Organizing an Illinois Limited Liability Company

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This is my chapter 3 for the Illinois Institute on Continuing Legal Education's LLC's and S Corporations text. It describes in detail the process for organizing an Illinois limited liability company, compares tax, liability, and control in LLC's to other entities, and provides information on tax and other elections available for new LLC's.

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Organizing an Illinois Limited Liability Company

  1. 1. 3 Organizing an Illinois Limited Liability Company WILLIAM A. PRICE Attorney at Law Warrenville
  2. 2. I. [3.1] Introduction II. Choice of Entity: Industry, Tax, Liability, Control, and Distribution Issues A. [3.2] For-Profit and General Nonprofit Business and Other Organization Types B. [3.3] Types of Business Operation, Industry Norms, and Tax Questions 1. [3.4] Sole Practitioner of Law 2. [3.5] Two Investors 3. [3.6] Software Company 4. [3.7] Corporate Group III. Organizational Filings and Forms Needed A. [3.8] LLC Organization and Tax Registration B. [3.9] Regulated Entity Compliance Certificates C. Not-for-Profit Organizations 1. [3.10] Charitable Trusts Registration and Reporting 2. [3.11] Religious Organizations D. [3.12] Tax Exemption 1. [3.13] Federal Income Tax Exemption a. [3.14] Religious Organization Exemptions b. [3.15] Political Organization Exemptions 2. [3.16] Sales Tax Exemption 3. [3.17] Property Tax Exemption E. [3.18] Local Registration and Permits IV. For-Profit Entity Tax Incidence A. B. C. D. [3.19] Tax Planning [3.20] Federal and State Income Tax [3.21] Filings Needed To Obtain Specific Federal Tax Treatments Status Available Without Election Filings 1. [3.22] Disregarded Entity 2. [3.23] LLC Taxed as a Partnership 3. [3.24] Limited Partnership LLC E. [3.25] Entity Status Requiring Election or IRS Qualification Decisions 1. [3.26] S Corporation Status 2. [3.27] C Corporation Status 3. [3.28] LLCs Pay No Illinois Franchise Tax V. [3.29] Self-Employment Tax
  3. 3. A. [3.30] Self-Employment Tax Rates B. [3.31] Self-Employment Regulations Applicable to a Limited Liability Company or Other Organization Taxed as a Partnership C. [3.32] Use of Loans D. [3.33] Use of a C Corporation E. [3.34] Use of an S Corporation F. [3.35] Combined Elections G. [3.36] Other State and Local Taxes VI. Liability Limitation A. [3.37] Statutory Protection B. [3.38] Risk Management VII. Control and Management A. [3.39] Control B. [3.40] Management C. Distributions 1. [3.41] Distributions in the Ordinary Course of Business 2. [3.42] Distributions on Dissolution VIII. [3.43] Pre-Organization Agreement IX. [3.44] Reservation of Name X. Articles of Organization A. [3.45] In General B. [3.46] Filing Form LLC-5.5 1 [3.47] Question 1 — Limited Liability Company Name 2. [3.48] Question 2 — Address of LLC’s Principal Place of Business 3. [3.49] Question 3 — Date That Articles of Organization Are Effective 4. [3.50] Question 4 — Registered Agent’s Name and Registered Office Address 5. [3.51] Question 5 — Purposes for Which LLC Is Organized 6. [3.52] Questions 6 and 7 — Dissolution 7. [3.53] Question 8(a) — Management by Managers 8. [3.54] Question 8(b) — Management by Members 9. [3.55] Question 9 — Affirmation 10. [3.56] Other Provisions for Regulation of Internal Affairs of LLC 11. [3.57] Transacting Business Under Assumed Name
  4. 4. XI. Tax Registration A. [3.58] Unemployment Insurance B. [3.59] Business Tax Registration XII. Appendix A. [3.60] Pre-Organization Agreement B. [3.61] LLC Operating Agreement — Simple Form, Member-Managed C. Additional Resources 1. [3.62] Bibliography 2. [3.63] Internet Resources
  5. 5. I. [3.1] INTRODUCTION As the attorney responsible for organization and operations counseling in a new business venture, counsel must consider more than the minimum legal requirements for filling in the blanks on limited liability company (LLC) organization forms. First and foremost, company legal counsel may be the only experienced business professional a startup entrepreneur consults. Moreover, counsel is often brought in considerably after actual business operations have started. Also, the clients who seek counsel may not excel in organization outside their own fields of specialization. Counsel, therefore, should take care to provide information on all appropriate business and legal/liability protection considerations relevant to the business, as well as the initial and continuing state, federal, and local government filings and compliance requirements affecting the enterprise. II. CHOICE OF ENTITY: INDUSTRY, TAX, LIABILITY, CONTROL, AND DISTRIBUTION ISSUES A. [3.2] For-Profit and General Nonprofit Business and Other Organization Types For-profit business organizations are not the only types of entities that may be organized as limited liability companies or other varieties of associations defined by statute. Not-for-profit entities, for-profit corporations, business trusts, limited partnerships, and (in some states) limited liability limited partnerships each come with their own tax treatment, degrees of liability protection, forms of organizational control, and rights to distributions. Organizational counsel often need to assist clients as they make a choice among the various types of entities, usually with very little time to compare and consider complicated explanations. At the startup stage, clients also do not want to spend much money on entity research or explanations of comparative benefits and drawbacks. They just want a business formed — now — so they can do their deal. With all the world to choose from and every state in the Union at least somewhat different in its organizational and liability laws, how should counsel and their clients choose appropriate forms of organization? Where should they organize? When should their choice of organizational form change? The answers to these questions will be as variable as the markets, investors, stage of growth, and business plans of the client organization. Lawyer use of LLC’s: Liability only partly limited: An individual or group organizing a professional law practice, for example, may will not be permitted to limit his or her or their liability for professional errors and omissions to amounts invested in the venture, although other business debts may be limited. Cf. Illinois Supreme Court Rule 721(d), which reads: “[T]he articles of incorporation or association or organization, or the partnership agreement, shall provide . . . . that all shareholders, members, or partners shall be jointly and severally liable for the acts, errors, and omissions of the shareholders, members, or partners, and other employees of the corporation, association, limited liability company, or registered limited liability partnership, arising out of the performance of professional services by the corporation, association, limited liability company, or registered limited liability partnership.” See generally Annot., 4 A.L.R.3d 383 (1965), cited in Alan R. Bromberg and Larry E. Ribstein, LIMITED LIABILITY
  6. 6. PARTNERSHIPS AND THE REVISED UNIFORM PARTNERSHIP ACT, p. 249 n.74 (1996). This answer applies, of course, to use of professional service corporations or other business entity types, as well as LLC’s. Venture-Backed Startups: An organization that plans to raise investment capital through venture capital funds will have to consider corporation form in order to avoid the incidence of unrelated business income tax by not-for-profits that are major investors in such funds. See generally Constance E. Bagley and Craig E. Dauchy, Ch. 8, Venture Capital, THE ENTREPRENEUR’S GUIDE TO BUSINESS LAW (11th ed. 1997). These entities are not subject to the unrelated business income tax on dividend income, but might be so taxed on income from entities taxed as partnerships, such as LLC’s. Publicly Traded Companies: A publicly traded organization, whether in partnership or corporation form, is likely to be subject to double taxation on organizational income unless it derives more than 90 percent of its income from real estate, natural resources, or other qualifying sources under U.S. tax law. See generally Code §7704. Several exceptions can be found, however, such as the exception to double taxation provided by a publicly traded real estate investment trust (REIT) or a two-layer investment, such as a venture capital partnership, which takes in limited partners that are pension funds and uses such pension funds as pass-through entities with members of the public as their investors. Elimination of double taxation is one of the major benefits usually sought by organizers of LLC’s. B. [3.3] Types of Business Operation, Industry Norms, and Tax Questions The charts below compare the various types of organizations required to file with state authorities and show their tax, liability, and management characteristics as well as those of sole proprietorships and business trusts, which are the other major business forms used in Illinois. Table: Sole Proprietorships and Partnerships Legal Forms of Operation Compared: Sole Proprietor and Partnerships Sole Proprietor General Partnership Limited Partnership Limited Partnership (Foreign) None None SOS Business Services SOS Business Services None (local assumed business name may apply) None None (local assumed business name may apply) SOS Form LP 201 SOS Form LP 902 SOS Form UPA 1001 None Annual filing fee or capital tax None None $150; expedited: add $100; online: credit card fee (varies) SOS Form LP 210; $100; expedited: add $50 $150; expedited: add $100; online: credit card fee (varies) SOS Form LP 210; $100; expedited: add $50 Liability None None General Partner(s) General Partner(s) $100 per partner; minimum $200, maximum $5,000) SOS Form UPA 1103(D); No fee, no expedited service; Note: Form UPA 1101(h)/1101(g) is required if amendments: Fee $25; Partners limited Filing required to form or operate Formation Filing fees, minimum tax Registered Limited Liability Partnership SOS Business Services Limited Liability Limited Partnership (Foreign) None if full faith & credit, RLLP if want Illinois statutory protection SOS Form UPA 1102 $500 SOS Form UPA 1103(f); $300, no expedited service; Note: Form UPA 1101(h)/1101(g) is required if amendments: Fee $25 Partners limited to
  7. 7. protection Multiple ownership classes allowed? Management Not possible Yes none; Limited Partners limited to investment amount Yes Self Apparent authority to bind entity in contract Self General Partners (per partnership agreement) General Partners (or per agency filing) General Partners (per partnership agreement) General Partners (or per agency filing) none; Limited Partners limited to investment amount Yes to investment amount investment amount Yes Yes General Partners (per partnership agreement) General Partners (or per agency filing) General Partners (per partnership agreement) General Partners (or per agency filing) General Partners (per partnership agreement) General Partners (or per agency filing) Legal Forms of Operation Compared: Sole Proprietor and Partnerships (cont.) Sole Proprietor General Partnership Limited Partnership Limited Partnership (Foreign) Personal property replacement tax None 1.50% of net income (all partner income except guaranteed payments) 1.50% of net income (all partner income except guaranteed payments) 1.50% of net income (all partner income except guaranteed payments) Federal/state entity level income tax No No No No Registered Limited Liability Partnership 1.50% of net income (all partner income except guaranteed payments) No Limited Liability Limited Partnership (Foreign) 1.50% of net income (all partner income except guaranteed payments) No Table: Limited Liability Companies Legal Forms of Operation Compared: LLCs Limited Liability Company (Domestic) Filing required to form or operate Formation filing fees and minimum tax SOS Business Services SOS Form LLC 5.5: $500; expedited: add $100; online: credit card fee (varies) Annual filing fee or capital tax SOS Form LLC 50.1; $250; expedited: add $50; online: credit card fee. Member liability limited to investment amount. Liability protection Multiple ownership classes allowed? Yes Members and/or managers (per operating agreement) Management Members or Managers Members or Managers (see articles of organization) Apparent authority to bind entity in contract Limited Liability Company (Foreign) SOS Business Services SOS Form 45.5: $500; expedited: add $100; online: credit card fee (varies) SOS Form LLC 50.1; $250; expedited: add $50; online: credit card fee. Member liability limited to investment amount. Yes Members and/or managers (per operating agreement) Members or Managers Members or Managers Limited Liability Company (Not-forProfit) Low-Income LLC Limited Liability Company (Series) SOS Business Services SOS Form LLC 5.5: $500; expedited: add $100; online: credit card fee (varies) (IRS NFP language neededmust be in Articles of Organization to qualify for Fed tax exemption) SOS Form LLC 50.1; $250; expedited: add $50; online: credit card fee. Member: no liability; limited for officers/directors if not paid salaries. SOS Business Services SOS Form LLC 5.5: $500; expedited: add $100; online: credit card fee (varies) (special language needed for IL statutory) SOS Business Services SOS Form LLC 50.1; $250; expedited: add $50; online filing allowed: credit card fee. Member:no liability no liability; limited for officers/directors if not paid salaries. SOS Form LLC 50.1; $250; expedited: add $50. No online filing. Member liability limited to investment amount. Yes Members and/or managers (per operating agreement) Yes Members and/or managers (per operating agreement) Yes Members and/or managers (per operating agreement) Members or Managers Members or Managers Members or Managers Members or Managers Members or Managers SOS Form LLC 5.5(s): $750; expedited: add $100; online: credit card fee (varies) Members or Managers
