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Who Owns an LLC?

Who are the owners of an LLC?  Although, limited liability companies have become an extremely popular form of business entity, many small business owners or people forming a start-up business are still unfamiliar with ownership and structure issues related to an LLC.  The article below discusses ownership issues of an LLC, which is a typical question for business owners and those starting up a business.  Please remember to consult your business attorney with your specific facts, questions and circumstances.

The varying types of ownership interest in an LLC are very important for a business owner to understand, and can be very useful in the overall structure of business and even the drafting of operational documents such as the operating agreement.  The owners of an can be:

 

  • LLC Members with an economic interest (often called a “membership interest”) in the LLC;
  • Non-economic members; and
  • Assignees

The LLC Act in Colorado does not define “ownership interest” but the act defines “membership interest” as “a member’s share of the profits and losses of a limited liability company and the right to receive distributions of such company’s assets.”  When forming the LLC, the members will contribute cash, property or can provide services or a promissory to the note to the company.  In Colorado, a person can be a member and receive a membership interest without necessarily making a contribution or being obligated to the LLC in another manner.  Under such an arrangement, the member may receive a profits interest in the LLC whereby the member is allocated a share of the profits and losses of the LLC, but does not yet have a capital interest in the LLC.  A capital interest would be more defined as an interest in the value of the LLC.  In both cases, whether contributing capital or receiving an interest for services or an obligation, the member would hold a “membership interest” in the LLC and have the rights afforded in the act and within the operating agreement of the LLC.

The ability to have non-economic members within an LLC can be very advantageous for the LLC and the members.  The LLC Act in Colorado allows a member to be a non-economic member whereby the person is a member of the LLC but does not acquire a membership interest, and may not be obligated to make any contribution to the LLC.  The non-economic member may hold all of the rights of other members such as voting rights, but no right to an economic interest in the LLC.

An assignee may be admitted through the sale or transfer of an interest.  The assignee may not need to be admitted as a member, and thus although the assignee may receive the right to receive profits and losses from the LLC (the economic portion), the assignee may not have the right to participate in the management of the business, and vote.  The operating agreement of the LLC could control many of these issues.  Allowing the assignee the economic benefit of the interest but not the management portion of the interest can be very beneficial in a closely held business whereby the original members may not want the wife or other family member of an original member to have an operational or management power, but the assignee can still receive the economic portion of the original member’s interest.

Denver Business Attorney

 

 

Limited Liability Companies in Colorado

A limited liability company (LLC) is a popular choice of entity for many business owners in Colorado.  Further, many business owners in Colorado will form other forms of partnerships whether they actually mean to or not.  When forming the actual entity though many business owners are unaware of the statutory requirements to form the business in Colorado.  The article below has been prepared by a business attorney to provide information regarding the necessary requirements, but please remember to always consult directly with your business attorney.

In Colorado, a limited liability company is formed by filing articles of organization with the Colorado Secretary of State.  The articles of organization must provide the following:

  • The LLCs name and principal office address:
  • The name and address of the registered agent;
  • The true name and mailing address of the persons that are forming the LLC;
  • Whether the LLC is a member managed or member managed LLC; and,
  • That there is at least one (1) member of the LLC.

 

Section 7-80-204(1)(h) of the Colorado Revised Statutes also permit but does not require the article to disclose any other matter related to the LLC or the articles of organization that the persons forming the business determine to include in the articles.

Other Partnerships

A simple handshake can for a general partnership in Colorado, and no filing with the Colorado Secretary of State is necessary.  Section 7-64-202(1) of the Colorado Revised Statutes states, “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.  Thus, you can form a partnership and expose yourself to liability without even intending to do so!

Limited partnerships, however, require the filing of a certificate with the Colorado Secretary of State.  All of the general partners must approve the filing of certificate of limited partnership.  A limited partnership will be governed by CULPA or CUPL, but limited partnerships formed on or before August 10, 2016 that does not elect to be governed by CUPA will be governed by CUPL for issues not covered by CULPA.  The information required on the limited partnership certificate is:

  • The name of the limited partnership, and the initial and principal address of the limited partnership;
  • Name and address of the registered agent;
  • The name and mailing address of each general partner LLC; and,
  • That there are at least two partners in the partnership, and at least one of them is a general partner.

