set up so that the LLC owner is materially participating in the property management and also qualified as a real estate professional. Otherwise, the real estate owner will be disallowed from lawfully deducting the property depreciation to offset the rental payments. The inability to deduct real property depreciation will usually make it nearly impossible to profitably invest in real estate.
Real estate profit reinvestment misunderstandings. Real estate rental income cannot be reinvested without first reporting the rents as taxable income — even if no tax is ultimately owed on the income because it is offset by expenses and deductions. LLC owners regularly misunderstand this fundamental principle that LLC income cannot be reinvested in an LLC through repaying a mortgage on the property without first reporting the gross rents as taxable income. Then, after paying any applicable taxes on the rental income, the real estate owner can use the after-tax money to pay the mortgage. Deduction for expenses to operate the property, or depreciation could offset the obligation to pay taxes.
However, mortgage principal payments are not deductible expenses — principal payments are treated like other investments and must be made with after-tax money. Unless there are other expenses or the real estate owner qualifies to take property depreciation, the mortgage will need to be paid with after-tax rents (which would make real estate investing impossible in most situations).
S corp holding real estate issues. It is a rare situation where an S corporation should hold real estate because deductions for business-level debt are difficult, and S corporations cannot later distribute the real estate out of the S corp or reorganize easily without an immediate depreciation recapture risk under Section 1250 of the Internal Revenue Code.
Partnership income tax risk. Tax-free real estate partnership formation under IRC Section 721 can still cause IRC Section 108 compensation income tax to the sweat equity partner who does not contribute capital, with the compensation amount equal to the non-contributing partner’s interest in the company. To get around deemed income tax, partners may consider entering into a genuine debt agreement and pay regular, statutory interest on the debt under the IRS Original Issue Discount rules.
The partnership cannot wait to pay interest until profitable, or the debt will be reclassified as a contribution of capital, and the sweat equity partner who is given 50% will be taxed on 50% of the capital contribution from the money partner.
LLCs must file annual taxes. A common but very costly mistake when operating an LLC is to not report the LLC financial transactions on tax filings on an LLC simply because the LLC “didn’t make any profit.” Unfortunately, many people don’t realize that even if an LLC doesn’t make a profit, it is still required to report income and expenses.
Single-member real estate LLCs. Real estate LLCs with one owner are taxed as sole proprietorships, and real estate LLCs with multiple owners are taxed as partnerships by default, unless they elect otherwise. Real estate LLCs that fail to report or file annual taxes face a penalty of $220 per partner per month, and the IRS will charge interest on the unpaid amount under IRC Section 6651(a)(1), which provides that in case of failure to file any return “… on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate.”
Note: Rev. Proc. 2002-69 permits community property spouses to treat an LLC owned by spouses as a disregarded entity (an entity that does not itself file a tax return, but is instead scheduled on the personal tax return of the spouses). Also, a business owned by both spouses with no entity formed under the state can operate under the qualified joint venture rules to report the venture’s finances on separate Schedule Cs based on their respective ownership stake.
LLCs are a very common type of business entity, easily formed online, easily leading to catastrophes. LLCs are surprisingly complex to manage and can quickly implicate diverse tax rules, tax pitfalls and asset protection issues. Be sure to consult with a tax attorney so that you can achieve LLCs’ many advantages and avoid their many pitfalls.
My next article will be about advanced asset protection and tax planning with irrevocable trusts.
Other Articles in This Series
- Part one: To Avoid Probate, Use Trusts for Estate Planning
- Part two: How Quitclaim Deeds Can Cause Estate Planning Catastrophes
- Part three: Revocable Trusts: The Most Common Trusts in Estate Planning
- Part four: With Irrevocable Trusts, It’s All About Who Has Control
- Part five: Ins and Outs of Domestic Asset Protection Trusts (DAPTs)
- Part six: Irrevocable Trusts: Less Control Equals More Asset Protection
- Part seven: Should You or the Trust Pay a Trust’s Income Taxes?
- Part eight: How to Handle Irrevocable Trust Assets Tax-Efficiently
- Part nine: Repeal the Death Tax? These Are the Taxing Trade-Offs
- Part 10: Gift and Estate Tax vs Capital Gains Tax: Which Is Less?
- Part 11: This Double-Dip Trust Benefit Really Is Too Good to Be True
- Part 12: This Trust Strategy Can Reduce Your Taxes Big-Time
- Part 13: Limited Liability Companies (LLCs): How Assets Are Protected
- Part 14: How Trusts Can Be Used to Protect LLCs From Creditors
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