  8. 8. Personal property replacement tax 1.50% of net income (all member income except guaranteed payments) Federal/state entity level income tax 1.50% of net income (all member income except guaranteed payments) No No None (1.50% on unrelated business income ) 1.50% of net income (all member income except guaranteed payments) 1.50% of net income (all member income except guaranteed payments) No (yes on unrelated business income) No No Table: Corporations and Other Corporate Entities Comparison of Corporate entities Corporation (Sub S Election) Corporation (Sub C Election) Corporation (Foreign) Corporation (Sub S), (Foreign) Filing required to form or operate SOS Business Services and IRS election SOS Business Services SOS Business Services SOS Business Services Formation filing fees and minimum tax SOS Form LLC 5.5BCA 2.10, $150 plus franchise tax ($25 min.); : $500; expedited: add $100; online: credit card fee (varies) SOS Form LLC 5.5: $500BCA 2.10, $150 plus minimum franchis tax of $25; expedited: add $100; online: credit card fee (varies). File IRS 2553. SOS Form BCA 13.15: $150 plus minimum franchise tax of $25; expedited: add $100; online: credit card fee (varies). Registration in home state also required. SOS Form BCA 13.15: $150 plus minimum franchise tax of $25; expedited: add $100; online: credit card fee (varies). Registration in home state also required. Annual filing fee or capital tax SOS Form Domestic Corporation; Annual Report Fee $75 plus franchise tax (minimum $25 maximum $2 million, 0.001 times stated capital) SOS Form Domestic Corporation; Annual Report Fee $75 plus franchise tax (minimum $25, maximum $2 million, 0.001 times stated capital) SOS Form Foreign Corporation Annual Report Fee $75 plus franchise tax (minimum, $25 maximum $2 million, 0.001 times stated capital). Also home state fees/tax. SOS Form Foreign Corporation Annual Report Fee $75 plus franchise tax (minimum $25, maximum $2 million, 0.001 times stated capital). Also home state fees/tax. Liability protection Shareholders limited to investment amount Shareholders limited to investment amount Shareholders limited to investment amount Shareholders limited to investment amount Multiple ownership classes allowed? Management Apparent authority to bind entity in contract (see articles of organization) Personal property replacement tax Federal/state entity level tax No Yes Yes No Board of Directors President Board of Directors President Board of Directors President Board of Directors President 2.50% of net income 2.50% of net income 2.50% of net income 2.50% of net income No Yes Yes No Net tax by entity type depends on minimum salaries required and individual income vs. capital gains rate, as well as entity level tax. Will change for 2011 tax year, depending on repeal or lack of same for Bush presidency capital gains rates, individual tax rates. Comparison of Corporate entities (cont.)
  9. 9. Corporation or other Entity (Alien) Business Trust (Foreign or alien) Corporation (Not for Profit) Corporation (Not for Profit), Foreign Filing required to form or operate SOS Business Services and federal alien agent registration None (see home state/country law); fed foreign agent if alien entity SOS Business Services and AG if Charitable Trust Act Applies SOS Business Services and AG if Charitable Trust Act Applies Formation filing fees & min. tax SOS Form BCA 13.15 $150 plus min franchise tax of $25 If expedited add $100 and if online credit card fee (varies) Registration in home country also required None (Local Assumed Business Name May Apply) SOS Form NFP 102.10 $50 If expedited add $25 and if online add $2.75 payment processing fee SOS Form NFP 113.15 $50 If expedited add $25 No online filing Annual filing fee or capital tax SOS Form Foreign Corporation Annual Report Fee $75 plus franchise tax (min. $25 max $2 million, 0.001 times stated capital) Also home state fees/tax Home state/country forms and fees, if any SOS Form C 54 NFP Annual Report Fee $10 Expedited fee $25 plus credit card fee if filed online SOS Form C 54 NFP Annual Report Fee $10 Expedited fee $25; No online filing available Liability Protection Liability limited by home state law; Illinois full faith & credit should recognize Member no liability; Limited for officers/directors if not paid salaries Multiple Ownership Classes Allowed? Management Apparent authority to bind entity in Contract (See Articles of Organization) Personal Property Replacement Tax Federal/State Entity Level Tax Yes Yes Member no liability; Limited for officers/directors if not paid salaries Yes Trustee(s) Trustee Board of Directors President Board of Directors President None (except unrelated business income 2.5%) No (Yes for unrelated business income) None (except unrelated business income 2.5%) No (Yes for unrelated business income) 2.50% of net income 1.50% of net income Yes No The primary determinant of the legal form of organization that the clients and their investors or contributors will expect depends to a large extent on the industry in which the company will operate. This is usually a combination of custom and tax, liability, or other advantages. For instance, most hospitals are nonprofit organizations, which allows them to be managed by salaried professionals who do all the work doctors do not want to take on. The hospitals get income, sales, and property taxation breaks if their work is sufficiently charitable. Lawyers and accountants, by contrast, are responsible for each other’s work and so practice in partnerships, limited liability companies, and professional corporations that allow mutual control to those who produce income, i.e., the licensed professionals. Corporate real estate holdings are normally set up as real estate investment trusts, which limit liability for such assets that otherwise might spill over from high claims fields like construction or demolition. A federal tax advantage also eliminates entity-level tax for real estate investment trusts that pass enough of their annual income on to their owners. Industries develop and test common sets of forms, usual and customary billing and accounting methods, and functional corporate relations. These may change
  10. 10. over time, but the “right answer” tends to fall into patterns similar to those chosen by others in similar lines of business. (3.4) For-Profit or Nonprofit Purpose Permitted For Illinois LLC’s Note that §1-25 of Illinois’ Limited Liability Company Act (LLCA), 805 ILCS 180/1-1, et seq., permits LLCs to be organized for “any lawful purpose” (with a few provisions for regulatory compliance for any licensed profession or occupation and, in some cases, ownership restrictions to practitioners of the particular licensed profession for LLCs that are to carry out functions associated with insurance, dentistry, law, and medicine), so LLCs can be adapted to any of these industries, as well as to various tax-exempt purposes. (3.5) Client Organizational Issues, By Size of Business The following are reasonable organizational concerns for nonpublic organizations of different types at different stages of business growth: 1. liability limitation; 2. federal tax minimization; 3. administrative cost reduction (i.e., filing, legal, and bookkeeping fees to maintain the entity); and 4. foreign investor needs (restricted from investment in S corporations). Other criteria may be more significant, however, particularly in states where local franchise taxes or high LLC filing fees may impose significantly different costs for alternative organizational forms. Note the significance of employment tax in the choice of entity advice given, as well. (3.6) Securities Registration and Liability For some deals, securities registration liabilities and costs may be significant. The court in Keith v. Black Diamond Advisors, Inc., 48 F.Supp.2d 326 (S.D.N.Y. 1999), held that LLC interests can be securities. The Keith court applied the Howey test (see Securities & Exchange Commission v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100 (1946)); i.e., an interest is a security if the individual purchasing the interest depends primarily on the efforts of others to make money. Sections 3.74 – 3.107 below discuss typical circumstances and the forms of organization most likely to satisfy the client’s needs. A final note on taxes may help make the choice. Every form of tax treatment (nonprofit, pass-through, S corporation, C corporation for federal income tax; sales or property tax exemptions for state tax) can be available to entities formed as LLCs. The rest of this chapter assumes the choice of an LLC instead of some other form of entity. 1. [3.74] Solo Practitioner of Law
  11. 11. For a sole practitioner of law, sole proprietorship would likely be the best form of organization. Liability limitation. Entity organization would not be significant for professional errors and omissions, as these would all be that of the individual, or for most business debts, as bank loans and real estate leases require individual guarantees. If general creditor debts are avoidable and dissolution is possible, there may be some benefit to the limited liability form, as long as initial and continuing capitalization is sufficient. Good insurance might be enough, however, and there is a state entity-level tax of 1.5 percent for all non-guaranteed distributions. Federal tax. The entity would be disregarded under the “check-the-box” rule if it is not a corporation. See Treas.Reg. §301.7701-2(c)(2). Double taxation of income is unlikely to provide any benefits. As an owner of more than 2 percent of a corporation, the individual would have available a medical insurance deduction, but all distributions for it would be taxed to the individual, as they would in a partnership. Code §1372; Rev.Rul. 91-26, 1991-1 Cum.Bull. 184. Administrative costs. Sole proprietorship requires only bookkeeping for an IRS Schedule C, Profit or Loss From Business, which is estimated to cost $500 or more per year if an outside accountant sets up the initial chart of accounts and reviews the return. Tax reporting for a separate entity will require additional bookkeeping and tax preparation, which would result in an opportunity cost if done by the sole practitioner or a cost of $1,000 or more if an outside accountant is hired. Organizational filing fees would also add to administrative costs. Growth needs. The capital gains tax on conversion to corporation form is unlikely to apply as professional corporations are limited to investments by attorneys, so a closely held entity tax pattern (usually a partnership) is likely to apply. Foreign country individuals or organizations. The relevant level of tax varies by tax treaty. The United States may allow reciprocal admission. 2. [3.85] Two Investors For two investors purchasing a condominium unit intending to share investments, costs, and revenues equally and to sell the unit on agreement or as soon as investments qualify as long-term capital gains, the best choice for form of organization is likely to be a limited liability company. Liability limitation/management. Significant capital in the property would make a liability shield against slip-and-fall claims by invitees of tenants or subcontractors on a build-out possible without piercing the corporate veil exposure and other similar claims. See generally Sarah Spear, The Limited Liability Company: The Importance of Choosing the Correct Business Vehicles (June 2006), www.llrx.com/features/llc.htm; Charles W. Murdock, Limited Liability Companies in the Decade of the 1990s: Legislative and Case Law Developments and Their Implications for the Future, 56 Bus.Law. 499 (2001). This makes cotenancy unattractive, though that would not carry 1.5-percent personal property tax replacement tax (2.5 percent for separate S corporations). These factors indicate an LLC or S corporation form, rather than such forms as a limited partnership, which would limit management of one partner. Registered limited liability partnerships (RLLPs) are not available in all states for limited liability partnerships and therefore might not be recognized in other states’ courts for tort claims by their citizens, if they rent condominium time.