One should also note that a general partnership may become a limited liability partnership (LLP) and limited partnerships may become a limited liability limited partnership (LLLP), by filing a registration statement with the Colorado secretary of state.

The above article was prepared by John McGuire, a business attorney at The McGuire Law Firm.  Please consult directly with your business attorney or other advisors regarding your specific issues.

Distributions of Stock and Stock Options

Many corporations may provide or distribute stock or stock rights to employees. When a corporation distributes it’s own stock, this would be referred to as a stock dividend and when a corporation grants stock rights, these are typically referred to as stock options. When individuals receive stock dividends and stock options, they generally will ask or inquire as to whether or not these dividends or stock options are taxable. Generally, the answer is no, stock dividends and stock options are not taxable, and thus not reported on an income tax return. However, under certain circumstances, the stock dividends or stock options can be taxable. These circumstances are discussed below, and please remember to always consult directly with your tax advisors regarding your specific circumstances.

A distribution of stock dividends and stock rights or stock options are taxable if any of the following apply:

1) The corporation distributes cash or other property to certain shareholders of the corporation and provides other shareholders with an increase in their percentage of interest in the assets and earnings and profits of the corporation.
2) The distribution can be converted by the shareholder into preferred shares.
3) Any shareholder has the ability to choose cash or other property be received as opposed to the stock or stock rights.
4) The distribution is a distribution of preferred stock. It should be noted, however, that such a distribution would not be taxable if it is solely an increase in a conversion ratio of convertible preferred stock, which has been made solely due to a stock dividend, stock splitting or similar action that would result in reducing the overall conversion rate.
5) The distribution allows for preferred stock to be issued to some common stock shareholders and common stock of the corporation to be issued to other shareholders.

When a taxpayer does receive a taxable stock dividend or stock rights, the taxpayer would include the fair market value at the time of the distribution in their income. It is also important for shareholders to be aware of constructive distributions. A shareholder may have to treat certain transactions that increase their proportionate share or interest in the earnings and profits or assets of the corporation as if stock or stock options were distributed if the result is the same as items 1, 2, 4 or 5 above. This treatment would apply to a change in a shareholder’s conversion ratio or redemption price, a difference between the stock’s redemption price and issue price, a redemption that is not treated as the sale or exchange of the applicable stock and other transactions whereby the similar effect is realized on the shareholder’s interest in the corporation. An example of a taxable distribution would be the receipt of preferred stock that holds a redemption price higher than the price the stock was issued for. This difference is considered the redemption premium, and generally the redemption premium would be considered a constructive distribution and taxable.

The above article has been prepared by John McGuire of the McGuire Law Firm for informational purposes and should not be considered tax or legal advice. John is a tax attorney and business attorney in Denver, Colorado and Golden, Colorado serving clients in Colorado and nationwide on certain tax matters.
Denver Tax Lawyer

Gain, Loss & Realization Events in Property Transactions

When must I realize gain?  For the most part, it is easy to recognize when gain or loss has been realized, but at other times it may be hard to ascertain.  The article below has been prepared by a tax attorney to discuss gain or loss on certain property transaction and certain realization events.  Please remember this article is for informational purposes and specific facts and circumstances should be discussed specifically with your tax attorney and other tax advisors.

When an asset is sold, disposed of or transferred it may go without saying that a realization event has occurred.  Gain on the sale or disposition of the asset will be the amount received (realized) in excess of the adjusted basis of the property.  Loss, on the other hand would be the amount the adjusted basis exceeded the amount realized.  It is important to remember that not all transactions would require one to recognize the gain or loss in their income at the time of the transaction.  The word recognize in the previous sentence would mean to include the gain or loss in your current income.  A requirement to include gain or loss in your income is the occurrence of some realization event.  Once a realization event has occurred, then you must ascertain and determine the proper tax treatment of the transaction such as:

 

  • The adjusted basis in the property that was sold, transferred or disposed of;
  • The amount realized from the transaction as a whole;
  • Was gain or loss recognized from the transaction;
  • The character of the gain. For example, was the gain short term capital gain or long term capital gain.  Or perhaps, is the gain subject to recapture rules.
  • If there was a loss, is the loss allowed in whole or in part.

