Archive for the ‘liability protection’ Tag

Do I Need to Set up an LLC or Incorporate?

Originally published in the Cedar Street Times

October 3, 2014

Two weeks ago I discussed some of the pitfalls of using an online service to help you set up an entity such as an LLC, C-Corporation, or S-Corporation for your business.  In a nutshell, you really need tailored advice from an accountant and an attorney to address your circumstances and you should use an attorney to properly set everything up.  I have found that people that utilize these services generally do not have a good understanding of what they did and why, and they don’t know much about their ongoing responsibilities, the importance of carrying them out, or the consequences of failing to do so.

Now I am going to turn the tables and ask you why you think you need a formal entity at all?  When I say this I am thinking about small businesses getting started.  If your accounting and legal advice is from family or friends, hopefully they actually are accountants and business attorneys and reviewing your WHOLE situation.  Or maybe you read something online – maybe even an article like this!  Be careful what you read!

My personal feeling is that there are a lot of small businesses out there that have set up entities prematurely, and have entangled themselves in a lot of extra cost, record keeping, and administrative hassle for very little benefit.

The vast majority of people setting up entities for small businesses do it because of perceived liability protection for their personal assets.  Some do it for certain circumstances that can lead to tax benefits, and others do it in rare circumstances where a major customer requires it.

It is important to understand there is no bullet proof solution when it comes to shielding yourself from liability.  There is almost always a way to spoil a good plan.  Legions of lawyers make their living at this.  Layers of protection are often implemented to mitigate the risk of chinks in your armor.  For instance have an entity and also having insurance would be a good example.

It is also important to understand that entities do not protect you from all forms of claims.  For instance, professionals cannot be shielded by an entity for acts of malpractice.  Malpractice insurance, however, could cover you.

If you do not respect the entity by following all the rules of corporations, s-corporations, or LLCs promulgated by various government authorities, then if there is a lawsuit, the courts could say, “You didn’t respect the entity, so why should we?”  They could look right through your entity and allow a creditor to go after your personal assets.

Small businesses are at a much higher risk for this since they generally don’t have a legal department trying to keep up with all the details!  I have seen small businesses that have gone through the hassle and expense of setting up corporations, filing tax returns and paying the California Franchise Tax each year and yet they have never held a corporate meeting or elected officers, never recorded any corporate minutes (and even if it is just you wearing all hats, you can’t ignore these things!), and treated the bank accounts of the company like an extension of their personal checking account.  And all the while they were thinking they had solid liability protection because they were a corporation…uhh no.  The devil is in the details as it is said!

Besides the initial cost of setting up an entity properly which could run two or three thousand dollars or more, you then have to file separate business tax returns, file an informational filing with the Secretary of State, possibly have an attorney draft a document or two each year, have better accounting for the tax returns (true double-entry accounting which includes an accurate balance sheet in addition to the profit and loss statement), and then you get the privilege of paying California at least $800 a year whether you make a dime or not.  So you have at least another couple thousand dollars each year of ongoing costs (more if you need to hire a bookkeeper when you find out that QuickBooks actually requires a fairly good amount of accounting knowledge to operate it properly.)

If the inherent risk of the business is relatively small or moderate, and especially if you are starting very small and do not even know if the business is going to be successful, then I think you need to carefully way the benefits and costs.  Could you just carry really good insurance and mitigate your risk to an acceptable level?  Do you need the additional layer of protection?  You can always incorporate or set up an LLC later.  Do you have employees, and what amount of risk do they expose you to?  Are they driving vehicles a lot for your business?  Or do you have rental property with lots of tenants?  Maybe you are a free-lance graphic artist designing business cards remotely from your home – not much risk there!  What are you trying to protect anyway – maybe the bulk of your personal assets you have would be considered exempt assets from creditors already? Although attorneys are generally risk-averse because they see all the things that can go wrong, and therefore would prefer to set up an entity, I think these types of discussions can be had with them and really question if it is right to set up an entity for your business for liability reasons.

Taxwise, there can be benefits to setting up an entity, depending on your circumstances, but it is rarely a driving force in and of itself for most small businesses.  The most common one people ask about deals with reducing self-employment taxes for the owner of an S-corporation.  There are ways this can be successful, but it is an issue that is in jeopardy of being eliminated.  It also has the drawback of possibly reducing your future Social Security benefits – although our government will probably beat you to the punch on that one anyway.

If you read this article and think, gee, I am not sure I really need the entity I have – do not just ignore the entity and pretend it doesn’t exist anymore!  Besides getting the proper tailored advice for you, you generally must properly dissolve it, or you will be plagued with continuing mandates for tax returns as well as Franchise Tax fees to California.  (There are limited circumstances where you can just walk away.)

In summary, get competent advice from an accountant and an attorney in light of YOUR facts and circumstances before jumping into an entity.  And question its necessity if you are small or if your business has low or moderate inherent risk and you have access to insurance that could protect you sufficiently.