  12. 12. See generally William Callison, Limited Liability Partnerships and Limited Liability Limited Partnerships, www.lectlaw.com/files/buo04.htm. General partnership would not shield owners from liability. Federal tax. Adopting the partnership form will avoid double taxation of income, not only when earned but also on distribution. Active management of assets by both investors can prevent passive activity loss limits and allow losses (if any) to be offset against other investor income. Cf. Larry E. Ribstein and Peter V. Letsou, BUSINESS ASSOCIATIONS, pp. 268 – 269 (Matthew Bender & Co., 4th ed. 2007). See also Code §469 (passive activities). Separate ownership as tenants in common would provide similar benefits. Administrative costs. Separate organization will impose costs for separate tax return preparation, which would be avoidable if the asset were held by tenants in common, in which case only individual IRS Schedule C filings would be necessary. See Code §761(a); James A Nepple, What Are the Tax Aspects Relating to Limited Liability Companies?, Illinois State Bar Association Law Ed Series, p. 17 (Sept. 25, 1998). Delaware or other out-of-state LLC organization would add expense. Organization in a state where the operations are intended will eliminate the need to pay both state-of-operation and state-of-organization filing fees. The Illinois Limited Liability Company Act is a good, general-purpose LLC statute, so local organization is not a significant disadvantage. Growth needs. If the investors plan a series of real estate investments, partnership tax elections for the LLC and the ability to set up different classes of ownership for each new deal would still permit growth. Such investments are typically cashed out from time to time, making the realization of gain at the time new investors are brought in less of a penalty than would be realized for recapitalization of a growth business. Even if the organization were continued, reorganization of the partnership form would not necessarily incur immediate recognition of gain or loss in the way a distribution to partners, a conversion to a corporation, or a new LLC (new series in a series LLC) for each new deal would. Cf. Prop.Treas.Reg. §105162-97 (Oct. 27, 1997), cited in Nepple, p. 21. Foreign country individuals or organizations. The LLC form would permit partnership taxation rules on distributions to individuals. Organization income streams may be characterized as corporation income (double taxed) or as partnership income (flow through to foreign entity investors according to foreign country’s own tax rules), depending on the organization type. Treas.Reg. §301.7701-2 (b)(8) generally treats organizations equivalent to U.S. publicly traded corporations as corporations and others as partnerships unless they elect business association status under U.S. law. Foreign country organizations and nonresident alien individuals are not permitted owners for S corporations, so the LLC form may be preferred if the investors fall into this class of taxpayers. See Ribstein and Letsou, supra, p. 274. 3. [3.96] Software Company For a software company with a patent on key new technology that is ready for an angel investment of $800,000 (10 investors at $80,000 each), the choices for forms of organization would be a C corporation, if reasonably certain to proceed to venture funding, or a limited liability company taxed as a partnership.
  13. 13. Liability limitation. Angel investors will require limitation of their liability to the amount of their investments in the organization and typically are interested in being able to throw out management that fails to perform. This implicates the corporation or LLC forms, not the more passive investor styles provided in limited partnerships or business trust forms (the last is not a native Illinois business type in any case). The general partnership and registered limited liability partnership forms would be equally unacceptable, given full or partial exposure of investor assets to business debts and the high filing fees of a RLLP. Federal tax. Partnership tax status would be preferred for organizations not likely to need to convert to a C corporation. Note, however, that venture capital organization is a likely means of cashing out initial investors for fast growth businesses. Because venture capital organizations usually need to invest in C corporations to avoid unrelated business income tax incidence on distributions through them to their not-for-profit investors (Constance E. Bagley and Craig E. Dauchy, THE ENTREPRENEUR’S GUIDE TO BUSINESS LAW (11th ed. 1997)), conversion of partnerships in which they invest to C corporations before or at the time of venture capital investment is a distinct possibility. With share valuations likely to increase significantly at each funding stage because more research and market testing are done at each stage, allowing the company to support a higher valuation at each successive financing, potential capital gains liability on conversion would be substantial. Founders and investors usually prefer to defer recognition of such gains until they have a public market for their shares. Administrative costs. At these capitalization levels, the elimination of state franchise taxes may well offset any initial or continuing high organization fees, when investors come from states with such taxes (such as Illinois). The practical requirements of avoidance of investor mistrust and potential securities law liability under antifraud clauses of federal law and state blue-sky laws, even without public registration, will require CPA certification of accounts. The deal is also sufficiently large to support specifically tailored investor-company agreements and buy-sell arrangements. Growth considerations. The tax needs of investors in institutionally managed funds (to avoid passive source income) outweigh those of friends and family and angel stage investors, as these deals have to mature fast or die. Foreign country individuals or organizations. Neither class of investor is restricted from owning interests in U.S. corporations or LLCs. 4. [3.107] Corporate Group Assume a corporate group with a variety of new technology projects, funded in part by a “cash cow” organization and burdened with a subsidiary with potential Superfund site cleanup liability. No excess of liability over capitalization of the subsidiary is anticipated, but total liability is uncertain. The likely choice for a form of organization would be a corporate parent with limited liability company subsidiaries or spinoffs for early stage investment in new technology ventures. Use a business trust or spinoff for the Superfund-burdened subsidiary. Limited liability. The corporate parent and cash cow/technology venture combination would be burdened for the period of Superfund liability determination with significant attorneys’ and accountants’ annotations to financial reports on group performance, based on the liability
  14. 14. amounts, and with the duty (present in federal and state securities laws) to make disclosure of all facts that could be material to an investment in the venture. Failure to make such a disclosure can give rise to a finding of securities fraud. See 17 C.F.R. §240.10b-5. Absent undercapitalization or other grounds for piercing the corporate veil, separation of the Superfund-burdened subsidiary by transferring it to a business trust with trustee duties — including winding up the claims, operating the subsidiary until such claims are resolved, and either winding up the organization or reconveying the organization to the corporate parent once all claims are resolved — would eliminate potential charges on the corporate parent. LLC subsidiaries, like corporate subsidiaries, would shield the parent from liability beyond amounts invested in the subsidiary. Such liabilities can be significant when new and potentially overlapping technologies are involved. Federal tax. The separation of the Superfund liability subsidiary will not save taxes because business trusts are subject to tax on business operations. If the spinoff were made irrevocable, the organization could realize an immediate capital loss to set off against gains from the cash cow/technology components of the group. Technology or other small-growth components present an interesting tax opportunity. They can be separated into units small enough to be privately placed, with securities not traded on national or local markets, but with contract and other rights associated with the corporate parent. Cash flow from the LLCs can be directed to investors and to reinvestment in technology venture growth, with the parent having a controlling share and thus the right at 50.1 percent, instead of 80 percent or more, the requirement for the dividends-received deduction under the definition of controlled group organizations to avoid tax at the subsidiary level on dividends directed to the parent. Any LLCs organized as wholly owned subsidiaries could simply be disregarded for federal tax purposes. Treas.Reg. §301.7701-2(c)(2). They would still protect the corporate parent from patent and other claims against the new venture, based on the liability protections provided for LLC investors under state law. Administrative costs. Once an organization has established the accounting and legal staff to manage more than one company, additional subsidiaries do not provide excessively large amounts of additional administration. Savings in franchise taxes and other state fees (as trusts do not require the same level of filing) by use of LLC and trust forms may be of some marginal benefit. Elimination of the $2,000 – $3,000 per year or more of additional accounting costs associated with auditing a separate set of books and submitting separate tax returns for wholly owned subsidiaries could save substantial amounts if no use of such forms for tax savings to investors is needed. Growth considerations. In investments, growth tends to produce additional capitalization. When the growth components of an organization can be united with positive cash flow elements and given some tax advantage, the corporate counsel has contributed value to the organization. Foreign country individuals or organizations. If the technology ventures involve out-ofcountry participants, they can be structured as joint ventures through LLC subsidiaries, without tax incidence to each partner at the subsidiary level. Appropriate contracting and operations locations can make income streams to the partners payable in the nation of organization, which may help to avoid additional potential for multiple taxation on single-source incomee. C. (3.11) State Tax Planning.