In regards to a realization event, generally speaking, a transaction with property will be considered a realization event if the taxpayer’s relationship, or control of the property is terminated, or the interest is significantly or materially reduced.  The lack of any transaction would tend to show a lack of a realization event.  Further, it should be noted that the mere increase or decrease in the fair market value of property does not, by its self, create a realization event.  For example, you may purchase Microsoft stock.  As the stock increase, you do not recognize gain, but rather, when you sell the stock, if the sale price of the stock is in excess of your adjusted basis, gain would likely be realized, and need to be recognized by reporting the gain on your income tax return.  Furthermore, transferring or disposing of property through a gift is generally not a realization event.  While the gift may have many tax implications, the gift alone may not be enough for a realization event whereby income or loss would be recognized on an income tax return.

There are multiple issues to consider relating to realizing gain and loss, and recognizing gain and loss.  Further, there are many situations whereby a loss may be disallowed in whole or part, or the loss can only be recognized in certain amounts or over certain times.

This article has been prepared by John McGuire at The McGuire Law Firm.  John is a tax attorney and business attorney working with individuals and businesses before the IRS and assisting clients with other tax and business matters.  John can be reached at 720-833-7705.

Original Issue Discount and Debt Instruments

What is original issue discount?  Original issue discount (OID) is a form of interest that you may not realize you have earned, received or need to report.  The article below has been prepared by a tax attorney to provide information regarding (OID), but please consult directly with your tax advisors regarding your specific facts and circumstances.

Generally, you should (or will) report OID as income as it accrues over the term of any debt instruments even if you do not received any payment(s) of the actual interest from the party paying the debt and/or interest.  A debt instrument could be a promissory note, bond, debenture or any other evidence of indebtedness based upon the facts and circumstances.  You may typically see a debt instrument have OID when the debt instrument was issued for less than the stated redemption price.  A debt instrument that pays no interest before the instrument matures would likely be considered issued at a discount.  The following are examples of discounted debt instruments.

 

  • Municipal Bonds (interest may not be taxable)
  • Notes between individuals or private parties
  • United States Treasury Bonds
  • Stripped Bonds
  • Certificates of Deposit (CODs)

An example may help illustrate the discount and interest amount.  If a bank issues a bond with a maturity price of $1,000 for $900, the original issue discount is $100, and the discount would be included in income as it accrues over the term of the bond.  Please note, if the discount is less than one-quarter of an interest percentage (.0025) the discount may be considered de minimis discount and treated as zero.

 

All of the above being said, many people will ask if there are any exceptions to reporting OID income. The OID may not apply to the debt instruments below, but please always check current law and regulations with your tax attorney or tax advisors.

 

  • United Savings Bond
  • Tax Exempt Obligations
  • Debt instruments with a fixed maturity date less than one-year from the date of issuance (short-term debt instruments)
  • Obligations issued by an individual prior to March 2, 1984
  • A loan between individuals if the loan and any other prior loans between the same individuals is less than $10,000 (USD), the individual lending the money is not in the business or regularly lending money; and, a primary purpose of the loan is not to avoid federal income tax.

Is a 1099 issued?  If the total of the OID is $10 or greater, the party issuing the debt instrument should issue a 1099-OID.

You can speak with a tax attorney or business attorney with questions related to interest and OID by contacting The McGuire Law Firm.   Call 720-833-7705 to discuss your matters with a tax attorney.

