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ISBA LLC and S Corporations Tax and LLC Amendments Seminar May 2018

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Illinois State Bar Association May 15, 2018 presentation on the 20% gross income deduction for pass-through entities in the 2017 federal tax code amendments, and on changes appropriate for Illinois limited liability company operating agreements as a result of the 2017 amendments to the Illinois LLC Act

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ISBA LLC and S Corporations Tax and LLC Amendments Seminar May 2018

  1. 1. LLC and S Corporation Tax Issues Part I Illinois State Bar Association May 15, 2018 Presenter: William A. Price Attorney at Law www.growthlaw.com Tel/Fax 1-800-630-4780 email: wprice@growthlaw.com
  2. 2. Tax Questions For LLC and S Corporation Drafters 1. What is the basic tax structure of an LLC or S corporation? 2. What entity structure will best fit my client and this deal? 3. How can I change the tax structure of an entity, and what are the consequences if I do? 4. What are the results of entity dissolution? 5. Did the new LLC Act require any change in my documents?
  3. 3. 1. What is the basic tax structure of an LLC or S corporation?
  4. 4. Basic Rule: Pass-Through Entities vs. Business Associations Business Associations Taxed under IRC Subchapter C: Double Taxation Corporate tax at entity level: 21% since new tax bill Individual tax when entity distributes to owners (dividends, salary, etc…)
  5. 5. Basic Rule: Pass-Through Entities vs. Business Associations Pass-Through Entities LLC’s, Subchapter S Corporations, Partnerships No tax at entity level Individual tax to owners on net income of entity, whether or not distributed
  6. 6. Single Owner LLC Entity is Disregarded: No separate entity tax return No entity level tax Individual tax to owner on net income of entity, reported on Schedule C, Form 1040 Treas.Reg. §301.7701-2(c)(2)
  7. 7. Two Or More Owners LLC Entity is taxed as a Partnership, IRC Subchapter K: Can elect to be taxed as C Corporation: No entity level income tax on partnerships Owners pay individual tax on net entity income, whether or not distributed Entity Files Form 1065; Schedule K-1 to owners on their share of net income
  8. 8. Subchapter S Corporation Entity files election to be taxed under IRC Subchapter S: No entity level income tax Owners pay individual tax on net entity income, whether or not distributed Entity Files Form 2553 to elect sub S; annual Form 1120S, shareholders get 1120S Schedule K-1
  9. 9. Net Tax, Business Association Example: Gross income $100, Corporation tax rate 21%, Individual income max rate 37% Income $100 Less entity level tax $79 21% Less in- dividual tax $50 37% Total tax $50
  10. 10. Net Tax, Pass-Through Entity Example: Gross income $100, Individual income max rate 37% Income $100 Less in- dividual tax $63 37% Total tax $37
  11. 11. Payment Options To Owners That Change Net Taxable Income/Other Taxes C corporation can deduct salaries for owners (so less taxable net at entity level) S Corporation dividends have statutory exception to employment taxes: (Treas. Reg. Regs. Sec. 1.1368-1(c) specifies S distributions are reduction in basis or capital gains income.)
  12. 12. 2. What entity structure will best fit my client and this deal?
  13. 13. Legal Issues For Choice Of Entity 1. Management Rights 2. S Corporation: Only One Class of Stock, one share = one vote. 3. LLC: Member Class and other rights set by Operating Agreement: Capital shares do not have to equal management authority
  14. 14. Legal Issues For Choice Of Entity 1. Agency Authority 2. S Corporation: President has apparent authority, otherwise per Board resolution 3. LLC: OA defines authority of Members or Managers: Statement of Authority can be filed with Secretary of State (IL SoS Form 13.15)
  15. 15. Legal Issues For Choice Of Entity 1. Liability 2. S Corporation: shareholders, officers, directors ordinarily not liable for entity obligations 3. Cosgrove Distributors, Inc. v. Haff,343 Ill.App.3d 426, 798 N.E.2d 139, 141, 278 Ill.Dec. 292 (3d Dist. 2003); Main Bank of Chicago v. Baker, 86 Ill.2d 188, 427 N.E.2d 94, 56 Ill.Dec. 14 (1981).
  16. 16. Legal Issues For Choice Of Entity 1. Liability 2. LLC: 3. Members and Managers ordinarily not liable for entity obligations 4. 805 ILCS 180/10-10
  17. 17. Legal Issues For Choice Of Entity 1. Liability 2. Veil Piercing 3. For corporations or LLC’s, question is whether entity adequately capitalized, or if individual tort or contract liability could attach to owners based on non-entity duties
  18. 18. Legal Issues For Choice Of Entity 1. Liability 2. Professional Services Entities 3. Entities will not protect professionals from malpractice claims for lawyer/doctor’s own conduct
  19. 19. Examples of Choice Of Entity Analysis 1. Sole Practitioner of Law: S Corporation • Liability shield limited to business debts, not professional malpractice (Supreme Court Rule 721). • Personal property replacement tax of 1.5% of income if entity used to mean sole proprietor form best. • 2017 tax law, however, gives 20% of gross income deduction to entity, not individuals.
  20. 20. Examples of Choice Of Entity Analysis 1. Two non-IL resident buyers of rental real property: Common Interest Association, tax-free state owner entities • No Personal property replacement tax of 1.5% of income, since no entity (just insurance and management company contracts). • 2017 tax law: 20% of income deduction to entities • Ownership alone is not doing business in IL, so no IL tax if distribution to non-IL owners from non-IL entity (805 ILCS 5/13.75 (9).)