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Advertisements

Rental Property Outside of CA: LLC Options and Issues – Part II

Originally published in the Cedar Street Times

July 12, 2013

Two weeks ago, I discussed that LLCs are a popular choice for holding rental property, but that it certainly comes at a cost in California when you consider a minimum $800 annual franchise tax, the cost of filing another tax return each year, having to maintain better accounting records, as well as the initial costs to set it all up.  I also advised that if you do setup an LLC, you want to utilize an attorney to set things up instead of a do-it-yourself online approach.  I have seen plenty of problems from people using the latter method.  It is pretty easy to jeopardize the liability protections of the LLC if you do not have competent legal advice.  Since liability protection is one of the main reasons you go to all this continued expense and trouble, you might want to consider the old adage: penny-wise, pound-foolish.

Two weeks ago, I also raised the question and left readers pondering about whether you could save the minimum $800 a year tax by setting up your LLC in another state, which of course would be a natural inclination anyway, if the property is located in another state.

Many Californians are already in this boat, and I would say quite a number of them are unaware that even if they have a non-California LLC holding non-California rental property, they are generally required to register in California and pay California the minimum $800 franchise tax.  The franchise tax is levied on you if you are considered doing business in California.  So how is your rental property in Arizona, for example, that is held in an Arizona LLC (that maybe even loses money every year) considered doing business in California and subject to a minimum $800 California tax?

California’s position is that the mere fact that a managing member of the LLC lives in California, is enough to constitute that the LLC is doing business in California.  More specifically, they say that if you have more than one member, LLCs are taxed under partnership law unless you elect to be treated as a corporation.  Partnership law says that the activities of the partnership flow through and are attributed to the partners, and that the partners are therefore, by statute, doing business.  If they reside in California, then they are doing business while in California, thus requiring registration of the LLC in California and payment of the $800 minimum franchise tax (and filing of a tax return).  Limited partners also have statutory rights to participate so California is not letting them off the hook either.

Single member LLCs (a husband and wife are treated as one member in California) are disregarded entities for tax purposes and are not taxed as partnerships or corporations, but are reported directly on your personal tax returns.  For single member LLCs and corporations California will look to facts and circumstances.  If you could somehow build a case that your LLC had absolutely no connections with California (such as tax preparation, bank accounts, etc.) and that every time any decision needed to be made with regard to managing your property or LLC, you were out of the state of California (and not on your living room telephone), you might have a shot at not “doing business” in California! It is an extremely difficult threshold, and taxpayers have been losing case after case in court over this issue.

California has also put into place a steep new penalty for anyone failing to register.  In addition to the minimum $800 franchise tax, they are now assessing a $2,000 penalty plus interest for every year you have failed to register.  At about, $3,000 a year, that adds up quickly. Generally, California does not go back to assess past delinquencies if you start reporting before they discover you.  The internet and increased sharing of information between state taxing authorities is making this much easier to detect.  So make haste and get compliant if you are not already.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Rental Property Outside CA: LLC Options and Issues – Part I

Originally published in the Cedar Street Times

June 28, 2013

A lot of Californians find themselves with rental property outside the state at some point in their lives.  Sometimes it is from a past life in another state, or from an inheritance when a parent passes away.  Military folks often jog around the country collecting houses like refrigerator magnets from each state in which they have lived.  There are also a lot of people that invest in rental properties in Nevada, New Mexico, Arizona, and Texas because you actually have a shot at a positive cash flow situation right out of the gates, unlike California.  And then there is the Hawaiian contingency that buy investment properties that always need at least two to four weeks of maintenance work done by the owners each year – not sure if I want one of those with all that work – it’s funny, I never hear of clients having to go to Phoenix for a month in the summer to work on those properties.

Anyway, the question always arises about whether or not to form an entity such as a corporation or Limited Liability Company (LLC) to hold the real property.  An LLC is generally the preferred vehicle to hold real property for many good reasons, including liability protection for your personal assets in the event you are sued, and the elimination of double taxation that can plague corporations.  They also have less formalities to follow compared to a corporation and avoid some nasty pitfalls of corporate tax rates and structure that could cause a lot of pain upon sale of the property.

As a result, a lot of people these days do hold property in LLCs.  Of course this comes at a price.  If you create an LLC in California (or a corporation for that matter) to hold your property, and are therefore granted the privilege of doing business in California, you are also granted the privilege of paying California a minimum $800 franchise tax each year.  You also have to pay someone like me to file another tax return every year, and you have to keep better books.  Don’t forget you have to hire an attorney to set it up initially for another $1,500 to $3,000.

I would not recommend an online filing company or do-it-yourself approach, as you are not getting any legal advice and have no one keeping you on track with formalities which could completely blow the liability protections and the whole reason you went to all the effort in the first place.  Correcting or trying to close ill-formed or mishandled entities can be a real pain as well.

So what if you form your LLC in another state such as Texas or Wyoming to hold your property?  Many states have much lower or no annual LLC fee and they have simpler annual filing requirements.  (You generally do not have to form the LLC in the state where the property is located.)  Could you save some dollars by setting up your LLC in another state?  In two weeks we will discuss California’s current position on non-California LLCs and some new rules that are just coming into play.  If you have a non-California LLC, you do not want to miss the next installment.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.