Tax Attorney

Denver Tax Attorney

 

 

Operating Agreement Invalidating S Corporation Election

Limited Liability Companies (LLC) are a very popular entity choice and structure for new businesses and closely held entities.  An LLC can be formed quickly and has a lot of flexibility regarding members, operations and taxation structure.  It is not rare for an LLC to eventually consider and perhaps decide to be taxed as an S corporation.  Although, an LLC converting to a Subchapter S corporation has benefits, such as potentially reducing self-employment taxes, these benefits may be mistakenly lost if the Subchapter S corporation status is invalidated.  A means by which to invalidate the S corporation status, which is many business owners may not consider is the LLC operating agreement.  Abiding by the LLC operating agreement may cause the entity to operate in a manner than invalidates the S corporation election.  The article below has been prepared by a tax attorney and business attorney to further discuss the risk of losing S corporation status by abiding by an operating agreement.  Please remember this article is for information purposes only, and is not intended to be legal or tax advice.

To properly evaluate how an S corporation could lose or invalidate the S corporation election, it is important to remember how a business qualifies and the requirements for an S corporation.  The qualify as an S corporation, the corporation must:

 

  • Have only allowable shareholders (no partnership, corporate or non-resident alien shareholders)
  • Have only 100 shareholders or less
  • Have only one class of stock
  • Be a domestic corporation
  • Not be an ineligible corporation (insurance companies and other disallowed companies)

Our focus will be on the one class of stock requirement.  The one class of stock requirement requires that all shareholders receive distributions and liquidation preferences pro-rata per their stock ownership.  An S corporation can have a different class of stock for voting rights, but the economic benefits and distributions to the shareholders must follow the ownership percentage, which is directly related to the number of shares each shareholder owns.  Many LLC operating agreements will contain clauses and language that actually require unequal or disproportionate distributions to the LLC members.  Thus, if the distributions are in accordance with the operating agreement, the issuance of disproportionate distributions could lead to the IRS claiming the corporation has multiple classes of stock, and therefore, the S corporation election is invalid.  Treasury Regulation Section 301.7701-(3)(c)(1)(v)(c) states that the S corporation election is valid only if ALL requirements are met.  Thus, an LLC electing be to be taxed as an S corporation should consider removal of certain clauses within the operating agreement relating to substantial economic effect, IRC Section 704 and any other clause that could create disproportionate distributions.  If the S corporation election was lost, the owners may be subject to additional self-employment tax, or the business, if taxed as a C corporation would be subject to tax at the corporate level, and the shareholder level, thus double taxation.

If you have questions related to your choice of entity, taxation matters and internal business documents, it is recommended you speak with a tax attorney and/or business attorney to review the documents, taxation matters and intended tax treatment.

Denver Tax Attorney Denver Tax Lawyer IRS Tax Attorney

 

Denver Business Attorney

Deductible or a Capital Expense?

Is an amount paid by a business an expense that is currently deductible, or is it a capital expenditure that should be depreciated,, amortized or depleted?  This issue is one of the most common issues in a tax audit with the Internal Revenue Service, as well as one of the most litigated issues in United States Tax Court.  The article below has been prepared by a tax attorney to provide additional information related to this common issue.  Please remember that this article is for informational purposes, and you should consult directly with your tax attorney and advisors related to your specific issues.

A currently deductible expense is an ordinary and necessary expense that is paid or incurred by the business during the taxable year in the ordinary course of operating the trade or business.  Please reference Internal Revenue Code Section 162.  In comparison, a capital expenditure would be the cost to acquire, improve or restore an asset that is expected to last more than one year.  These capital expenditures are not allowed a deduction, but rather are subject to amortization, depreciation or depletion over the useful life of the property. See Internal Revenue Code Section 263.

That being said, how does one determine whether an expenditure is an expense to be deducted or a capital expenditure?  The answer is, it is a question of fact.  The Courts have applied the principles of deductibility versus capitalization on a case by case basis, and the facts and circumstances of each case will likely determine the outcome.

