The common wisdom is to select an LLC for a new business.  That wisdom needs to be scrutinized.  Sure forming an LLC is easy.  Generally, the filing fees are less than a corporation, and the documentation is less complicated.

While the LLC may remain the best choice for an investment, it can create issues for an operating business.  With the corporate tax rate now only 21%, the tax advantages of an LLC have diminished.  Yes, in early years the LLC is likely to generate losses, which can flow through to the owners but this flow through status can cause headaches down the road.   For example,  employees in corporations are often given stock options.  In an LLC employees might be given “profits interests,” which means they start to participate when the founding owners are paid back. The problem is that the profits interest will have to be valued upon receipt.  Intangibles, etc… are hard to value. The LLC may not have the resources to provide a professional appraisal or they may not even be aware of the issue.   If the LLC become valuable, the IRS will have to benefit of hindsight in valuing the profits interest and the employees may have no evidence to counter the IRS with.  The result could be a huge tax surprise for the employees.  In addition, the IRS treats all of the owners as partners, which means they will receive a K-1 from the LLC, which will disclose financial information about the LLC.  Also, each owner is responsible for their own tax withholding payments.

Finally, as a general rule, private equity and venture capital prefers to invest in corporations rather than pass-through structures.  This is because those entities are typically flow through entities and they don’t want the income or loss of their investments to flow through to their limited partners.  This might require their limited partners to pay tax on the income and file a return.  Filing a return creates an additional audit risk they would prefer to avoid.

Again, the type of business will have a significant influence on the legal structure.  Just keep in mind it isn’t as easy as LLC.

Contained in the TCJA, qualified opportunity zones are a new tax incentivized investment vehicle aimed at encouraging investment in low-income housing.  Here are the highlights:

  1.  If a taxpayer has a realized capital gain, taxpayer can invest the gain in a Qualified Opportunity Fund within 180 days and defer the capital gain.  A Qualified Opportunity Fund is an investment vehicle that holds at least 90% of its assets in Qualified Opportunity Zone Property.
  2. A Qualified Opportunity Zone is a low-income community designated as a Qualified Opportunity Zone.  Governors of the states nominate properties, and those nominations are submitted to the Department of Treasury for certification.
  3. An investment in a Qualified Opportunity Zone can be made in a domestic corporation, partnership or a Qualified Opportunity Business Zone Property.  Regardless of the type of investment vehicle, it must be a Qualified Opportunity Business Zone Business.   A Qualified Opportunity Zone Business is a trade or business that owns or leases substantially all of its tangible property in Qualified Opportunity  Business Zone Property.  Among other requirements, the business must generate at least 50% of its total gross income from active business conduct, and alas there is a long list of excluded businesses, including golf courses. Qualified Opportunity Business Zone Property must be acquired after December 31, 2017 and can be new or “substantially improved.”  To be “substantially improved” the taxpayer must invest in the property an amount that exceeds taxpayers adjusted basis in the property over the 30 month period  beginning with acquisition.

The tax benefits of investing in a Qualified Opportunity Fund increase with the holding period.  If the investment is held for 5 years, the taxpayer receives a 10% increase in basis.  If the taxpayer holds for at least 7 years, taxpayer receives an additional 5% basis increase.  All Qualified Opportunity Fund interests held on December 31, 2026 are taxed.   If the Fund continues to be held after December 31, 2026 and the total holding period reaches 10 years, the taxpayer receives a basis step up to the fair market value at that time.  Accordingly, all appreciation after December 31, 2026 avoids tax.

Regulations on Qualified Opportunity Funds were recently issued, and we are studying them.  Let us know if we can assist if you are considering investing in this interesting new investment vehicle.

A power of attorney is a document in which you give someone else the power to act on your behalf for financial transactions.  Texas, like many states, has adopted a statutory durable power of attorney form.  The form has a laundry list of transactions from which you can pick and choose from, and you can add additional powers as you wish.  The most significant issue to decide is whether to make the power effective immediately or become effective upon disability.  The problem with making the power effective upon disability is that the powerholder will have to prove disability to the third party to whom the power is presented.  Accordingly, I usually recommend that the power of attorney be effective immediately.  Now there have been situations in my career, where husband and wife didn’t trust each other, and were insistent on making the power effective upon disability.  They probably should have come to see a marriage counselor, instead of an estate planning lawyer.

