Employment Taxes, LLCs, and Asset Protection

The Limited Liability Company (LLC) is a flexible legal entity that allows taxpayers to elect how they want to account for their state and federal tax liabilities. Unfortunately many taxpayers do not understand issues surrounding whether they should use the LLC and in what form to achieve their tax and asset protection goals. This article will briefly discuss one issue in this analysis, namely employment or payroll tax liabilities.

The IRS regards a single member LLC (i.e, a LLC owned by one individual or entity) as not being a separate taxable entity distinct from the owner, unless the owner opts to have the LLC treated as a corporation for tax purposes. As a disregarded entity the sole owner of the LLC can simply account for the profits and losses of the LLC on the taxpayer's personal tax returns (on the taxpayer's Schedule C).

It is the sole owner of a single member LLC that is personally responsible for employment taxes related to the LLC's employees. The IRS has the ability to impose a lien or levy or seize the sole owner's personal assets if the LLC's employment taxes are not paid, but the IRS cannot levy or seize the LLC's assets to satisfy this type of liability. This is true regardless of whether the sole owner elected to use his or her name and social security number for the LLC tax reporting or if the sole owner elected to use the LLC name and a separate taxpayer identification number for the LLC tax reporting.

The result for the multi-member LLC (i.e., a LLC owned by more than one individual or entity) may be different depending on the applicable state law. If the state law provides that members of LLC's are not liable for LLC debts then the IRS's recourse with regard to the LLC's unpaid employment taxes lies with the LLC and not with the member owner.

For the most part businesses are started with the aim of making a profit. The thought of incurring a loss is often not planned for in the business formation or start up process. As such, this type of employment tax issue typically does not arise until after the LLC is facing financial difficulties. In these cases the LLC may be unable to meet its state and federal employment tax obligations. If the LLC employment taxes are not timely remitted, the question is whether the state and federal government may collect the employment tax liability from the LLC or the LLC owner or owners.

This issue is most important for LLC's that employ a number of employees and/or that employ highly paid service employees. In these cases the LLC owners with little or no assets and no expectation of having significant assets or whose only significant assets are those used in their trade or business (e.g., a mechanic whose only assets are his or her tools) may prefer that the IRS pursue him or her individually for the LLC's employment tax obligations. On the other hand, the financially well off LLC owner may prefer that the IRS only be able to pursue the LLC for the LLC's employment tax liabilities.

Given this dichotomy it may make sense for single member LLC owners to convert their single member LLCs into multi-member LLCs or to elect to have the LLC be taxed as a corporation once the LLC has achieved some measure of financial success. Of course, the business owner must also consider other tax factors, such as the trust fund recovery penalty and the role of self-employment taxes.

Asset Protection Steps Cannot Include Fraudulent Trasnfers

Asset protection planning is best done in advance of any claims or the person becoming insolvent. Planning opportunities after that point may constitute violations of the state and/or federal fraudulent transfer act. Leverage Leasing Co. v. Smith provides a good example of this concept.

Leverage Leasing Co. refinanced a $200,000 loan to Kenneth and Carol Smith. Prior to this refinancing loan the Smith's personal residence was titled in Carol's name only. At the request of Leverage Leasing Co. Carol quitclaimed or transferred her interest into a joint tenancy with her husband. The Smiths then pledged their interest in their home as collateral for Leverage Leasing Co.'s loan. A couple of years later Kenneth transferred his ownership in the residence to Carol. Kenneth did not get anything in return for this transfer.

It appears that the Smiths probably defaulted on their loan with Leverage Leasing Co. or Leverage Leasing Co. found out about the transfer. Either way, Leverage Leasing Co. brought suit to ask the court to set aside the transfer from Kenneth to Carol as a fraudulent transfer.

The trial court found that this transfer from Kenneth to Carol was not a fraudulent transfer. On appeal, the Colorado Court of Appeals disagreed.

Creditors have the option of using the federal or state fraudulent transfer statutes. In this case Leverage Leasing Co. opted to use the Colorado Fraudulent Transfer Act. In general this Act provides that fraudulent transfers are those made without an exchange of “a reasonably equivalent value” and those made by insolvent debtors.

The transfer from Kenneth to Carol failed both of these tests in that Kenneth received nothing in return for the transfer and he made the transfer when he was insolvent.

Had Kenneth or Carol consulted with an attorney, they might have been advised to (1) make the transfer at a time when Kenneth was not insolvent and (2) to ensure that Kenneth received some quid pro quo for the transfer.

