LLC Lawyer

LLCs and Taxation

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Many of my clients are curious about forming LLCs and how they are treated for tax purposes.  In Colorado, a limited liability company is considered to be a pass-through entity and is treated like a partnership or sole proprietorship for tax purposes. All of the profits and losses of the LLC pass through the business to the LLC members (owners) who then report this information on their personal tax returns. The LLC itself does not pay federal income taxes.  

If the LLC is owned by a single member, the IRS treats it as a sole proprietorship for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS. The sole owner of the LLC reports all profits or losses and submits it with his or her 1040 tax return. If the company makes a profit, even if the member leaves this money in the company, he or she must still report this and pay taxes on this money at the end of the year.

If the LLC is a multi-member LLC, the IRS treats it as a partnership for tax purposes. This means that multi-member LLCs do not pay taxes on business income. Instead, the LLC members each pay taxes on their share of the profits on their personal income tax returns. The LLC members’ share of profits and losses, called a distributive share (usually ownership percentage), should be set out in the LLC operating agreement.

Most operating agreements provide that a member's distributive share is in proportion to his or her percentage interest in the business. If the members decide to split up profits and losses in a way that is not in proportion to the members' percentage interests in the business, it's called a special allocation. The IRS has guidelines as to how this works.

The IRS treats each LLC member as though the member receives his or her entire distributive share each year. This means that each LLC member must pay taxes on his or her whole distributive share, whether or not the LLC actually distributes all (or any of) the money to the members. The practical significance of this is that even if LLC members need to leave profits in the LLC, each LLC member is liable for income tax on his or her rightful share of the profits left in the company.

As a result, if the members intend to keep a substantial amount of profits in the LLC (retained earnings), the members might benefit from electing corporate taxation. Any LLC can choose to be treated like a corporation for tax purposes by filing a form with the IRS within a certain time frame of the LLCs formation.

Rental Properties and Colorado LLCs

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In Colorado, the Limited Liability Company business structure is popular because it is a hybrid of a corporation and a sole proprietorship/partnership, offering the benefits of both. For a rental property owner, an LLC provides many advantages and protections in legal, tax, and management flexibility. An LLC offers owners, also known as members, limited personal liability for liability created by the entity. One of the biggest benefits an LLC provides is personal property protection. An LLC maximizes asset protection, whether the rental owner has one or multiple properties. Each rental property should have its own LLC, so if the property owner gets sued, only the one property (LLC) will be liable instead of all of the investment properties and the personal assets of the owner. An LLC can be considered an alternate form of insurance because it protects the personal assets of a rental property owner from certain legal claims, such as slip-and-fall cases and contractual tenant disputes. Rental property owners must also be properly insured to protect the property from claims made directly against the LLC.

For tax purposes, an LLC must file a tax return as a sole proprietorship, partnership or corporation because the federal government does not recognize an LLC as a federal tax classification. One tax advantage of a single member LLC is the ability to use pass-through taxation. A single member LLC can choose to be taxed as a sole proprietorship. Income and capital gains from the LLC pass directly to the owner/member, avoiding double taxation. As the legal owner of the property, a single-member LLC can deduct mortgage interest based on IRS rules. An LLC can also choose to be taxed as a corporation. If an LLC has multiple members or opts to be taxed as a corporation, mortgage interest deductions and taxes become more complicated, so a consulting with a good CPA is helpful.

Once the LLC is set up, the owner/member is obligated to follow the guidelines spelled out in the operating agreement rather then the statutory obligations required of a corporation. Additionally, after the LLC is set up the member/members are required to file annually with the secretary of state, hold an annual meeting, keep a separate bank account, and not comingle funds.

If the rental property is mortgaged, retitling it into an LLC is an issue that will need to be addressed with the lender.

Are your personal assets protected from your business liability? Business Foundation Checklist

For the last six months I have been a part of a wonderful business- coaching group by Cheri Ruskus of the

Victory Circles.