An example may help illustrate the difference between an expense that would be deductible versus one that would be capitalized.  If a business owner bought certain office supplies such as pens and paper, they would be deductible.  If the same business owner, purchased a building to operate the business, the building would be capitalized.  Let’s look at a different example that might not be as obvious.  Assume a business owns and rents property.  In one property a hole was placed in the wall when a tenant moved.  In another property, the owner decided to replace the walls with new drywall and paint.  It is likely the fixing of the hole in the wall would be deductible as a repair or maintenance, whereas the cost to replace the walls would be capitalized by the business.

One further issue to consider beyond the matters discussed above is that the Internal Revenue Code requires books and records to be maintained to verify and substantiate the expense whether it be a deduction or capital expense.  If the item or amount of the expense cannot be verified and substantiated by the taxpayer, the IRS may disallow the deduction or the capital expense.

If you have questions related to a deduction or capital expense, you can speak with a tax attorney by contacting The McGuire Law Firm.   The McGuire Law Firm offers a free consultation with a tax attorney to discuss your questions and issues.

Denver Tax Attorney

How is a Profits Interest in an LLC Taxed?

If I am given a profits interest in a partnership or limited liability company, how am I taxed?  It is relatively common for an LLC (for purposes of this article, a partnership and LLC may be considered the same type of business) to give an interest to a service provider.  The taxation of the interest is different depending upon the type of interest as a capital interest can be different than a profits interest.  The article below discusses a profits interest.  A profit’s interest is a type of equity in the applicable business, and is designed to give the individual a predetermined share of future growth in the value of the business.  A profits interest can be differentiated from a grant of stock within a corporation because the profits interest would not entitle the holder of the profits interest to share in the businesses current value.  Rather the profits interest provides for a share of future profits and appreciation within the business, as opposed to an interest or share in the company’s current value.  This position, is what dictates the tax treatment of a profits interest when provided to the holder of the interest.

 

Initially, courts appeared to have mixed feelings regarding the taxation of a profits interest.  In 1974, a federal court of appeals held that the receipt of the profits interest should be considered taxable income when the interest had a readily determinable market value.  However, later another federal court made a determination that would appear to suggest the service provider receiving a profits interest and acting as a partner within the company could receive the interest without the interest being taxed upon receipt.

 

Revenue Procedure 93-27 was issued by the Internal Revenue Service in 1993 to provide guidance regarding the taxation and treatment of a profit’s interest in a partnership.  The Internal Revenue Service used a hypothetical liquidation test in the Revenue Procedure 93-27 analysis.  Under the hypothetical liquidation analysis, a liquidation would not give the profits interest holder a share of the partnership assets if the partnership liquidated all assets and distributed cash to the partners.  In terms of the timing of the liquidation, the liquidation is deemed to occur at the time of the partner receives the profits interest, and thus there would have been no real increase in the value of the business from the time of receipt to the time of the deemed liquidation.  This analysis entitles the holder of the profits interest only to a share of future profits and appreciation in the business, rather than an immediate interest in the partnership’s current value.  Thus, when a partner receives a profits interest for services, or for the benefit of the partnership in a partner capacity, or even in anticipation of being a partner, the IRS will likely not treat the receipt of the interest as a taxable event.  It is important to note that the IRS may not treat the receipt of a partnership interest as a non-taxable event if in fact the profits interest would bring about a substantially certain and predictable amount of income to the recipient.

 

The article above has been prepared by John McGuire of the McGuire Law Firm.  As a tax attorney and business attorney, John’s practice focuses primarily on taxation issues and business transactions.

Denver Tax Attorney

Denver Tax Attorney

Deducting Business Expenses

Can I deduct my meals as a business expense?  Can I deduct this flight as a business expense?  Can I deduct the cost of my clothes or uniform as a business expense?  As a tax attorney, these are common questions I am asked, and rightfully so as everyone wants to take advantage of all potential deductions allowed by the Internal Revenue Code.  Not only is the deductibility of certain business expenses a hot topic with business owners, it is a hot topic and highly litigated topic with the Internal Revenue Service.  In fact, I recall reading a recent annual report to Congress by the Taxpayer Advocate Service whereby the deductibility of trade or business expenses he been one of the top ten most litigates issues for a very long time.  Furthermore, the same report stated that the courts affirmed the position taken by the Internal Revenue Service (the dissallowance 0f the deduction) in the vast majority of cases and that the taxpayer only prevailed (in full) about two-percent (2%) of the time.  The article below is not intended to be legal advice, but rather to provide general information regarding this issue.