Estate Tax Valuation vs. Income Tax Valuation

The question in Janis v. Commissioner is whether a taxpayer can claim that property has a low value for estate tax purposes and then turn around and claim that the property has a high value for income tax purposes. The Ninth Circuit said "no," but the answer could have been different under slightly different facts.

Conrad and Maria Janis inherited a gallery of artwork from Conrad’s father. The artwork consisted of over 500 pieces of art by famous artists, such as Piet Mondrian, Jean Arp, and Grandma Moses. Several years prior to his demise Conrad’s father had transferred the gallery of artwork to a trust for the benefit of himself and his two sons – one of whom is Conrad. The father and the two sons were named as the trustee and the sons were named as the executors of their father’s last will and testament.

After the father’s demise, Conrad and his brother, as executors and trustees of the trust, hired Sotheby’s to value the art collection. Sotheby’s valued the collection without applying any discounts. Conrad filed fiduciary trust tax returns listing the artwork at a discounted value of $12 million. This discounted value caused the art gallery to report a net operating loss each year, minimizing the amount of taxes it owed.

The IRS Art Advisory Panel determined that the undiscounted value of the collection was $36 million and the discounted value was $14 million.

Conrad, as co-executor and trustee, consented to the IRS’s adjustment and to its discounted valuation of the estate’s artwork. Conrad signed a Form 890 Waiver of Restrictions on Assessment and Collection of Deficiency and Acceptance of Overassessment. The IRS time period for assessing the estate tax return had already expired before this time.

Immediately after signing the Form 890 Conrad filed amended fiduciary income tax returns for the trust claiming the undiscounted value of $36 million for the artwork. This increased valuation created an even larger net operating loss for the gallery.

The trust was terminated shortly thereafter and its assets were distributed to a partnership created by Conrad and his brother. The net operating losses for the trust were rolled over into the partnership. These losses allowed Conrad and his brother to reduce their federal income tax on their personal tax returns.

The IRS reviewed the brothers’ individual and trust tax returns and determined that the brothers should have used the $14 million discounted value that was calculated by the IRS for their father’s estate tax liability on the trust tax returns, which would limit the net operating losses that flowed through to the brothers’ personal tax returns.

The court applied the "duty of consistency" in holding that the brothers must use the estate tax value for the artwork for the trust and their personal tax returns. The "duty of consistency" only applies where (1) a taxpayer has made a representation, (2) the Commissioner has relied on the representation, and (3) the taxpayer has attempted to recharacterize the representation after the statute of limitations has run in such a way as to harm the Commissioner.

The taxpayer argued that if any "representation" was made it was made by the estate, not by Conrad. The court did not buy this argument because Conrad was the beneficiary and co-executor of the estate. Thus, the idea is that Conrad was an interested party with regard to the valuation. It would have been interesting if Conrad had not been the co-executor or trustee, but merely a trust beneficiary. In that case it would have been even harder for the court to argue that Conrad "represented" that the value of the artwork on his father’s estate tax return was $14 million and not $36 million.

While this case involved estate tax discounts associated with artwork, the same situation often arises with regard to estate tax discounts for real estate or ownership of small business interests. In each of these cases the game is to try to claim a lower valuation for estate tax purposes and a higher value when the property is later sold for federal income tax purposes. In many cases taxpayers plan on holding the assets for a period of time following the death of the owner so that they can claim that the disparity in the value of the asset for estate tax and income tax purposes resulted from appreciation in the assets that occurred after the owner’s demise.

Of course what beneficiaries are giving up in these scenarios is the stepped up tax basis in the inherited property, which results in a higher federal income tax liability upon the subsequent sale of the property. In most cases it is more beneficial for taxpayers to take the lower estate tax valuation regardless of the lower tax basis and ride out the waiting period because the federal estate tax rates are higher than the federal income tax rates. This is especially true given that the full step up in tax basis is set to be eliminated in coming years.

Perhaps the lesson to be taken from this case is that if the taxpayer is faced with this dilemma, they should remove themselves from the estate administration process so that they are not the taxpayer who is making the "representation" as to the lower estate tax value. Then once the time for assessing additional taxes has expired for the estate tax, the taxpayer can make a "representation" using the higher value for federal income tax purposes.

Rental Real Estate & the Passive Activity Rules

More and more Americans are investing in real estate due to the appreciation of real estate markets in the past few decades. The real estate tax rules are complex. This complexity causes a number of taxpayers to not realize the full tax benefits associated with their real estate investments. This article will briefly address the passive activity limitation rules as they relate to rental real estate investments and it will point out some basic planning opportunities.

