Be Aware of Tax Impact of Funding Decisions
Asset protection includes taking steps to legal shield your wealth and assets from federal taxes. The manner in which you fund your business in order to limit liability in your business structure can seriously affect your tax status.
Funding a business entity with equity or debt can usually be accomplished tax-free. That is, in equity and debt funding, normally neither the owner nor the entity recognizes gain. However, in some situations, the owner will recognize gain when he acquires his equity interest. And that gain can have significant tax implications.
You need to be aware that certain ownership contributions are taxable events. Moreover, how the business is funded will have an impact on the eventual allocations of income and interests, and how they are taxed.
Certain Ownership Contributions Are Taxable
You may have to recognize gain when acquiring an equity interest in the business if you:
- receive the ownership interest in exchange for a contribution of past or future services;
- receive some kind of property in return for the interest (a "disguised sale")
- contribute property subject to a liability (such as an outstanding mortgage)
- distribute previously contributed property to another owner within 7 years of the original contribution
The first three rules will apply to both a limited liability company (LLC) and the corporation, although the third rule will be applied differently for an LLC and a corporation. The fourth rule applies only to an LLC.
Equity Interests Obtained as Payment for Services May Be Taxable
If you acquire an equity (ownership) interest in the business entity in exchange for compensation for services performed or to be performed, you will be treated as having received taxable income. You will be taxed on the value received by the business for the equity interest because it is compensation for services rendered or to be rendered.
A contribution of future services can be an excellent way to capitalize an entity with an equity interest, where the owner does not have sufficient capital, in the form of cash or other property, to contribute. This type of funding also can serve an important asset protection purpose. Through this option, the owner is able to adequately capitalize the equity interest, and thus perhaps stave off any attack based on "piercing of the veil" of limited liability, while at the same time avoiding the necessity of placing vulnerable assets within the business form.
However, owners are personally liable for the value of contributions promised to the entity, in return for the equity interest, until the contribution is actually delivered. Thus, the owner must be cautious in not taking back too valuable an equity interest by promising too much.
To avoid promising too much, you must know what your services are worth. You must determine the per hour rate for your services. The actual per hour value of the services will be a function of the going rate for similar services. The entrepreneurial efforts required of a business owner will certainly make this per hour rate much higher than it would be in a different setting.
Once you have determined your hourly rate, then you must determine the number of hours you are willing to commit in return for the equity interest. Too long of a commitment (or too small of a rate) can mean there will be a difference between what was promised and what was delivered, at a time a financial crisis strikes. The owner would have personal liability for this difference.
You must also take into account that the the full value of the promised services must be included as income on the date the equity interest is received, not over the time the services are rendered. Individuals are always taxed on amounts received for services rendered. However, taxation normally takes place only when the owner receives the salary. Here, the owner is, in effect, prepaid in one lump sum. Thus, you must immediately recognize income equal to the full value of the contribution upon capitalizing the entity with the promise of future services.
Any compensation scheme between the entity and the owner must be documented and approved at the entity level. It is essential that the amount of services to be contributed is specified, and a mechanism must be set up to value these services. The number of ownership interests (shares) that will be issued in return must be specified and documented. An agreement must be authorized and executed, which details the rate of pay (an hourly rate or annual salary), the total value of the contribution, and the number of ownership interests issued.
Of course, subsequently, you must actually perform the services, and the performance, too, must be documented. This type of documentation should be part of the accounting system in place for any small business.
Disguised Sales and Certain Contributions Are Taxable Events
Normally, you acquire an equity interest in your business entity by contributing money, other property or services to the entity. In return, you receive only an equity interest. Under these circumstances, the receipt of the equity interest doesn't trigger immediate tax liability.
However, if you receive cash or other property in addition to your equity interest, you really have made a taxable sale of the property to the entity, This is what the IRS terms a "disguised sale." This ordinarily should not affect the small business owner, because it is unusual for an owner to take back anything except the equity interest itself.
An IRS "safe harbor" rule for partnerships provides that a contribution will not be treated as a disguised sale if more than two years go by before a distribution is made to the owner. Because of their treatment as partnerships for tax purposes, this exception also should apply to multi-owner limited liability companies (LLCs).
If the owner of an LLC receives a distribution within two years after his contribution, he must be able to prove it was not consideration paid for a sale of the asset to the entity. This can be done by showing the distribution was for compensation or as lease or loan payments.
Contributions of Encumbered Property May Be Taxable
Contribution of encumbered assets, i.e., subject to a liability (such as an outstanding mortgage), in exchange for an equity interest in your business entity may be a taxable transaction. Here, the rules differ, depending on whether the contribution is to an LLC or a corporation.
Generally, in the LLC or corporation, the owner's contribution will be taxable if the amount of the liability assumed by the entity exceeds the owner's tax basis in the asset contributed. In the corporation, the liability is subtracted from the owner's basis in the asset contributed, to derive the tax basis of his ownership interest. In the LLC, the liability assumed by the LLC affects the tax basis of each owner in the LLC.
