by Roger Russell
Tax practitioners should get familiar with handling limited liability companies this tax season, as 85 percent of tax professionals responding to a recent poll reported that LLCs accounted for up to a quarter of the returns they filed last tax season.
Despite the preponderance of LLC work, there are a lot of unknown difficulties in handling these kind of filings.
“The number of LLCs has skyrocketed in the past few years, but there are plenty of pitfalls that can be avoided with basic knowledge and planning,” said Bruce Elliot, who hosted a recent Internal Revenue Service-sponsored discussion forum, Tax Talk Today. That program conducted the survey, which asked practioners around the country about their work with LLCs.
“Most people don’t have enough knowledge of them right now,” said Hollywood, Fla.-based CPA Jeffrey Greene. “There are a lot of variables involved in choosing an entity. The LLC is a vehicle that can be used to give every individual or member the protection from liability of being a corporation, and the total flexibility, tax-wise, of being a sole proprietorship or a partnership.”
A major advantage to the LLC is the flexibility in membership it affords, according to Greene. “You can have any form of entity as a member. Owners can be individuals, an S corporation, a C corporation, another LLC, a foreign partnership, or a foreign corporation or trust —there are no restrictions on who the owners can be.”
Another advantage, said Greene, is the availability of the Section 754 election. “If the entity files, you get a stepped-up basis for any new member coming in. You can’t do this with either an S corporation or a C corporation.”
Since the LLC is a creation of state law, advantages and disadvantages may vary by state, according to David Cartano, tax partner in the Los Angeles-based law firm of Barton, Klugman & Oetting LLP. For example, in comparing an S corporation to an LLC, he noted that an S corp is limited to 75 shareholders, while an LLC may have an unlimited number of members.
However, an S corporation may be preferable for one-person companies, since some states require that an LLC have at least two members, while states such as Texas, New Mexico, New Hampshire and New York permit one-member LLCs.
For Las Vegas-based enrolled agent Merrily Whalen, the LLC is the answer for her clients who want to minimize estate tax and limit their business liability. A disadvantage, she said, is that “California taxes LLCs prohibitively — they’re subject to significant franchise tax and a gross receipts tax.”
Cartano agreed. In his book, “Federal and State Taxation of Limited Liability Companies,” he cites three advantages of LLCs for estate planning:
● Transfer of property. An LLC may facilitate the transfer of property, especially real estate and other property that is not easily divisible. For example, a donor can make annual gifts to his children of units in an LLC that owns real estate. This is less expensive and less cumbersome than preparing and recording a deed to an undivided interest each year.
● Basis step-up. Until 2010, a member’s death beneficiaries may step up the basis of a membership interest on the death of the member. No gain or loss is recognized on the subsequent sale or disposition of the membership interest except to the extent of appreciation or depreciation after the date of death or the six-month alternate valuation date.
● Valuation discounts. A taxpayer may receive significant valuation discounts for property transferred to family members through an LLC. The discounts include the minority discount, marketability discount, liquidity discount and a number of other discounts.
The states with the highest taxes and fees on LLCs are California, Texas and New York, said Cartano. In addition to the tax on a member’s share of distributable income, he said, “California has an annual $800 franchise tax, and a gross receipts tax that applies if you’re over $250,000 in gross receipts. The tax starts at $900 and goes to $11,790 for gross receipts over $5 million.”
The gross receipts tax is particularly burdensome for companies that have substantial revenue but little or no profit, he noted: “If an LLC has high gross receipts but is losing money, it still has to pay the same tax as a company making a great deal of money.”
The accelerating number of LLCs can be explained in two words — “toxic mold,” observed Cartano. “If you protect yourself by putting real estate into a corporation, there’s the problem of double taxation. So in the ‘old days’ people would own real estate as individuals and there would be no problem —they’d buy insurance to cover any possible liability. But now, toxic mold is one of a number of serious potential liabilities that you cannot insure.”
“Everyone is suing landlords for toxic mold and, in order to get financing, lenders are often requiring that a purchaser form a single-purpose LLC to acquire property. And whether the lender requires it or not, owners are doing it to protect themselves from liability.”
Other liabilities that are difficult to insure against are earthquakes, terrorist attacks and unstable shifting of the earth.
“The tax aspects of an LLC are complicated,” said Cartano. “You really need an accountant or an attorney who knows what’s going on in the area. If you have a knowledgable attorney or accountant, it’s a wonderful vehicle; if not, it can easily cause a lot of problems.”