In general the passive activity limitation rules prevent taxpayers from using losses from passive activities to offset income from active activities. Losses from unused passive activities can be carried forward to future tax years or deducted in full upon the taxable disposition of the loss asset.

Active activities include income from a trade or business, wages, and interest and dividends. Passive activities include trade and businesses in which the taxpayer does not materially participate and rental real estate activities. The passive activity rules do not apply to rental activities performed by a real estate professional and certain short term rental activities.

With this said, there is an exception that allows a taxpayer to use up to $25,000 of passive rental real estate losses to offset active income. To qualify for this $25,000 exception the taxpayer must be an active participant, which is different than the more stringent "material participant" requirement (discussed below), and the taxpayer must have recognized less than $100,000 from all sources during the year (technically it is $100,000 of Adjusted Gross Income (AGI), which is income less certain above the line deductions, less certain types of income). The $25,000 exception is phased out for taxpayers whose AGI is over the $100,000 threshold and it is completely phased out when AGI reaches $150,000.

To be an active participant one only has to participate in the activities associated with the property, such as making management decisions, approving new tenants, approving repairs or writing checks. For most weekend or small real estate investors this exception will allow them to use all of their passive real estate losses to offset some of their active income. If the taxpayer's AGI is over this amount, then their passive losses from rental real estate activities may be limited if they do not "materially participate" in the rental activity.

Taxpayers are deemed to have materially participated in a real estate activity if:

• They participated in the activity for more than 500 hours during the year,
  
• Their participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
  
• They participated in the activity for more than 100 hours during the tax year, and they participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
  
• The activity is a significant participation activity, and they participated in all significant participation activities for more than 500 hours (A significant participation activity is any trade or business activity in which a taxpayer participated for more than 100 hours during the year and in which they did not materially participate under any of the material participation tests, other than this test).
  
• They materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
  
• The activity is a personal service activity in which they materially participated for any 3 (whether or not consecutive) preceding tax years (An activity is a personal service activity if it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor).
  
• Based on all the facts and circumstances, they participated in the activity on a regular, continuous, and substantial basis during the year.
  

Participation in an activity includes almost any activity, including the taxpayers spouses efforts. It does not include efforts that the taxpayer expends as an investor or a limited partner in the activity.

Taxpayers have structured their real estate investments in a number of different ways to achieve their desired tax results, especially where real estate investments that are intended to be held for rental purposes are expected to generate losses in excess of $25,000 for many years and/or the taxpayer's AGI is too much to qualify for the $25,000 exception to the passive activity rules.

The trick to understanding and planning for these rules is determining whether the taxpayer has or expects to have other passive income or losses. If the taxpayer has other passive income and a passive loss from the rental investment, the taxpayer may want the passive loss from the rental activities to remain passive. That way the taxpayer can use the rental loss to offset the other passive income. On the other hand, if the taxpayer has only passive losses the taxpayer may want to consider other alternatives for their rental real estate losses.

This is where transferring ownership of the rental property to a Subchapter S corporation and entering into a lease back arrangement might be helpful. S corporations are flow through entities and they are not subject to the passive activity rules; however, the owners of the S corporation is individually subject to the passive activity rules. The S corporation is simply a legal entity, such as a regular C corporation or Limited Liability Company, for which the taxpayer has made a S corporation election with the IRS.

Generally contributing rental real estate to a S corporation results in no negative tax consequences. The taxpayer takes a tax basis in the S corporation stock equal to the amount of the rental property contributed (less certain deductions) to the S corporation and the S corporation takes a tax basis in the rental real estate equal to the taxpayers basis in the S corporation stock.

If the S corporation owns the rental real estate and the S corporation rents or leases the property back to the S corporation owner, any loss from the rental activity will be deemed to be a passive loss if the owner materially participated in the S corporation business (this is often referred to as the "self-rental rule").

So why would a taxpayer enter into this type of transaction? The answer is that if the S corporation is expected to generate other losses, those losses will flow through to the taxpayer and can be used to offset the taxpayer's other active income. If the taxpayer did not enter into this type of transaction these other S corporation losses may not have been recognized until sometime in the future, as S corporation losses can only be deducted to the extent of the taxpayer's tax basis in the S corporation - which the contribution of the rental property to the corporation increased.

Given the current speculation that there is a "real estate bubble" that is about to "burst," it is important that current rental real estate investors understand these rules and consider whether they can benefit from restructuring their rental real estate holdings.