Importance of Maintaining Formalities with Your LLC: It Will Affect Your Deductions

Patrick J. Murphy

By Patrick J. Murphy



Many individuals establish LLCs and then operate a business as if it was an extension of themselves, commingling funds and not following proper formalities. A recent Tax Court decision provides a sobering realization for individuals who fail to properly title their assets and follow the required formalities. In this case, the court found that a taxpayer’s purchase of an RV did not increase the amount he had at-risk in the LLC because he could not show the LLC owned or used the RV. As a result, deductions he had taken based upon that amount at-risk were disallowed by the IRS.

In Estate of Roberts v. CIR, the taxpayer had established an LLC to lease equipment to his S corporation. He lent money to the LLC, which issued him a promissory note in that amount. With the proceeds of the loan, the LLC purchased an RV. However, there were several issues with the RV’s ownership and use. Even though the RV was titled in the name of CTI Leasing, it was not titled in the name “CTI Leasing, LLC,” the company’s legal name. The EIN on the car title belonged to his S corporation. The RV was not on the LLC’s depreciation schedule. The taxpayer used the RV for his own purposes. Lastly, there was no record that the LLC ever used the RV, because there was no written lease between the LLC and the S corporation concerning the RV.

As a result, the IRS concluded, and the Tax Court confirmed, there was no evidence that the LLC owned the RV or used it. Because the taxpayer could not show that the LLC owned or used the RV, the taxpayer was unable to claim tax deductions based upon the LLC’s capital at-risk in connection with the RV.

There are a few items to take away from this case:

  1. You should always properly title your corporate assets and use the corporate title LLC, Corp., or Inc., as the case may be.
  2. If you have multiple business entities, you must keep assets of each entity separate from other assets. If you lease an asset among entities, you must have a proper lease in writing executed by both entities.
  3. It would be much cheaper for the taxpayer to seek the guidance of an accountant or attorney when completing these transactions than suing the IRS in Tax Court for the disallowed tax deductions.

These days, with Legal Zoom and other ready-to-order LLCs, people are buying assets and operating businesses without knowing the consequences of their actions. Before you enter into large transactions, it is important to understand the formalities that must be followed in order to receive the intended tax consequences.

Posted by Attorney Patrick J. Murphy, CPA. As both an attorney and a CPA, Murphy’s practice includes sophisticated estate planning approaches as well as corporate transactions and advice in mergers and acquisitions, buy/sell agreements, corporate structuring, and real estate transactions for small to medium-sized businesses.

Will There be a 3.8% Sales Tax When You Sell Your Home?

Patrick J. Murphy

By Patrick J. Murphy



With the passing of the health care bill, there are a number of new tax code provisions and many people are concerned about how these new provisions will affect them. One of these new tax code provisions is the 3.8% Medicare tax that applies to “net investment income,” which is such items as interest, dividends, annuities, royalties, rents, and net gain on the sale of property (like your primary residence). One of the misconceptions about the new 3.8% Medicare tax is that it will affect a number of people when they sell their primary residence for a gain. Fortunately, this new tax will only affect a small percentage of people who are high income taxpayers.

One reason the new tax will not impact many taxpayers is the current exemption for gain on the sale of your primary residence. For single individuals, they are able to exclude the first $250,000 in gain from the sale of their primary residence. For married couples, the first $500,000 in gain from the sale of their primary residence is excluded. As a result, depending upon the taxpayer, the first $250,000 or $500,000 may be excluded from gross income and would not be subject to the 3.8% tax. The only individuals who should be concerned about the 3.8% Medicare tax is individuals who sell a second home or a have a very large gain on the sale of their primary residence.

Another reason that the new 3.8% Medicare tax will not affect many people is that it only applies to high income individuals. The tax will only be incurred when a single individual has adjusted gross income over $200,000 or when a married couple filing jointly has adjusted gross income over $250,000. Only a small percentage of taxpayers earn incomes over these threshold amounts, even for taxpayers who sell their primary residence for a gain over the $250,000/$500,000 exemption.

Therefore, due to the $250,000/$500,000 income exemption and the tax’s income thresholds, the only individuals who will be affected by this tax are high income taxpayers. If you believe you may be subject to the 3.8% Medicare tax due to a sale of your primary residence or otherwise, it is important that you speak with your tax attorney or accountant to develop a tax planning strategy to minimize the impact of this new tax. The goal behind the tax planning will be to minimize your adjusted gross income through such strategies as recognizing losses at the time you sell your primary residence or purchasing municipal bonds which pay tax-exempt interest. Through proper planning, you can minimize the impact of this new tax.