Different rules also apply in the case of the corporation, when there is a contribution of property and the transferors do not control 80 percent or more of the corporation.
These other rules could apply, for example, to subsequent contributions to a corporation by a single transferor who, alone, controls less than 80 percent of the corporation. Here, when property is contributed to a corporation subject to a liability, or non-cash property is contributed, gain is recognized on the contribution, as if the property were sold to the corporation. In this case, no basis adjustments are required for the liability. Instead, the corporation picks up the asset on its books at fair market value (along with the liability) as if it had purchased the asset.
Clearly, these calculations are complicated. Professional guidance should be sought before property subject to a liability is contributed to an LLC or a corporation.
Distributions to Another Owner May Be Taxable
If you contribute property to an LLC, and the LLC distributes the same property to another owner within seven years of the contribution, the contributing owner must recognize gain or loss on the distribution. This amount is the difference between the property's tax basis and its fair market value at the time of contribution. This rule does not apply to a corporation.
This really will only apply when a specific asset, other than cash, is contributed, and then that same asset is redistributed in this way. Here, again, this will not ordinarily be an issue of concern to the small business owner. Again, if you are considering this option, be sure to consult with a tax attorney to make sure you comply with the complexities of these transfers and/or distributions.
Allocations of Income and Interests May Have Tax Consequences
Decisions you made when forming and funding your business can have serious tax implications down the road when it comes time to allocate business interests and income. Since tax law is particularly complicated, the owner should seek advice from a tax professional in these matters. However, owners should understand the basic rules.
Tax basis. To properly comply with the tax rules, you must be familiar with the different measures of the term "basis," and the effect these different measures have on the allocation of income among the owners of the business.
When contributing non-cash property to an LLC, any difference between the property's fair market value and tax basis to the owner will require that the entity allocate depreciation, related to the item, away from the contributing owner and in favor of the other owners. The allocation of gain and loss from the sale of the asset will be to the contributing owner and away from the other owners.
For example, the building contributed in our case study, below, on tax implications of funding decisions falls under this rule. This allocation will usually mean less depreciation expense, but higher gain will be attributed to the transferor when the asset is sold by the business entity.
The critical concepts affecting the taxability of income and interest allocations are
- the tax basis of the owner's equity interest,
- the fair market value of the owner's equity interest, and
- how the operating agreement dictates the division of profits.
Understanding Tax Basis of Owner's Equity Interest
The initial tax basis of the owner's equity interest is equal to the initial cash plus the tax basis of non-cash property contributed to the entity, subject to adjustments when non-cash property with a liability is contributed to an LLC. When non-cash property is contributed, the tax basis of the owner's equity interest is based on the owner's tax basis in the asset contributed.
This tax basis is carried over. It is equal to the owner's original cost in the asset, plus the cost of any capital improvements the owner made to the asset, minus any depreciation he took on the asset. With property that has appreciated (or depreciated) in value, or that has been depreciated, this tax basis will usually be different from the fair market value of the property.
The entity also uses this same carryover tax basis in the acquired property for purposes of determining its depreciation, and gain or loss. Also, the holding period for the property, for capital gains purposes, includes the contributing owner's holding period.
If the owner sells his business interest, the gain or loss is determined by subtracting the tax basis for the equity interest from the proceeds received from the sale.
Determining FMV of Owner's Equity Interest
If only cash or services are contributed, the tax basis of the owner's equity interest and the fair market value of the owner's equity interest will be equal.
In other cases, the figures will be different. These differences arise because the fair market value of the owner's equity interest is based on the fair market value, and not the tax basis, of the property the owner contributes to the entity.
When cash or services are contributed, the face value of the cash and the lack of a prior value for the services mean that tax basis and fair market value are equal.
When non-cash property is contributed, free of any liability, the full appraised value is the property's fair market value. On the other hand, when non-cash property is contributed, subject to a liability that will be paid by the entity, the amount of the liability is subtracted from the appraised fair market value of the property, to determine the actual fair market value contributed.
Taxing Division of Profits
Limited liability company (LLC) owners typically divide profits based on the relative capital accounts of the owners. Subchapter S corporation owners divide profits based on relative number of shares owned. However, the number of shares owned is determined by the relative capital contributed by the owners. Hence, in both cases, the relative amounts credited to each owner for his or her contribution will control the division of profits.
Note that, even in the LLC, the relative amounts credited will translate into the issuance of ownership interests. These ownership interests may be termed shares. Division of profits can then be made according to the relative number of shares owned in the LLC, which will be the same as the relative balance of the capital accounts.
Voting rights in the LLC also are usually dictated by the relative capital accounts of the owners, or the relative number of shares owned, which is based on the relative capital accounts. Voting in the corporation is usually on a per share basis and is unaffected by the ratio. However, relative capital account contributions will, again, dictate how many shares each owner will be issued.
Unfortunately, the issue left open by many small business owners is which capital accounts are to be used in making these assessments: the capital accounts based on the tax basis of the owner's equity interest or the capital accounts based on the fair market value of the owner's equity interest. The differences can be significant.