In certain cases, such as where the the client has complicated assets, it is recommended that the client go beyond the statutory form and prepare a power of attorney that addresses specific transactions that might arise in the management of these complicated assets.

Powers of attorney are a simple but important piece of any adult’s personal planning.  Usually used in the case of an illness or travel, they can be a lifesaver in more dire situations.  I remember years ago a client came to me with the follow situation.  Her husband had disappeared (his car was found abandoned on the way to work), but no body was found.  Since he couldn’t be presumed dead under Texas law for four years,  the wife couldn’t sell the family home.  With the husband being the sole provider, she was forced to give up the home in foreclosure.

Time to Lighten Up

With markets, both private and public, at all time highs, a lot of people are coming to me for ideas to mitigate the income tax hit of selling an appreciated asset.  There are a number of charitable structures that a client may want to consider (i) charitable remainder trusts, (ii) donor advised funds, (iii) charitable lead trusts and (iv) pooled income funds.

Pooled Income Fund-What is it?

This post will introduce an old idea that is finding a new life, the pooled income fund (“PIF”).  The concept of a PIF is quite simple.  The client gives an appreciated asset to a PIF, the PIF sells the assets and invests the proceeds, and the client receives the income generated by the fund for life.  PIFs have been around a long time, but, for various reasons, had gone out of favor.  Recently, given the low interest rate environment, PIFs have made a comeback.  Here is why.

Why is it Popular Again?

Given the low interest rate environment coupled with the rule that a PIF that is less than three years old can use the average of the last three years AFRs to calculate the charitable deduction means the charitable deduction for a PIF is substantially greater than a charitable remainder trust.  This is because the deduction is for the value of the assets remaining at the end of the term, and using a low interest rate to determine that value means that the discount for time is smaller.   When you couple this with the fact that most state laws allow the PIF to define income to include not only interest, dividends, rents and royalties, but also short and some long term capital gains, you have a very powerful income tax planning strategy.  We are finding charities very interested in working with us to create these donor friendly PIFs.

Bottom Line

A PIF can (i) produce an income tax deduction of 60-80% of the value of the substantially appreciated asset depending on the client’s age, (ii) avoid taxation of the sale of the substantially appreciated asset, and (iii) pay the client a lifetime income interest enhanced by a definition of income that includes some capital gain.  If the client takes a bit of the tax savings and purchases an insurance policy to cover the amount passing to charity and mitigate the risk of a premature death, he or she has all the bases covered.

I generally don’t recommend structuring a business as an S corporation.  Unlike LLCs and partnerships, the S corporation rules (i) restrict the number and type of owner, (ii) provide no flexibility in allocating income and loss, (iii) do not allow a step up of the assets at death of the shareholder and (iv) unlike other pass-through entities, the sale of assets and liquidation are both taxable events. This creates a sticky wicket to navigate.

Straight Stock Sale Tax Treatment Unlikely with S Corporations

A business sale can be structured as either a stock sale or a sale of the assets.  Buyers like asset sales because they can pick and choose what they want, and they do not inherit the existing liabilities of the company.  Sellers like stock sales because there is only one taxable event, rather than two.  However, even if an S corporation shareholder is able to negotiate a stock sale, the tax code allows buyer and seller to elect to treat the sale as an asset sale by making a Section 338 election.  Buyers like to do this because it allows them to step up the basis of the assets.  In a simple sale for cash the 338 election often works fine.  Assuming the asset sale results in a taxable gain.  It is passed through to the seller and taxed, and the gain increases his basis in his stock, so the distribution of the sale proceeds, which is deemed a sale, results in no gain because the basis in the stock equals the cash distributed.

Earnouts and Contingent Payments Cause a Sticky Wicket

The problem is that most transactions are not straight stock for cash.  Typically, a portion of the payments are made over time, and, when we introduce the installment sale rules to the mix, we find a huge disparity in tax treatment.  It is possible to have a situation where the seller has a large gain in the year of sale, but not enough cash to pay the tax.  That is a bad situation in its own right, but it can be made downright intolerable later when it turns out the seller reported too much gain in the year of sale, and only has a capital loss in later years that he cannot use.  A lot of these problems can be mitigated by structuring all of the sale consideration as notes, but that introduces business risk to the seller that the notes do not get paid.

Plan Ahead

Given the sticky wicket discussed above, an S corporation shareholder contemplating the sale of his company needs to consult with counsel before he starts the sales process.