Purchase Price Contingencies (Earn-Outs)

Patrick J. Murphy

By Patrick J. Murphy



“In the business world, the rear view mirror is always clearer than the windshield” (Warren Buffet)

Private business owners, by and large, over estimate the value of their business.  Potential purchasers will not (and should not) ascribe the same sentimental value to the business that a founder would. 

A potential purchaser will base their purchasing decision on what is in the rear view mirror – – what are the historic financial results for the Company.  The potential purchaser’s lenders/investors will be like minded.

The current owner will have a firm grasp on how well the business has done in the past, but they tend to look out of the windshield more in terms of valuing their business with bright, optimistic expectations. 

In almost any sale, there is this friction between the Buyer and Seller of the value of the enterprise.  The Seller doesn’t want to lose the upside potential if they sell and the Buyer does not want to pay for unproven results. 

This friction is exasperated by poor economic conditions which causes the historical financial numbers to become skewed. 

EXAMPLE

Imagine that there are two similarly situated business owners who manufacture and sell the same product.  One of the owners (Sam) was age 65 in 1995 and the other was age 55 (Dianne) in 1995.  Both desire to retire at age 70.

In 1995 each of their business had sales of $10M and net income of $3M. Then year 2000 rolls around and Sam sells his business for $12M (which equates to four times the three year average net income) and retires comfortably.

Diane continues to operate her business throughout the ensuing decade with varied success due solely to the overall economic conditions.  From 2000 – 2007, her sales and net income figures remain strong, but starting in 2008, the Company’s sales decreased significantly as did the corresponding net income. 

  2007 2008 2009 2010
Sales $13M $8M $6M $7M
Net Income $3M $2M $1M 1.3M

 It is now 2010 and Dianne still desires to retire.  If Dianne sells her business using the same formula that Sam had used, the value of her Company would be approximately 5.73M.

So, Sam gets $12M when he sells his Company and Dianne only gets $5.73M?  Was the first one to ‘jump ship’ the winner?  Did Dianne sell too soon?  What are some alternatives that she could have considered?

PURCHASE PRICE CONTINGENCIES

A common technique used by owners of private enterprises to alleviate the inherent friction between the Buyer and Seller based on past versus future operational results is the use of a purchase price contingency. 

An earn-out is a purchase price contingency that can allow the Seller of a business to enjoy part of the up-side potential of a business.  Earn-outs can be based on any number of financial or performance benchmarks. 

For example, assume that Dianne agreed to sell her Company for a down payment of $5.7M, plus one-half of the Company’s net income for the next three calendar years in excess of $2.5M per year.

  2010 2011 2012 2013
Sales $7M $9M $12M $15M
Net Income $1.3M $2.8M $3.2M $6M

 The earn-out provision would provide the following payments to Dianne: 

  2011 2012 2013
Earn-out Payment $150,000 $350,000 $1,750,000

STRUCTURING THE CONTRACTUAL PROVISIONS

There are numerous contractual considerations that must be thought through when dealing with an earn-out. Carefully defining the benchmarks is a key to avoid post-closing disputes between the Buyer and Seller. 

In many earn-out situations, a group of key employees are retained as employees of the Company to assist in the growth of the operations.  Consideration should be given to what should happen if their employment with the Company is prematurely cut short.  An acceleration of the earn-out based on a liquidated formula would be possible, but that needs to be considered well in advance.

If the earn-out provision has benchmarks dealing with net income or Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), the Seller’s will want to be certain that certain caps are placed upon the Company’s ability incur additional expenses such as executive compensation that would negatively affect the earn-out payment. The Buyer will want to have a greater degree of flexibility in conducting the operations of the business and will not want undue constraints placed upon them. 

Some variations of an earn-out can avoid these potential disputes by using gross revenue as a benchmark, but using gross revenue can be risky for the Buyer as it will not necessarily correspond with available liquid assets to pay the earn-out payment. 

The more clearly defined the benchmarks you use are, the fewer disagreements there might be later between the Buyer and Seller when calculating the earn-out payments.