  15. 15. Organizations that operate in multiple states can sometimes locate sales offices in states like Oregon, without sales tax, and home offices in states, like Delaware, Nevada, and Wyoming, that impose no income tax on out of state operations. (See generally 2009 State Tax Handbook, CCH, ISBN 9730808019213 (hereafter "CCH") or later editions, or All States Handbook, 2010 Edition, RIA Thomson, ISBN 978-0-7811-0415-9 ("RIA") or later editions.) The general federal standard for income tax allocation is expressed in 15 USC § 381 - Imposition of net income tax (Ref current to Pub. L. 112-238): (a) Minimum standards No State, or political subdivision thereof, shall have power to impose, for any taxable year ending after September 14, 1959, a net income tax on the income derived within such State by any person from interstate commerce if the only business activities within such State by or on behalf of such person during such taxable year are either, or both, of the following: (1) the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State; and (2) the solicitation of orders by such person, or his representative, in such State in the name of or for the benefit of a prospective customer of such person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph (1).” Some tax variations: Delaware: no state corporate income tax on out of state transactions. (See generally DEL shelter: http://www.nytimes.com/2012/07/01/business/how-delaware-thrives-as-a-corporate-taxhaven.html?pagewanted=all&_r=0, accessed Jan 14, 2013; and see also Del tax center: http://www.delaware.gov/topics/TaxCenter.) NV, SD, WY: no state corporate income tax States with no individual income tax: • • Alaska • Florida • Nevada • South Dakota • Texas • Washington • Wyoming
  16. 16. Two states have a limited income tax on individuals. These states tax only dividend and interest income: • • Tennessee New Hampshire States with no sales tax: (Good for sales operations sites: check before using the jurisdiction to be sure the state’s laws allow licensing charges to be remitted to a no income tax state for HQ entity. Also note difference between “unitary” and non-unitary businesses for tax allocation, see below.) AK DEL NH MT OR Unitary businesses may not be able to avoid tax on their separate business units. For purposes of state corporate taxation, the determination of whether income is classified as “business” or “nonbusiness” can have significant tax implications. The U.S. Supreme Court recently addressed this issue in Meadwestvaco Corporation, Successor in interest to Mead Corporation v. Illinois Department of Revenue, 553 U.S. 16 ( 2008). In this case, the taxpayer, an Ohio corporation with its headquarters in Ohio, had sold one of its business divisions (the Division) with headquarters located in Illinois. Although the Division’s regular business activities were subject to Illinois income tax, the taxpayer took the position that the gain on the Division’s sale constituted “nonbusiness” income that was not subject to Illinois tax. As nonbusiness income, the taxpayer allocated the gain to Ohio (the taxpayer’s state of domicile) for state income tax purposes. In Meadwestvaco, the Court was asked to address whether Illinois constitutionally had the right to tax as business income a significant capital gain realized by an out-of-state corporation on the sale of one of its business divisions based on the state’s apportionment factors. If the gain were determined to be nonbusiness income, the gain would not be subject to tax in Illinois, and the taxpayer would have a right to a refund of Illinois income tax and penalties totaling approximately $4 million. In its decision, which did not resolve the issue, the Supreme Court concluded that the state appellate court had failed to address the “key” factor needed for resolution - whether the Division and the taxpayer were a “unitary business.” Although the Illinois trial court determined that the Division was not a unitary part of the taxpayer’s business, it concluded that the state could tax the taxpayer’s capital gain on an apportioned basis. In affirming the trial court’s decision, even though the Illinois appellate court had determined that the Division served an “operational” function in the taxpayer’s business, the appellate court failed to address the issue of whether the Division and the taxpayer were a “unitary business.” The Supreme Court therefore remanded the case back to the state appellate court to consider whether the Division and the taxpayer’s business were unitary. Shaping the legal issues required to reach a conclusion, the Supreme Court’s opinion notes that a state’s power to tax out-of-state activities is derived from the application of the Commerce Clause and Due Process Clause of the U.S. Constitution. Since the Division was doing business in Illinois, the Due Process requirement had been met - there was a definite minimum connection between Illinois and the transaction it sought to tax. To meet the requirement of the Commerce
  17. 17. Clause, the inquiry shifted from whether the state may tax to what it may tax. The Supreme Court noted that it had developed the “unitary business principle” to answer just such a question. Under this principle, a state need not “isolate the intrastate income-producing activities from the rest of the business” but “may tax an apportioned sum of the corporation’s multistate business if the business is unitary.” A court must determine whether the intrastate and interstate activities form part of a single unitary business. Thus, where the value of what a state wants to tax is derived from a “unitary business” operated both in and out of state, the state can tax on an apportioned basis (generally, a state’s apportionment factors include sales, property, and compensation in the state) versus an attempt by the taxing state to isolate the value attributable to the operation of the business within the state. On the other hand, if the value to be taxed by the state is derived from a “discrete business enterprise,” the state cannot tax even an apportioned share of that value. Although it may be easy to identify the principle to be applied, it has been difficult for state courts to define when a business is “unitary.” Towards this end, courts have determined that where the asset at issue served an “operational” function, such a finding was instrumental in addressing the constitutional relevant conclusion that the asset was a unitary part of the business being conducted in the taxing state rather than a discrete asset to which the taxing state had no claim. Where the asset in question is another business, the Supreme Court described the “hallmarks” of a unitary relationship as “functional integration, centralized management, and economies of scale.” In Meadwestvaco, the state trial court concluded that these “hallmarks” were lacking and concluded that the Division was not part of the taxpayer’s business. The salient facts in the case included the following: • although subject to the taxpayer’s oversight, the taxpayer did not manage the day-to-day affairs of the Division • the headquarters of the taxpayer and the Division were located in different states, with the taxpayer and the Division having their own management teams • the two businesses maintained separate manufacturing, sales, and distribution facilities, as well as separate accounting, legal, human resources, credit and collections, purchasing, and marketing departments • the taxpayer’s involvement, generally, related to approving the Division’s business plan and any significant corporate transactions (such as capital expenditures, financings, mergers and acquisitions, or joint ventures) • the taxpayer and the Division were not required to purchase from each other and, if they did, there were no discounts, etc. III. ORGANIZATIONAL FILINGS AND FORMS NEEDED A. [3.128] LLC Organization and Tax Registration Many clients do not want elaborate advice on tax, liability, or other alternatives to limited liability companies. The practitioner should provide at least minimal information on such alternatives, but this can be done by, e.g., giving them the Department of Commerce and Economic Opportunity’s STARTING YOUR BUSINESS IN ILLINOIS, www.commerce. state.il.us/dceo/bureaus/entrepreneurship+and+small+business/publications. This section outlines the forms and steps needed for basic LLC formation and tax registration. Be careful when filling
  18. 18. out forms. If you indicate, for instance, that the company being formed sells tangible goods and services, your client will need to file retailers’ occupation tax forms regularly, not just reports of income tax due. See generally Secretary of State, A Guide for Forming Domestic Limited Liability Companies, www.cyberdriveillinois.com/publications/pdf_publications/c334.pdf. Check for name availability. Pick a name that will not be confusingly similar to any other entity or business now in operation. Do a Corporation/LLC Name Availability search online at www.cyberdriveillinois.com/departments/business_services/corp.html. Do an LP/LLLP/LLP Name Availability search online at www.cyberdriveillinois.com/departments/business_services/ lpsearch.html. Do a trademark search by, e.g., searching the name with an Internet search engine and checking state and federal trademark registries at www.uspto.gov/trademarks/process/search and www.cyberdriveillinois.com/departments/business_services/trademark.html. NOTE: If the client desires trademark filing, once the entity is filed, examine the Trademark Registration and Protection Act, 765 ILCS 1036/1, et seq., and Registration and Protection of Trademarks and Servicemarks, www.cyberdriveillinois.com/publications/pdf_publications/c249.pdf. Regarding federal trademark filing, see also www.uspto.gov/trademarks/basics/index.jsp. Do an Internet Corporation for Assigned Names and Numbers (ICANN) website name availability search (i.e., a WHOIS search) at any registrar site, such as www.allwhois.com, www.register.com, www.godaddy.com, www.networksolutions.com. Note that the registration service may be a free add-on to Internet hosting service, which should be researched on price, anonymity of owner, merchant account linkage, site software, etc. File LLC Form 5.5, Articles of Organization, www.cyberdriveillinois.com/departments/ business_services/publications_and_forms/llc.html. See §§3.45 – 3.57 below for comments on filling in the form. For the price of an expedited service fee, you can use the online filing option for quicker filing and results. See www.ilsos.gov/llcarticles/frontinstructions.html. Pay careful attention to restrictions on use of words like “bank” or “banking,” Olympics references, corporate fiduciary functions limits (unless registered as same), and other common reasons for “go-backs” (i.e., rejections of your filing by the Department of Business Services, which cost time and embarrassment.) Apply for an Employer Identification Number. Download IRS Form SS-4 from www.irs.gov/pub/irs-pdf/fss4.pdf. This should be filled in online for fastest results. There is no charge for either hard-copy or online FEIN request. See www.irs.gov/businesses/small/article/ 0,,id=102767,00.html. Register with the Illinois Department of Employment Security. Download Form UI-1 from www.ides.state.il.us/pdf/forms/ui1.pdf to see the questions. Register (and later pay, if you have employees) online at Illinois TaxNet, https://taxnet.ides.state.il.us. Register for other Illinois taxes. Find the Illinois Department of Revenue (IDOR) Form REG1 at www.revenue.state.il.us/taxforms/reg/reg-1.pdf. This and the associated schedules (also available for download at the IDOR site) give the questions you will need to answer. For immediate registration, file online at http://tax.illinois.gov/businesses/register.htm. Register for professional or other industry-specific permissions to operate, if applicable. For instance, lawyers must register with the Attorney Registration and Disciplinary Commission to practice law. If the business being formed needs state permissions to operate (e.g., new source