First and foremost, we should start with the current law regarding deductions for business expenses.  Internal Revenue Code (the “Code”) Section 162 allows deductions for ordinary and necessary expenses incurred in a business or trade.  What actually constitutes ordinary and necessary may better be understood through an analysis of the case law, which is significant, surrounding the question.  Generally, the determination is made based upon a court’s full review of all facts and circumstances.

Based upon the black and white law under the Code, what constitutes a trade or business for purposes of Section 162.  Perhaps it is ironic that the term “trade or business” is so widely used in the Code, but yet, neither the Code nor the Treasury Regulations provide a definition for Trade or Business.  Personally, I think it would be quite hard to provide a definition for trade or business, especially under the auspices of income tax.  The concept of trade or business has been refined and defined by the courts more so than the Code.  The United States Supreme Court has held and stated that a trade or business is an activity conducted with continuity and regularity, and with the primary purpose of earning a profit.  Albeit broad, I would agree this definition would be sufficient for the majority of businesses I work and assist.

Now that we have an idea of what may constitute a trade or business, what is “ordinary and necessary?”  Again, the Supreme Court has helped provide definitions for these broad, but important terms.  Ordinary has been defined as customary or usual and of common or frequent occurrence in the trade or business.  Necessary has been defined as an expenses that is appropriate and helpful for the development of the business.  Further, it should be noted that some courts have also applied a level of reasonableness to each expense.

John McGuire is a tax attorney and business attorney at The McGuire Law Firm focusing his practice on issues before the IRS, tax planning & analysis and business transactions from formation to sale.

Denver Tax Attorney

Attempting to Avoid Shareholder Loan Reclassification

Many corporate shareholders may have taken a loan from their corporation.  In a prior article we discussed issues related to corporate loans and issues considered regarding the reclassification of a loan.  The article below discusses issues and actions a shareholder may consider taking to prevent the reclassification of a loan.  Please remember that this article is for informational purposes and it is recommended that you discuss any corporate loan issue directly with your tax attorney, business attorney or other advisors.

Proper recordkeeping and maintaining current promissory notes are of extreme importance regarding this issue.  The promissory notes must be kept current and reflect the payments that have actually been made by the shareholder to the corporation, the accrual of interest and other related issues in the previously executed notes.  Moreover, the approval of the loans should follow the proper approval and acceptance by the corporation’s board of directors and memorialized via the corporate minutes and other corporate memorandums.  The shareholder should also be able to verify that the interest has been paid on the note, the interest should be paid at regular intervals, and at least on an annual basis.  Contemporaneous evidence is always important when verifying loan payment and loan treatment to the Internal Revenue Service. From a tax return perspective, the corporate tax return should accurately reflect the loan on the balance sheet.

Because payment of the loan is such a vital factor, I often find it can be helpful to have multiple options or strategies for repayment.  Of course, the shareholder can make regular payments on a monthly, quarterly or yearly basis, but there are also other options for repayment.  If the corporation has strong earnings and profit, the shareholder could also use a distribution to pay make payment on the loan, perhaps even a lump sum payment to expedite payment on the note.  The shareholder may also be able to provide additional services to the corporation and receive bonuses for their work.  These bonuses could be paid to the shareholder and then paid to the corporation, or at least taxed to the shareholder as compensation and then reduce the amount of the note.

In short, generally the most important issues will be recordkeeping from corporate documents such as minutes, agreements and returns to the actual promissory note and making sure the shareholder is making payments with interest on the loan.

John McGuire is a tax attorney and business attorney at The McGuire Law Firm.  John assists clients with matters before the IRS, tax planning and advice, and business matters from contracts to the sale of business assets and interests.

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