BOTTOM LINE

The use of an earn-out provision can be extremely useful to bridge the gap between the Buyer’s and Seller’s perceived value and can be instrumental in closing transactions that otherwise would not.  The contractual earn-out provisions should be meticulously structured to provide clear guidance for post-closing calculations and avoid timely and costly disagreements.

A New Headache for Business Owners – The IRS Form 1099

Patrick J. Murphy

By Patrick J. Murphy



Buried within just 23 lines of Section 9006 of the Healthcare reform bill, The Patient Protection and Affordable Care Act, H.R. 3590, 111th Congress, signed into law by President Obama on March 23, 2010 is a dramatic change to the 1099 reporting requirements.

Prior law IRS reporting laws required, generally, that if a business made payments in excess of $600 to a person or a business over the course of a year, the business was required to file a Form 1099 to report those payments. One copy would be sent to the IRS, another copy was sent to the person/unincorporated business to whom you paid in excess of $600. Payments made to a corporation and payments made in exchange for merchandise were generally not required to be reported.

Now, beginning January 1, 2012, every business, both large and small, will be required to issue additional tax documents to any vendor of services or property to which the business has paid more than $600 to in a tax year. As before, the business will need to send the tax form to both the IRS and to the person who received payments. The Form 1099 will need to be issued for basic business expenses such as airlines, hotels, rental cars, and restaurants, according to the Small Business Legislative Council. Also, for a business who sells or distributes goods, all of their suppliers of inventory are also considered vendors under this law. This new 1099 trail would expose payments to small operators that might now be going unreported, and which the federal government expects to cause a dramatic revenue increase to offset the cost of the health bill.

In addition to issuing the Form 1099s to all its vendors, a business will also have to obtain Taxpayer Identification Numbers (TINs) from all qualifying vendors. If the business is unable to do so, the business will be required to withhold a portion of the vendor’s payment and send it instead to the IRS. If a business fails to accurately file their 1099s, significant penalties can apply. Hopefully technical corrections will be made to this legislation to lessen the record keeping and reporting burden placed on small businesses by these requirements.

The Employment Tax Compliance Program—And What It Means for Businesses

Patrick J. Murphy

By Patrick J. Murphy



What Is the Employment Tax Compliance Program?

The Employment Tax Compliance Program (ETCP) is an Internal Revenue Service (IRS) program which aims to lessen the income tax gap. The ETCP plans to do this by auditing 6,000 companies over the next three years to determine if the classification of certain employees within those companies as independent contractors is proper, as opposed to classifying those same individuals as employees. This classification is important for tax purposes as it is easier for taxes to be taken from employees, who are subject to the withholding system, as opposed to independent contractors. Independent contractors are not subject to this same withholding system, which can sometimes lead to the under-payment of taxes. By auditing these companies, the IRS can look to see if individuals who were claiming to be independent contractors are actually employees, and thus would be subject to more regulated taxing.

Who is the Employment Tax Compliance Program Targeted At?

The ETCP will mostly be targeting at those industries which traditionally have individuals working for them that are more often than not considered to be independent contractors. This will include industries such as construction, ground delivery, car service and trucking, to name a few. Unfortunately, there is no specific test which can differentiate an employee from an independent contractor. Typically an independent contractor will have and use their own tools, will create their own schedules and will have numerous “employers,” as opposed to working for the same individual or company for 40-hours-a-week for an extended period of time. However, many of those same factors can be used in finding that an individual is an employee. Determining the difference between the two groups is a very fact-intensive process, specific to each situation.

What Will the Audits Consist of?

Typically, the audits will be done on-site and face-to-face with an agent. Other information which will be pertinent to the audit will be documents provided by the IRS and information which can be gathered from the internet. As stated above, the audit will focus on the proper classification of individuals as independent contractors or employees.

What Can You do to be Prepared?

To be adequately prepared if the IRS should contact your business, one must be cognizant of those employees who may garner extra attention. These employees will be those who have been previously been classified as independent contractors, but perhaps for consecutive years have received a W-2 from your company. It would be prudent to gather documentation about these employees which bolster their independent contractor status (e.g. contracts, agreements between parties, etc.). Small changes in your relationships with these employees for the future might also help to bolster their status as independent contractor.

Businesses also should keep in mind Section 530 of the Revenue Act of 1978. This section allows for individuals who have long been classified as independent contractors to remain as such, so long as the requirements for “substantive consistency,” “reporting consistency,” and “reasonable basis” are met.