  19. 19. registration from the state Environmental Protection Agency for potential sources of air pollution), apply for these before beginning operations. Similarly, comply with nonprofit charitable registration or other special registration statutes. Register for local taxes, if any, and check zoning for location-relevant permission to operate, as well as any “general business” or other entity registration requirements that apply. Draft and execute an operating agreement for the new LLC. See §3.61 below for a sample form for a single-member LLC. The operating agreement is a record of the organization and should be kept with ownership records, records of agreements, and other books and records that may be needed to resolve IRS or corporate controversies. The registered agent or primary manager may be the records custodian. Create a legal and tax reports due calendar for the new entity. This should include dates for annual and periodic federal and state income tax, retailers’ occupation tax/use tax, local and special taxes (if any), unemployment insurance taxes (if any), Social Security/Medicare taxes (if any), annual entity reports to the Department of Business Services due dates, and any other dates relevant to professional registration or internal organization and local ordinance compliance needed. Remind your client by e-mail of tax and other due dates, vendor contracts, employee contracts and policies, financing assistance, and other legal services that the new business entity may need. Some may be helpful or necessary at startup. B. [3.139] Regulated Entity Compliance Certificates Almost any form of business may require federal, state, or local licensing, with consequent periodic reporting, in addition to the filing of assumed business name or entity registration forms. As in Chicago’s instance, the licensing may be combined with particular home-rule tax incidence and reporting or may require initial or periodic examination, continuing education, requalification, or annual or other periodic license payments. The full scope of line of business regulation for, e.g., securities, insurance, public utilities, banking, airlines, or railroads, and the full requirements of licensing statutes for professions like law, accounting, architecture, or plumbing are beyond the scope of this chapter. Readers should be familiar with whatever is required for the client seeking their advice and should help assure compliance with local, state, and federal regulations on registration, qualification to practice, periodic reports, and other compliance elements. These, and LLC initial registration and periodic regulatory certification, can be included in a company’s International Organization for Standardization (ISO) 14000 environmental management standards certification and in the more general ISO 9000 management standards, both of which have commercial and legal significance. Major entities may not deal with suppliers that cannot document compliance. See www.iso.org/iso/iso_catalogue.htm. 805 ILCS 180/1-25 adds industry-specific requirements for use of the LLC form for the following professions:
  20. 20. Insurance. Groups of underwriters, incorporated and unincorporated, must have a finding from the Director of Insurance that the group meets the requirements of §86(3) of the Illinois Insurance Code, 215 ILCS 5/86(3), and the LLC, if insolvent, must be subject to liquidation by the Director of Insurance under Article XIII of the Illinois Insurance Code, 215 ILCS 5/187, et seq. Dental practice. Members and managers must be licensed as dentists under the Illinois Dental Practice Act, 225 ILCS 25/1, et seq. Medical practice. All the managers, if any, must be licensed to practice medicine under the Medical Practice Act of 1987, 805 ILCS 60/1, et seq., and each member must be (A) licensed to practice medicine under the Medical Practice Act of 1987; or (B) a registered medical corporation or corporations organized pursuant to the Medical Corporation Act [805 ILCS 15/1, et seq.]; or (C) a professional corporation organized pursuant to the Professional Service Corporation Act [805 ILCS 10/1, et seq.] of physicians licensed to practice under the Medical Practice Act of 1987; or (D) a limited liability company that satisfies the requirements of subparagraph (A), (B), or (C). 805 ILCS 180/1-25(4). Note that similar restrictions on ownership may exist in licensing statutes, even though these are not explicitly cross-referenced in the Limited Liability Company Act. Architectural design professionals. Architectural design professionals must be licensed, and advertising by firms must carry the firm’s registration license. 225 ILCS 305/23.5. Such firms may not be registered unless (1) two-thirds of the board of directors, in the case of a corporation, or two-thirds of the general partners, in the case of a partnership, or two-thirds of the members, in the case of a limited liability company, are licensed under the laws of any State to practice architecture, professional engineering, land surveying, or structural engineering; and (2) (2) a managing agent is (A) a director in the case of a corporation, a general partner in the case of a partnership, or a member in the case of a limited liability company, and (B) holds a license under this Act. 225 ILCS 305/21(b). The LLC Act, 805 ILCS 180/5-5 ( c ) allows organization for the purpose of accepting and executing trusts, but requires the filing of a certificate a statement executed by the Commissioner of the Office of Banks and Real Estate that the organizers of the limited liability company have made arrangements with the Commissioner of the Office of Banks and Real Estate to comply with the Corporate Fiduciary Act. Similarly, 805 ILCS 180/5-5(d) requires that Articles which are filed in order that the entity formed engage in banking be further filed with the Commissioner
  21. 21. of the Office of Banks and Real Estate, or with the appropriate federal banking authorities. By contrast, many licensing requirements in other statutes and state rules apply to mandate operator qualifications but do not restrict ownership in the operating entity. For example, attorneys-at-law are regulated by the Supreme Court Rules on Admission and Discipline of Attorneys, S.Ct. Rule 701, et seq. S.Ct. Rules 721 and 722 specify the requirements for attorney practice in limited liability organizations. Rule 721(c) prohibits the practice of law and the opening of an establishment for such practice in Illinois by a corporation, association, limited liability company, or registered limited liability partnership unless such organization has a certificate of registration issued by the Illinois Supreme Court. Note that the Attorney Act, 705 ILCS 205/0.01, et seq., prohibits unlicensed practice and provides for contempt of court sanctions, both equitable and punitive, for soliciting legal business or for practicing when unlicensed. Rule 721 requires that each natural person shall be licensed to practice law who is (A) a shareholder, officer, or director of the corporation (except the secretary of the corporation), member of the association, member (or manager, if any) of the limited liability company, or partner of the registered limited liability partnership, (B) a shareholder, officer, or director of a corporation (except the secretary of the corporation), member of an association, member (or manager, if any) of a limited liability company, or partner of a registered limited liability partnership that itself is a shareholder of a corporation, member of an association, member (or manager, if any) of a limited liability company, or partner of a registered limited liability partnership engaged in the practice of law, or (C) engaged in the practice of law and an employee of any such corporation, association, limited liability company, or registered limited liability partnership and that the entities not violate any other rules attorneys must comply with in practicing before Illinois courts. Note that Illinois Rule of Professional Conduct 5.4 restricts division of fees and other professional associations with nonlawyers. The net effect is that, for instance, nonlawyers could inherit a lawyer’s interest, but they could not practice in LLC form, but they would be able to sell such interest to another practicing lawyer. Creditors, similarly, could receive a charging interest on a lawyer’s distributive interests under the LLCA but could not control or otherwise manage in any way the active practice of law, just as those with charging orders in other circumstances lack management rights. See 805 ILCS 180/30-20. S.Ct. Rule 722 subjects owners of law practices operating as LLCs or other limited liability entities to liability for claims up to the amount of the deductible of their malpractice policies or for the amount of the minimum for such policies (or for proof of financial responsibility for such amounts, if no policy is in hand). The required minimum coverage or financial responsibility proof is “a minimum amount of insurance of $100,000 per claim and $250,000 annual aggregate, times the number of lawyers in the firm at the beginning of the annual policy period, provided that the firm’s insurance need not exceed $5 million per claim and $10 million annual aggregate.” S.Ct. Rule 722(b)(1).