  21. 21. 3. How can I change the tax structure of an entity, and what are the consequences if I do?
  22. 22. Tax Effects of Conversion Or Merger Organizations taxed as partnerships can convert to or merge with each other without any gain under IRC Section 721 Owners must be identical before and after conversion/merger. No deemed sale under IRC §708(b)(1)(B) for exchange of interest for something of same value.
  23. 23. Tax Effects of Conversion Or Merger Exceptions to taxable liquidation gain to shareholders: a. If gain is less than shareholder's basis, then there is a capital loss under IRC Section 331(a). b. Tax-exempt shareholding entities do not owe income tax on liquidation gains, IRC Sections 512(b)(5), 514(a). c. Subsidiaries merged into parent entity, no gain, IRC Section 337(a).
  24. 24. Alternatives To Taxable Corporation Conversion To Or Merger With LLC 2. Corporate Freeze: Old entity contributes assets to new LLC in exchange for profits share at “frozen” (time of conversion) value in exchange for new entity ownership. Shareholders make additional contributions to new LLC (or take on new entity liability) and get all new entity capital gains.
  25. 25. 4. What are the results of entity dissolution?
  26. 26. Dissolution and Other Business Ownership Termination Events 1. Dissolution For LLC's, see 805 ILCS 180/35-1 ff. Dissolution means the entity terminates: members receive their proportionate share of gain or loss, per their capital account balance as of dissolution. (IRC Section 731)
  27. 27. Dissolution and Other Business Ownership Termination Events 2. Dissociation For LLC's, see 805 ILCS 180/35-55 Dissociation means the member no longer has management rights or liabilities, but still gets distributions per their membership share, with gain or loss per their capital account balance as of time of distributions. (IRC Section 731)
  28. 28. Dissolution and Other Business Ownership Termination Events 3. Corporation dissolution See 805 ILCS 5/12.30 Shareholders get a distribution of the entity's assets according to their interests (e.g. preferred or common share order of distribution, percentage of company, etc...) IRC Section 331 treats distributions over share basis as capital gains.
  29. 29. 5. What Changes In LLC Operating Agreements Are Needed As A Result of the 2017 Amendments To That Act?
  30. 30. New LLC Act Effective July 1, 2017 P.A. 99-0637 Product of 6 year drafting project by the Institute of Illinois Business Law www.iibl.org
  31. 31. New LLC Act Effective July 1, 2017 P.A. 99-0637 Product of 6 year drafting project by the Institute of Illinois Business Law www.iibl.org
  32. 32. Oral Operating Agreements Allowed by new Act, not encouraged Permits default provisions of Act to help manage disputes
  33. 33. Member Management Act allows management by Members or by Managers Member management is default rule: can be changed by Articles of Organization or Operating Agreement
  34. 34. Member Anonymity Act requires official filings to list all Members or Managers with management authority Non-manager Members do not have to be listed: same rule as for shareholders of corporations
  35. 35. Member And Manager Rights Former Act definition of actions Manager can take deleted: Amendment of Operating Agreement to define Manager and member authority is recommended
  36. 36. Organization Records Transferees and dissociated Members can get access to organization's books and records, if their purpose is “proper” Amendment to OA: make sure trade secrets and NDA/other agreements with third parties items not “proper” reasons
  37. 37. Agency Authority of Members and Managers Neither Members nor Managers now have agency authority by default Amendment to OA: Define Member or Manager or other officer authority File Statement of Authority, IL SoS Form 13.15, to notify public
  38. 38. Duty of Loyalty Act now allows OA or Articles to restrict or eliminate Duty of Loyalty of members/managers Example: joint owners want freedom to pursue similar deals to LLC Change must be clear/unambiguous
  39. 39. Duty of Care Act now allows OA or Articles to modify Duty of Care of members/managers Limit: no intentional misconduct or knowing violation of law allowed Duties of good faith and fair dealing still apply
  40. 40. Wrongful Distributions Act now defines when Member may be liable (to LLC or other Members) for receipt of wrongful distribution OA Amendment recommended: define what distributions are allowed
  41. 41. Buy-Out Rights Act changed: dissociating Member no longer has default right to fair value buyout of Member's interest OA Amendment recommended: define buy/sell rights and dissociated Member rights
  42. 42. Outside Creditors Act defines charging order as only remedy for Member's creditors (distributions, not management/dissolution) OA Amendment possible: additional rights for creditors of whole LLC
  43. 43. Opression of Minority Members Act now allows alternative remedies, not just dissolution, for fraudulent or oppressive conduct OA Amendment possible: define information/oppression rights and remedies, including non-court remedies like arbitration
  44. 44. Entity Conversion and Redomestication Act now allows conversion to any type of domestic entity (partnership, LLC, corporation), and change of entity domicile (domestication) in other state Amendment possible: redomesticate in zero tax state
  45. 45. Remainder of Q and A Slide topics: James Nepple
  46. 46. Thank You For Your Attention Any Questions? After the program, you can contact: James Nepple William A. Price Attorney at Law www.nepplelaw.com www.growthlaw.com 866.355.6841 Toll Free Tel/Fax 1-800-630-4780 email: wprice@growthlaw.com

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