  Besides affording me the opportunity to learn and share with an amazing group of women entrepreneurs, I also have a new perspective and much better understanding on how to run my business from a business perspective rather then a lawyer's perspective.  I am grateful and most pleased because I am sure that it will help me advise my clients better in running their businesses as well.Many of my clients own businesses and/or rental properties.  I encourage them to meet with me on a yearly basis to review their business compliance and or landlord obligations - with the goal of making sure that their 

personal assets

 (such as their residence, savings, retirement, etc.) are protected should anything happen related to the business or rental property. If you don't have a proper business legally set up for either a business you are running or properties you are renting-- then your personal assets are at stake and up for grabs if your business or rental incurs liability.  If you do have a proper legal foundation and your business is properly recognized, your personal assets will most likely be protected should something happen.  I am always happy to meet with business owners and or property owners to review their business compliance needs and make sure their personal assets are protected. Check out the business compliance checklist below - for a quick self review.

Business success is not just about creativity and breaking through - its also about planning and having a solid legal foundation

Business Foundation Check List

 Does your business follow these simple steps:

  • Have you filed the appropriate documents with the secretary of state and if so are they kept up to date?
  • Do you have a working operating agreement or bylaws for your company and is your company notebook current?
  • Do you use a bank account (usually a checking account) in the name of your entity?
  • Can you ensure that you can document all moneys put into your entity in return for your ownership.
  • Is it clear that any interactions your entity has with other commercial enterprises or individuals that you are acting on behalf of your entity and not as an individual?
  • Do you use letterhead on all of your correspondence and contracts?
  • Do you include the entity designation ("Inc.," "Limited," "Ltd.," "LLC") whenever possible on business identifiers such as business cards, advertisements, etc.?
  • Do you sign documents in your representative capacity, and not as an individual:

YOUR ENTITY NAME ______________________________________________

by:  YOUR NAME, YOUR TITLE (Manager, President, Owner, etc.)

  • Have you ensured that all assets that are meant to be owned by your company are titled in the name of your entity and not in your name personally.
  • Are you careful to never commingle the funds or assets of your entity with your personal funds and assets.  If you need to fund the operations of your company with your personal assets, document the transfer as either a loan or a contribution to the capital of your entity.  If you need to use assets of the company for personal reasons, distribute the assets out of the company to yourself first as income, profit distributions, or a return of your capital contribution?
  • Have you held your annual meetings - yes - annually?!  This is one of the first things a judge will look for in deciding whether to allow a creditor or other to go after your personal assets.

Are your personal assets protected from your business liability?

Forming a business is only the first step in ensuring that your personal assets are kept separate from you business interests. - This is important because if you do not keep these separate there can be dire consequences-  if something happens in your business to create a liability issue your personal assets may end up being up for grabs as well.  Following the guidelines below will help to create and maintain your business as a separate entity- protecting your family and home from any business liability. First, it is extremely important to understand why Corporations, Limited Liability Companies (LLCs), and Limited Partnerships (LPs) are used to conduct business. These entities are legally created and regulated by state laws and thus are legally separate from the individuals who own them. To retain this separation between the owners and the entity, certain legal requirements and formalities regarding the maintenance and operation of the entity must be followed. If these requirements are not met, the separation between the owners and the entity may be disregarded—sometimes with disastrous consequences.

WHAT’S AT STAKE? If certain legal formalities and requirements are not met, your Corporation, LLC, or LP could be disregarded as an entity separate from its owners or managers and as a result your personal assets may be at risk for your business liability. The following is a brief summary of some of the consequences that may result:

  • Loss of Limited Liability: If you were to ask a randomly selected group of small business owners why they elected to do business using one of the above legal entities instead of operating as a sole proprietor or general partnership, the answer you are most likely to hear is that they want to protect their personal assets from the liabilities of the business. This is the number one reason business owners incorporate or organize an LLC or LP. If you do not treat your business entity as separate from yourself, it is possible that the business entity will be disregarded at some time in the future by a court or government agency like the Internal Revenue Service. The result could be financially devastating. If the business entity could not pay its debts, whether from regular operations or from liability attaching as a result of lawsuit or government action, the personal assets of the owners would be made available to the creditors of the business entity.
  • Continual / Perpetual Existence: Because business entities are legally separate from their owners, the death or disability of the owner does not mean that the business is dissolved (in the case of death) or unable to conduct business (in the case of disability). Changes is ownership and management are specifically addressed in the by-laws of corporations, in the operating agreements of LLCs, and in the partnership agreements of LPs.
  • Access to Capital: A business entity is a more attractive vehicle for investors than a sole proprietorship. Private investors are able to invest in business entities with confidence. This confidence comes from being able to invest and receive either a debt obligation (which may be convertible into equity under certain circumstances) or a portion of the ownership of the entity.
  • Potential Tax Benefits: The owners of corporations and LLCs taxed as corporations may be able to receive tax benefits by sheltering business income in the entity—thus reducing the owners’ overall tax liability.
  • Commercial Credibility: American consumers are more accustomed to purchasing goods and services from businesses than sole proprietors. This instant reputability is another leading reason individuals use a legally separate entity as the business vehicle of choice.
  • Employee Benefits: Under certain circumstances, the ability to offer more comprehensive and deductible fringe benefits may result from the use of a business entity.