  22. 22. An application for certificate of registration is required before the Supreme Court will issue a firm registration under S.Ct. Rule 721. There is a link to the registration information on the Attorney Registration and Disciplinary Commission’s (ARDC) website at www.iardc.org/ registration/reg_faqs.html and www.iardc.org/registration/profsvcentity.html. The Supreme Court website has a link to the form at www.state.il.us/court/supremecourt/prof_serv/default.asp. There is a filing fee of $50. Each attorney and law firm is required to report trust account and malpractice insurance status under S.Ct. Rules 756 and 722. The ARDC has information on these requirements at www.iardc.org/registration/unifiedreport_instruct.html. The relevant statute governing landfills requires a permitted person, but not that such person be the owner. This means that ownership and management are not restricted. The permit signer will presumably be required to be the licensed professional. 225 ILCS 230/1004. 805 ILCS 180/1-28 requires a Department of Financial and Professional Regulation certificate of registration for any LLC that “intends to provide, or does provide, professional services that require the individuals engaged in the profession to be licensed by the Department of Financial and Professional Regulation.” Initial certificates are $50, with $40 to be paid to that Department for annual renewal certificates.Certficate fees should be determined by contacting the Department of Financial and Professional Regulation, as these vary by profession. Contact information for the Department is as follows: 320 W. Washington Springfield, IL 62786 Phone: 217-785-0800 TDD: 217-524-6735 Fax: 217-782-7645 100 W. Randolph, 9th Floor Chicago, IL 60601 Phone: 312-814-4500 TDD: 312-814-2603 Fax: 312-814-3145 The Department’s website, which lists the professions and occupations it regulates, is www.idfpr.com. C. Not-for-Profit Organizations 1. [3.140] Charitable Trusts Registration and Reporting Charities and nonprofits, religious and nonreligious, may need to register with the Charitable Trusts Bureau of the Office of the Attorney General or file forms indicating that the organization is exempt from registration and reporting. Such entities could be formed under the Limited Liability Company Act, the Business Corporation Act of 1983 (BCA), 805 ILCS 5/1.01, et seq., the General Not For Profit Corporation Act of 1986, 805 ILCS 105/101.01, et seq., the Religious
  23. 23. Corporation Act, 805 ILCS 110/0.01, et seq., or other special legislative acts. The Charitable Trusts Bureau website is www.illinoisattorneygeneral.gov/charities/index.html. Not-for-profit organizations may be subject to the Charitable Trust Act, 760 ILCS 55/1, et seq., which requires registration with and financial reports to the Attorney General. See 760 ILCS 55/5, 55/7. Religious organizations may be exempt from reporting but may still be required to apply for exemption. 760 ILCS 55/4(a). The registration forms are Form CO-1, Charitable Organization — Registration Statement; Form CO-2, Charitable Organization — Financial Information Form; and Form CO-3, Charitable Organization — Religious Organization Exemption Form, which are available on the Attorney General’s website at www.illinoisattorneygeneral.gov/charities/index.html. Exemptions from sales taxation under the Retailers’ Occupation Tax Act, 35 ILCS 120/1, et seq., and the Use Tax Act, 35 ILCS 105/1, et seq., may also be available, as well as exemptions from local property taxation under the Property Tax Code, 35 ILCS 200/1-1, et seq. The sales tax exemption requires filing with the Illinois Department of Revenue of the Code §501(c)(3) recognition letter that would be the result of a successful application for recognition of exemption to the IRS. The property tax exemption filing, which is made to the local property tax appeals entity relevant to the county where the property in question is located, also requires proof of exclusively charitable or religious use for the property in question. 35 ILCS 200/15-10. See also 35 ILCS 200/15-40, 200/15-65. Religious organizations may be exempt from annual reporting under the Charitable Trusts Act but are still required to file the proof that they are exempt with the Charitable Trusts Bureau. 2. [3.151] Religious Organizations For religious organizations, most states have a form of organizational registration that avoids any determination of organizational form, rights to organizational property, methods for resolving disputes, or other state interference with the internal governance of the religious body. In Illinois, this form is provided by the Religious Corporation Act. Churches, mosques, and other religious organizations also can and do use the General Not For Profit Corporation Act of 1986. The “any lawful purpose or business” language of §1-25 of the Limited Liability Company Act permits not-for-profit organization under the LLCA as well. 805 ILCS 180/1-25. D. [3.162] Tax Exemption Not-for-profit organizations may potentially be exempt from federal and state taxation, but they lack (by definition and by tax exemption requirements) the ability to distribute profits to managers or to contributors except as fair market value salaries. 1. [3.173] Federal Income Tax Exemption Income taxation of entities may be excluded for qualified not-for-profit organizations. See generally Code §§509(a)(1) and 170(b)(1)(A)(i) – 170(b)(1)(A)(vi) for publicly supported charities exempt from taxation as private foundations. In general, exemption is governed by Code §501(a). Also, see generally IRS Publication 557, Tax-Exempt Status for Your Organization; IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal
  24. 24. Revenue Code. IRS forms and publications are available at www.irs.gov/formspubs. Counsel should cooperate with accounting professionals to prepare these materials, as multiple years of budget history or projections will be needed. Annual filings of IRS Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)), and Form IL-990-T, Exempt Organization Income and Replacement Tax Return, as well as unrelated business income tax returns and sales and unemployment tax filings may be needed. Exempt organizations pay income tax at the maximum rate at the entity level if the income is unrelated to their exempt purposes and they otherwise do not pay income taxes. Salaries are the only permitted form of distribution, apart from repayment of debt or payment of ordinary and necessary business expenses. These distributions are subject to individual income taxation if they are made to individuals. See generally IRS Publication 557, Tax-Exempt Status for Your Organization. CAVEAT: P.A. 96-126 (eff. Jan. 1, 2010) added the definition for ‘“L3C” or “low-profit limited liability company” and other provisions concerning such organizations to 805 ILCS 180/1-5. This designation is completely irrelevant for use of the LLC as a nonprofit, as LLCs may be organized for any lawful purpose. Use of a low-profit LLC will make federal tax exemption impossible, as such organizations (by definition) have profits, and federal exemption requires that no portion of the income of any entity applying for exemption accrue to any individual or organization, except for fair value of items provided or services rendered. See IRS Publication 557, especially the provisions suggested for Articles of Incorporation or of Organization. The low-profit LLC is a trap for the unwary, and the legislation should be repealed. The correct way to have some income for investors and a nonprofit function that is exempt is for the nonprofit to form a for-profit subsidiary, not a single, combined, nonexempt low-profit LLC. a. [3.184] Religious Organization Exemptions Religious organizations may be exempt from both initial qualification rulings and annual reporting. Initial filing for recognition of the exemption is recommended, to provide donors assurance of deductibility of contributions. Federal and state tax exemption for religious organizations can present complex issues of initial and continuing qualification for exemption. Private “inurement” (i.e., receipt of funds for something other than the market value of goods or services provided to the organization) of organizational profits or exclusive benefits to insiders can endanger the exemption. So too can lobbying or participation in political campaigns. The income of these organizations and their affiliates must be exclusively obtained in the course of exempt activity, or it is subject to “unrelated business income” tax. Such taxable income includes things like revenues from advertising in religious publications, gaming (except bingo), sale of merchandise or publications, or rental income. Salaries and benefits for members of the clergy have potential exemptions from Social Security and Medicare taxation. See generally IRS Publication 1828, Tax Guide for Churches and Religious Organizations; IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations; IRS Form 1023, Application for Recognition of Exemption Under
  25. 25. Section 501(c)(3) of the Internal Revenue Code; IRS Form 990, Return of Organization Exempt From Income Tax; and IRS Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)), as well as the accompanying instructions to these forms, all of which are available at www.irs.gov/formspubs. Religious organizations usually have extensive internal provisions for governance, either hierarchical or nonhierarchical. The Catholic Church clearly represents a hierarchical organization, with its corporations organized at the diocesan level, and the head of each (i.e., bishops and archbishops) is replaceable and responsible to the Pope. Likewise, the Presbyterian Church uses hierarchical governance, with congregational elders for individual churches, groups of churches organized in presbyteries, and, at the national level, organization in general assemblies. Nonhierarchical governance typifies independent congregations of Baptists or churches not affiliated with any denomination. Many denominations have group exemption letters that qualify each of the local congregations that form under the rules of the religious group for income tax exemption without a new application to the IRS for recognition of such exemption, thus avoiding the six or more months’ wait for a decision. See IRS Publication 1828. Local trustees and separate property ownership (or management organizations or corporations) are also common, with or without specific reference in a suborganization’s documentation to the church polity’s general standards for congregational governance and leadership succession. As might be expected, property and doctrinal fights in these organizations can be messy. First Amendment principles of noninterference by secular courts in religious affairs can be at odds with charitable purposes doctrines and the property control expectations of various factions. For-profit or not-for-profit entities are often used in religious contexts with separation of functions planned in advance to avoid confusion in the event of tax, employment law, or other disputes. Limited liability companies are one way to organize taxable properties and other local or national support organizations for these religious groups. Proof of “integrated auxiliary” status or independent basis for proof of exclusively religious, charitable, educational, cultural, or scientific activity sufficient to qualify for exemption from income taxation under Code §501(c)(3) may be needed from a religious organization client. Note that under the Unemployment Insurance Act, 820 ILCS 405/100, et seq., not-for-profit organizations may be exempt from unemployment insurance tax for certain religious employees. 820 ILCS 405/211.3. See Illinois Department of Employment Security, Guide to the Illinois Unemployment Insurance Act (Oct. 2009), www.ides.state.il.us/publications. See also the regulations of the Illinois Department of Employment Security, 56 Ill.Admin. Code pts. 2712 – 2960. b. [3.195] Political Organization Exemptions Political committees at the local, state, and federal levels are subject to ethics requirements for persons that lobby for or with them, disclosure requirements to election commissions, and to tax reporting and registration. They may be exempt from federal income taxation. In political campaigns, entities based on candidate, local, state, or national party, interest group, or coalition generate, administer, and make ethics, tax, and election regulation reports. Political committees can operate free of tax, but they must expend their funds within state or federal election law limits on pain of taxation at the highest corporate rate or loss of public
  26. 26. funding, along with civil and criminal fines. For information on filing and exemption requirements for various types of political organizations, including federal committees (e.g., the “independent” political committees authorized for exemption under Code §527), see www.irs.gov/charities/political/index.html. 2. [3.2016] Sales Tax Exemption Once an organization has an income tax letter, the entity can apply for exemptions from the Illinois retailers’ occupation tax and the Illinois use tax. An exemption number will be required in future purchases and sales. Illinois Department of Revenue Publication 104, www.revenue.state.il.us/publications/pubs/pub-104.pdf, explains such exemption in general. Publication 104 references 86 Ill.Admin. Code §§130.2005 and 130.2007 and Brochure PIO-37, http://tax.illinois.gov/publications/pios/pio37.htm. 3. [3.2117] Property Tax Exemption The Property Tax Code (part of the Revenue Act, which also governs sales and income taxes) allows exemption from property taxes for exclusively charitable use. Proof is required for each parcel, and application to county boards of review (in Cook County, the Appeals Board) is required. Their decisions are then reviewed by the Illinois Department of Revenue. See Brochure PIO-37, http://tax.illinois.gov/publications/pios/pio37.htm. IDOR decisions on specific issues are available at www.revenue.state.il.us/legalinformation/hearings/pt/index.htm. Property tax exemption decisions are frequently appealed to the courts, and court rulings on such decisions have changed considerably over the years. For example, the Provena Covenant Hospital in Urbana lost an appeal to the Supreme Court because lab and physician office space for an entity with less than charitable billing practices did not qualify for the “exclusive” charitable use requirement of the Code. Provena Covenant Medical Center v. Department of Revenue, 236 Ill.2d 368, 925 N.E.2d 1131, 339 Ill.Dec. 10 (2010). E. [3.2218] Local Registration and Permits Local business registration may be required for all, some, or no types of business depending on where the business is located in Illinois. Organizations that operate under their limited liability company name are not subject to the Assumed Business Name Act, 805 ILCS 405/0.01, et seq., which otherwise requires county-level registration. The most comprehensive regulation and registration schemes come, as might be expected, in the largest communities. Some examples: Chicago regulates everything imaginable and may impose a tax associated with registration or with incidents of business operation. The Department of Revenue’s Licenses, Permits, and Taxes website can be accessed at www.cityofchicago.org/city/en.html. The forms, permits, and licenses for the city of Naperville are available on the city’s website at www.naperville.il.us/community_relations_forms_permits_licenses.aspx. Information about the food and beverage tax, the real estate transfer tax, and utility payment is found at www.naperville.il.us/index_template.aspx?id=205.