Usually it makes more sense to use the fair market value of the owner's equity interest for each owner, as this is the true representation of what each owner contributed. However, since for tax purposes, records must be maintained based on the tax basis of the owner's equity interest, it is generally easier to simply base assessments on these figures.
In short, using the fair market value of the owner's equity interest usually provides a fairer result, but this requires that a separate record for the capital accounts be created and maintained. For this reason, some businesses make all assessments based on the tax basis figures.
For income allocation purposes, the best approach is usually to record interests within the accounting system based on the fair market value of the owner's equity interest. The agreement among the owners then must clearly specify that profit-sharing and voting (in the LLC) are to be based on this measure. As discussed above, determinations based on fair market value provide a much more equitable result.
For tax purposes, a separate record of the capital accounts based on the tax basis of the owner's equity interest is then maintained outside the accounting system. Alternatively, the owners could record the tax basis in the accounting records. This is not desirable because the accounting system does not reflect the true economic effect of the contribution.
A Sample Operating Agreement for a Delaware LLC appears in the Business Tools section. You should not attempt to use this form without first understanding all of the implications and alternatives available, and having it reviewed by an attorney. In other words, the small business owner should use the sample agreement as a guide and have it adapted to suit his particular needs.
Case Study: Tax Implications of Funding Decisions for LLC
John, Peter and Amy form a limited liability company (LLC). John contributes a building with a tax basis of $80,000, a fair market value of $170,000 and a mortgage of $60,000. The LLC assumes the $60,000 mortgage liability.
John's tax basis in the LLC normally would be the tax basis of the property he contributed, $80,000. However, the $60,000 liability assumed by the LLC changes this calculation.
The $60,000 must be allocated among all the owners, including John. Thus, the tax bases of John, Peter and Amy in the LLC will be increased by $20,000 each. In addition, John's basis must be decreased by the other owner's allocable share of the liability ($40,000). Thus, John's tax basis in the LLC is $60,000 ($80,000 + $20,000 - $40,000). The LLC would have a carryover basis of $80,000 for the building on its books.
Impact of Difference Between FMV and Tax Basis
The fair market value John contributed, and thus the fair market value of his equity interest, is $110,000 ($170,000 less $60,000.) This differs from his tax basis of the owner's equity interest, which is $80,000 before adjustment and $60,000 after adjustment.
This difference can lead to misunderstandings when profits are divided among the owners because John really contributed something of value to the LLC. As a result, it wouldn't be fair to give him credit for only his $60,000 tax basis, for purposes of division of profits or voting. Therefore, his owner's equity account in the LLC's accounting system should be credited for the fair market value contributed.
The entry for the accounting system would be:
|Building FMV ||$170,000 |
|John's Owner's Equity for Contribution ||$110,000 |
|Liability on Contribution ||$60,000 |
This requires that a separate tax record for the building be established, because the LLC's tax basis for the building will be $60,000 (i.e., the carryover basis from John.) This is the amount that must be used for purposes of depreciation, and calculation of gains or losses on the sale of the building by the LLC.
A separate record of the owner's capital accounts, based on tax basis, also will be maintained outside the accounting system. This record will reflect only the following adjustments: an increase in John's account for $80,000, his tax basis after adjustment, and an increase in the accounts for each of the two co-owners of $10,000 based on the liability adjustment.
Thus, the entry would be:
|Building ||$80,000 |
|John's Owner's Equity for Contribution ||$60,000 |
|Peter's Additional Owner's Equity ||$10,000 |
|Amy's Additional Owner's Equity ||$10,000 |
This way of recordkeeping ensures that the building is recorded for the amount that can be depreciated (i.e., the carryover basis from John). However, in this tax-based approach to recording, the liability is not recorded, as it is accounted for as an adjustment to the owner's equity accounts. This makes it difficult to account for the payments by the LLC on the liability, in the LLC's accounting system.
A separate record of the owner's capital accounts, based on fair market value, would be maintained outside the accounting system. This record will reflect only one adjustment: an increase in John's account for $110,000, the real value he contributed.
No adjustments are made here for the co-owners, as the $60,000 liability is simply subtracted from the value of the building, $170,000, and John is given credit for only the true value contributed, $110,000. This separate record will dictate division of profits and voting in the LLC.
For the sake of simplicity, the business could forego keeping the separate set of records based on fair market value, as these are not required for tax purposes. Division of profits and voting in the LLC could then be based on the relative tax basis of the owner's equity interests. This is usually not desirable, as it produces inequitable results.
Moreover, keeping records in the LLC's accounting system based on the fair market value of the owner's equity interest is a better approach from an asset protection perspective. The net amount of the asset recorded (asset minus liability) in the LLC's accounting system is $110,000, which is the true value of John's contribution. The additional amount of net assets has a beneficial effect on the calculation of liquidity and solvency. This additional amount will make it less likely that transfers from the business will be deemed fraudulent. This fair market value approach also is consistent with generally accepted accounting principles.
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