THE CHALLENGE All too often, the requirements of just keeping a small business running leave little time for the owner or owners to engage in corporate/LLC/LP “housekeeping” and “maintenance.” Without some level of diligence on the part of the owners, a gradual merger of the life of the business and the life of one or more of the owners or managers may begin. When this happens, the separate legal status of the business entity begins to fade.

WHAT YOU NEED TO DO TO PROTECT YOURSELF AND YOUR BUSINESS The following steps should be taken by all business entities, even those owned and managed by only one person.

Compliance with the Secretary of State:

As an initial matter, you should ensure that your business entity is in good standing at all times with the Colorado Secretary of State. You will receive an annual report from the Colorado Secretary of State each year (for entities other than Limited Partnerships). It is important that you complete and return this annual report with the required fee. Even if your entity is delinquent in annual filings or other matters, it is usually very easy to bring your entity into compliance with the Secretary of State. Typically, this will involve the filing of a delinquent annual statement or, possibly, reinstating your entity if it has been deemed dormant or inactive.

Internal Governance in Compliance with State Law:

It is important to keep your internal entity governance up to date. This step can not be over emphasized in its importance. Being in good standing with the Secretary of State is only the initial step in having your business entity recognized as separate from you (as the owner) at some future time whether in court or by a government agency. The most important action item is to ensure that your business document binder remains up to date. (This binder is universally referred to as the “Corporate Book” irrespective of whether you own a corporation, LLC or LP.) The binder should contain your entity’s organizing documents (articles of incorporation or articles of organization), the operating documents (by-laws, operating agreement, or partnership agreement), evidence of ownership (signed stock certificates, membership certificates, or partnership certificates), transfer ledgers, resolutions and agreements to extraordinary actions (opening bank accounts, signing a lease, making tax decisions, appointing officers, etc.), minutes of each annual meeting (discussed further below), tax documents (such as the Request for Employer Identification Number on Form SS-4 [the tax identification number for domestic business entities], S-Corporation Election on Form 2553, Tax Returns on the applicable forms [1065, 1120, 1120-S, etc.]), required permits and licenses for your type of business, leases, loan documents, and any other documentation that is evidence of your respect for the separation of the business entity from yourself.

Annual Meeting:

Reviewing the actions of the entity and planning for any upcoming changes on an annual basis is important. The documentation of this annual review/meeting in the Corporate Book is one of the first items a future judge will review if ever asked to disregard your entity.

You should also make sure the following tasks are accomplished and used in the daily running of your company:

  • Open a bank account (usually a checking account) in the name of your entity.
  • Ensure that you can document all moneys put into your entity in return for your ownership.
  • In any interactions your entity has with other commercial enterprises or individuals, make certain that it is clear that you are acting on behalf of your entity and not as an individual.
  • Use letterhead on all of your correspondence and contracts.
  • Include the entity designation (“Inc.,” “Limited,” “Ltd.,” “LLC”) whenever possible on business identifiers such as business cards, advertisements, etc.
  • Always sign documents in your representative capacity, and not as an individual:

YOUR ENTITY NAME

______________________________________________ by: YOUR NAME, YOUR TITLE (Manger, President, Owner, etc.)

  • Ensure that all assets that are meant to be owned by your company are titled in the name of your entity and not in your name personally.
  • Never commingle the funds or assets of your entity with your personal funds and assets. If you need to fund the operations of your company with your personal assets, document the transfer as either a loan or a contribution to the capital of your entity. If you need to use assets of the company for personal reasons, distribute the assets out of the company to yourself first as income, profit distributions, or a return of your capital contribution.

If you have any legal questions about how to conduct your business, please do not hesitate to contact Tanya R. Shimer LLC for guidance.