  27. 27. Springfield business licensing forms are available at www.springfield.il.us/license/ default.htm. The treasurer’s report for the most recent year available, 2010, listed pari-mutuel betting, foreign fire insurance, city hotel/motel, state auto rental, charitable games tax and license, and telecommunications tax revenue under “miscellaneous taxes.” www.springfield.il.us/treasure/ monthlyreports/fy2010_filed_annual_report.pdf. IV. FOR-PROFIT ENTITY TAX INCIDENCE A. [3.2319] Tax Planning Limited liability companies can function as almost any type of taxable or tax-exempt organization. The Limited Liability Company Act allows their organization for “any lawful purpose.” 805 ILCS 180/1-25. The restrictions on organization for insurance company, dentistry, and medical practice in §1-25 relate to professional qualification, not to taxability. Note that the default tax status for LLCs will be that of a partnership for federal and state income and personal property replacement tax purposes. To summarize business taxation in general, the taxes that organizations, their managers, and their investors pay may include federal or state taxes levied at the organizational level, passthrough taxes on individual income or proportional shares of income and liabilities (for organizations treated as partnerships), gross revenue and other sales taxes like those under the Retailers’ Occupation Tax Act, taxes on capital like franchise taxes under the Business Corporation Act of 1983, and a variety of local and regional levies on real property, lease revenues, or employment, like taxes under the Property Tax Code, the Chicago Personal Property Lease Transaction Tax Ordinance, Chicago Municipal Code §3-32-010, et seq., and the Chicago Employers’ Expense Tax Ordinance, Chicago Municipal Code §3-20-010, et seq. The attorney advising a new business is usually asked to minimize the taxes payable by the new entity. This job is too important to be left solely to the accountants. B. [3.240] Federal and State Income Tax Most businesses are subject to income tax levied only at the individual level, with liability for tax on profits regardless of whether they are distributed to owners. See generally William A. Price, Ch. 2, LIMITED LIABILITY ORGANIZATIONS (2001); Mark A. Sargent and Walter D. Schwidetzky, LIMITED LIABILITY COMPANY HANDBOOK: LAW, SAMPLE DOCUMENTS, FORMS, p. 3-2 (1997 – 1998). The partnership, which has all income and expenses attributed to its members, is the default form of business tax incidence for jointly owned organizations operated for profit. The Treasury Regulations specify the default tax status of business entities and how and when organizations can elect to be taxed as associations subject to corporation income tax. Treas.Reg. §301.7701-3. Single-owner entities will be disregarded (i.e., treated in the same manner as a sole proprietorship, branch, or division of the owner) unless they elect corporation status under Treas.Reg. §301.7701-3. Corporate income is subject to taxation at the entity level and again on distribution. Capital contributions may be subject to tax on any gain realized on distribution, together with excess accumulations of tax if amounts held at the entity level exceed reasonable business purposes. Ordinary and necessary business expenses provide a deduction from income. See, e.g., Code
  28. 28. §§311(b), 336. For not-for-profit organizations that fail to qualify for exemption, see IRS Publication 557, Tax-Exempt Status for Your Organization. Treas.Reg. §301.7701-2(b) makes the following organization types subject to corporation treatment by definition: (1) A business entity organized under a Federal or State statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic; (2) An association (as determined under §301.7701-3); (3) A business entity organized under a State statute, if the statute describes or refers to the entity as a joint-stock company or joint-stock association; (4) An insurance company; (5) A State-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act, as amended, 12 U.S.C. 1811 et seq., or a similar federal statute; (6) A business entity wholly owned by a State or any political subdivision thereof, or a business entity wholly owned by a foreign government or any other entity described in §1.892-2T; (7) A business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than section 7701(a)(3); and (8) Certain foreign entities. Publicly traded organizations will be taxed as business associations, even without an election of this status, unless special exemptions (such as those for real estate investment trusts) apply. See generally Joel Shapiro, Final Regulations on Publicly Traded Partnerships Reflect Practitioners’ Comments, 14 J. Partnership Tax’n 144 (1998). Note that the above may not apply to S corporations. The American Jobs Creation Act of 2004, Pub.L. No. 108-357, 118 Stat. 1418, increased the number of shareholders allowable in such entities to 100 and contains no exception for publicly traded companies. 26 U.S.C. §1361. The tests for “securities” that may require public registration for their offerings may be triggered by significantly lower numbers. Section 4(2) of the federal Securities Act of 1933, 15 U.S.C. §77a, et seq., as amended (15 U.S.C. §77d(2)), and the Security and Exchange Commission’s Regulation D that resulted from it (17 C.F.R. §§230.501 – 230.508), provide a limited exception to public offering requirements and are the usual exceptions relied on by promoters of “private” offerings. For instance, the Regulation D exemption references 35 investors. Any number of publicly traded entities that are otherwise qualified under Subchapter S could, presumably, form a commonly owned pass-through entity and thus have any number of public investors without paying organization-level tax, as long as they comply with SEC and state securities laws. Even if no entity is organized under business organization statutes, there may be joint tax liability. If individuals own property jointly, then they will be responsible for their pro rata
  29. 29. ownership shares of costs and of income for tax purposes. See Rev.Rul. 75-374, 1975-2 Cum.Bull. 261. Illinois income tax law follows the federal tax treatment of not-for-profit organizations and of partnership taxation or business association elections. C. [3.251] Filings Needed To Obtain Specific Federal Tax Treatments Sections 3.242 – 3.264 below summarize the possible tax status and regular tax filings needed for various limited liability company taxable and nontaxable types of status. D. Status Available Without Election Filings 1. [3.262] Disregarded Entity Treas.Reg. §§301.7701-3(b)(3)(i) and 301.7701-3(f)(2) specify that for organizations having only one owner in existence prior to January 1, 1997, and having elected to be taxed as partnerships, the organization will be disregarded as an entity. This means that no organizationlevel tax applies. Owners can simply file an annual Schedule C and pay taxes on organizational income as they would for any other business conducted under their social security numbers. A social security number can be used for a business if only the owner is involved in its operation. The business should obtain a separate employer identification number, using IRS Form SS-4, Application for Employer Identification Number, if employees are hired. A single-member limited liability company is disregarded (i.e., treated in the same manner as a sole proprietorship, branch, or division of the owner), and its tax is the same as for an individual-owner sole proprietorship. The LLC must file an annual IRS Form 1040, U.S. Individual Income Tax Return, and IL-1040, Illinois Individual Income Tax Return, and make quarterly estimated tax filings. The LLC may have sales tax responsibility and may incur unemployment insurance tax if the owner pays himself or herself a salary instead of dividends. Single-member are LLCs disregarded for state income tax purposes. Ill.Rev.Pvt.Ltr.Rul. IT-02-0005-PLR (Dec. 18, 2002). 2. [3.273] LLC Taxed as a Partnership Treas.Reg. §301.7701-3(a) specifies that a domestic business entity is eligible to make a status election if it is not otherwise required to be taxed as a corporation. If it does not make an election, it will be taxed as a partnership if it has two or more owners. Treas.Reg. §301.7701-3(b)(1)(i). This means that the attribution to members of all expenses and income that are characteristic of a partnership is the default form of business organization taxation that will apply unless an organization is one of the types listed in Treas.Reg. §301.7701-2(b), i.e., a corporation by definition. Illinois imposes a 1.5-percent tax on net income as a corporate “personal property tax replacement tax” on entities taxed as partnerships, on trusts, and on corporations that have elected pass-through tax treatment under Subchapter S of the Internal Revenue Code. 35 ILCS 5/201(d). This is in addition to any individual income taxes payable based on capital gains distributions to
  30. 30. partners or to the taxes that may result from the attribution of partnership income and loss to individual partners, regardless of whether income is distributed (“pass-through” tax treatment). A partnership LLC is taxed like a partnership for federal and state tax purposes. The LLC files an annual partnership return, with quarterly estimated returns if needed, and passes through information to members, which they then use to report and pay income taxes due on their annual Form 1040s. Members may have unemployment and self-employment tax incidence or out-ofstate withholding, depending on the personal service nature of the business. Sales and unemployment tax payments also may be due. For more partnership tax treatment information, counsel should consult the “check-the-box” regulations, Treas.Reg. §§301.7701-1 through 301.7701-4. Further partnership tax information is available on the IRS’ website at www.irs.gov/businesses/partnerships/index.html. See also IRS Publication 1518, IRS Tax Calendar For Small Businesses and Self-Employed, and IRS Publication 1066C, Virtual Small Business Tax Workshop (CD). 3. [3.284] Limited Partnership LLC A limited partnership-type limited liability company is member-managed with passive investors or other beneficiary members and pays partnership tax, but with an additional wrinkle. If passive members are family members receiving membership interests as part of an estate valuation freeze or gifting plan, then annual gift limits or gift tax returns need to be considered. None of the entities discussed in §§3.22 and 3.23 above needs to file any election of status forms. E. [3.295] Entity Status Requiring Election or IRS Qualification Decisions Any business corporation status will need appropriate tax filings to elect the relevant tax status. See §§3.3026 – 3.3828 below. 1. [3.3026] S Corporation Status A limited liability company taxed as an S corporation is still a pass-through entity and may be useful to fix capital gain and loss amounts as cash contributions. S corporation election is made by filing IRS Form 2553, Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code). Note the need for a corporate resolution of the board or sole shareholder or of all shareholders to support the election. This filing eliminates “hot asset” and other complex partnership tax rules. It requires an annual corporate income tax filing with information filings to members, who then pay individual income tax on their shares of organizational gains. Sales and unemployment tax filings are required as needed, as are estimated tax filings. The annual tax reporting form is Form 1120S. 2. [3.3127] C Corporation Status Organizations that are taxed as business associations must pay federal income tax up to the maximum corporate rate at the entity level based on net income unless a Subchapter S election is in effect. Code §11(b). They must also pay a 15-percent tax on distributed dividends and a capital
  31. 31. gains tax upon sale of the business, and individual income taxes must be paid for distributions taken as salary (though these are deductible from the corporation’s gross income if they meet the tests for ordinary and necessary business expenses). These organizations must also pay the Illinois corporation income tax at 4.87 percent and the corporate personal property replacement tax at 2.5 percent, with both taxes assessed on net income at the entity level. 35 ILCS 5/201(b), 5/201(d), see generally http://tax.illinois.gov/Businesses/TaxInformation/Income/corporate.htm, visited January 14, 2013.) Dividends or salaries are taxed again at the individual level unless a Subchapter S election is in effect. A limited liability company taxed as a business association makes the LLC the equivalent of a C corporation, which is advantageous if the intent is to retain gains in the entity and to profit from reinvestment of the gains, as long as the organizational tax rate is significantly lower than the individual rate. Double taxation (corporate and individual rate) applies, so counsel should consider not paying dividends or income and realizing any profits as capital gains, which can be sheltered by charitable remainder trusts. To elect business association treatment for an LLC or other entity otherwise routinely treated as a partnership under the “check-the-box” regulations (Treas.Reg. §§301.7701-1 through 301.7701-4), IRS Form 8832, Entity Classification Election, should be used. The form includes a consent statement that may be signed by all members or by one member on behalf of all members. If one member signs, there should be some record in company membership meetings that all members approved this election. You must provide owners’ names and identifying numbers (i.e., social security number for a single-member LLC or employer ID for a multiple-member LLC). 3. [3.3128] LLCs Pay No Illinois Franchise Tax LLCs do have one big state tax advantage, if they have significant capitalization: they pay no franchise tax. An S corporation or a C corporation would pay Illinois franchise taxes to the extent that earnings are retained as organizational capital. 805 ILCS 5/15.40. Organizations incorporated in other states would also pay their home-state franchise tax or organizational fees, if any. The Illinois franchise tax rate is one tenth of one percent of the “paid-in capital,” which is the sum of stated capital plus paid-in surplus of income over expenses for the organization. 805 ILCS 5/15.45. After January 1, 2004, the maximum franchise tax is $2 million; the minimum is $25. Id. For a retained earnings amount of $50,000, the annual franchise tax would be $50. V. [3.3229] SELF-EMPLOYMENT TAX Businesses in which income is not dependent on the personal services of the business owners may be able to reduce the amount of self-employment tax otherwise due by electing Subchapter S status or by organizing as a manager-managed limited liability company with distributions to non-managing members. The former would result in taxation of distributions as organizational
  32. 32. dividends, and the latter would result in tax treatment equivalent to that for limited partnership distributions. A. [3.330] Self-Employment Tax Rates The self-employment tax rate is 15.3 percent, which represents both Social Security tax and Medicare tax. Code §1401. An additional Medicare tax of 0.9% is imposed on some high income individuals. (See generally http://www.irs.gov/Businesses/Small-Businesses-&-SelfEmployed/Questions-and-Answers-for-the-Additional-Medicare-Tax, visited January 14, 2012.) The Social Security portion is capped after taxes are applied to $106,800 of income in 2010, while Medicare taxes (2.9 percent of the 15.3 percent) are not limited. Self-employment taxes are due on wages but not on corporate dividends or subchapter S non-wage distributions. B. [3.341] Self-Employment Regulations Applicable to a Limited Liability Company or Other Organization Taxed as a Partnership The IRS issued Prop.Treas.Reg. §1.1402(a)-2 in 1997, relative to the application of Code §1402(a)(13). It has not been incorporated into final regulations but is still useful in determining what will be regarded as taxable. The explanation of provisions in 62 Fed.Reg. 1702, 1703 (Jan. 13, 1997), which issued this proposed regulation, provides: Generally, an individual will be treated as a limited partner under the proposed regulations unless the individual (1) has personal liability (as defined in §301.77013(b)(2)(ii) of the Procedure and Administration Regulations) for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership’s trade or business for more than 500 hours during the taxable year. If, however, substantially all of the activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business will not be considered a limited partner. Exclusion of any of these is possible in an LLC agreement. For LLC members who are treated as limited partners, self-employment income includes only income paid to them for their own services, as opposed to passive investment income. For those treated as general partners, on the other hand, the rule is that their partnership distributions are treated as income from selfemployment and therefore subject to self-employment tax. IRS Publication 541, www.irs.gov/pub/irs-pdf/p541.pdf, describes what income is attributable to a partner and its ordinary tax treatment as follows: A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner’s interest in the partnership. Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she
  33. 33. generally does not recognize any gain until the sale or other disposition of the property. IRS Publication 541, p. 4. C. [3.352] Use of Loans It is also possible to create payments not defined as self-employment income if they come as repayments of loans or other guaranteed payments. If an investor made a loan to the organization based on, for example, proceeds of individually obtained second mortgages on residential or other real estate the investor owns, the returns on this capital would not be taxed as self-employment income. Note that use of loans could also provide income not subject to Illinois personal property replacement tax, as such income would represent a “guaranteed payment.” Legitimate and economically substantive loan transactions, and proof of loan documentation, would of course be required to survive either state or federal audits. D. [3.36.33] Use of a C Corporation As long as the organization and not the individual is the fee- or income-receiving organization, and the income is not derived from an owner’s personal services, a C corporation distribution of dividends does not create self-employment tax obligations. However, such income does this would subject earnings to organization level tax. For members in LLCs taxed as corporations, dividends are not self-employment income. Code §1402(a)(2). Note, however, that earnings attributable to employment in the organization are required, so some salary will be subject to employee or self-employment income tax withholding. The measure of what should be paid as salary is what is reasonable for the organization’s business operations. Federal tax legislation under consideration in 2010 may change the tax treatment of C and S corporations and LLC distributions. Elimination of low capital gains rates, which is scheduled for January 1, 2011, unless Congress passes changes, would make C corporation distributions and salaries worth examining as an alternative to LLC dividends. Since 2008, individuals in the two lowest tax brackets paid zero percent long-term capital gains tax while everyone else paid 15 percent. In 2011, individuals in the lowest tax bracket will pay 10 percent while the rest will pay 20 percent. Wage income tax rates will therefore need to be compared to these returning capital gains rates in the relevant tax brackets, to see which form of distribution carries less tax. E. [3.374] Use of an S Corporation A Subchapter S corporation election may permit distributions not subject to self-employment tax if the owner’s personal services are not the exclusive source of organizational income. Note, however, that earnings attributable to employment in the organization are required, so some salary will be subject to employee or self-employment income tax withholding. The S corporation is expressly excluded from "personal services corporation" treatment (See Publication 542 for a cross-reference to those rules as applied to C corporations), so the rules that apply are those that determine "reasonable" compensation. What that is is generally market based.
  34. 34. The only guidance in the general publication section is that if "most" of an organization’s income is from personal services, then "most" of the S corporation's income should be paid as salary. http://www.irs.gov/businesses/small/article/0,,id=203100,00.html The Service is allowed to recharacterize income as salary or dividends on what looks to me like an "economic realities" test. Which doesn't tell us much. Here's their page referencing tax decisions. It again recognizes the propriety of having some S corporation distributions be dividends. http://www.irs.gov/businesses/small/article/0,,id=203099,00.html In general, such distributions (all net income above whatever minimum salary is "reasonable") would be taxable to the extent that they exceed your basis (original capital contribution, probably whatever you put in to open your business bank account, which should be enough to meet current obligations for at least a quarter or six months or a year, depending on how conservative you want to be on the "quick" ratio for determination of adequate financing. If your current bank balance plus reasonably expectable revenue is more than probable liabilities, then your entity should get limitation of liability to amounts invested in same under state law. Federal tax only cares about basis as a limit on tax on gains. No tax applies until all amounts of basis have been exhausted. your accontant can calculate this for you. To determine "minimum reasonable" wages, national or state data from the Bureau of Labor Statistics or other generally applicable compensation surveys for similar occupations can be consulted. Remember that income tax is payable even if self-employment tax is not. Shareholders (or, for an LLC with a Subchapter S election, members) are liable for income tax on their shares of the corporation’s income (reduced by any taxes paid by the corporation on income). Shareholders or members must include their share of the Subchapter S organization’s income on their personal income tax return whether or not it is distributed to them. Unlike most partnership income, S corporation income is not self-employment income and is not subject to self-employment tax. See generally instructions for IRS Form 1120S. Subchapter S distributions are treated as dividends under Code §1368 unless the payment to a shareholder is a tax-free distribution that would reduce the shareholder’s basis in the organization or a distribution that exceeds the organization’s earnings and profits. S corporations are taxed on a pass-through basis on all earnings regardless of whether they are distributed to shareholders. F. [3.385] Combined Elections A business organization formed as a limited liability company can elect to be taxed as a business association rather than a partnership and can then elect Subchapter S status for federal tax purposes. This combination could help minimize nonpersonal services taxation for small businesses with income that results from something other than the personal services of the organization’s owner or owners. If non-managing members are willing to give up some control of the entity, organization as a member-managed LLC may suffice. G. [3.396] Other State and Local Taxes

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