Tag: entity

Family Office Vlog Series: Ep. 1 – Intro to Family Offices

Posted on by Peter Harper

In the premiere episode of our new Family Office Vlog Series, Peter Harper (CEO and Managing Director) will introduce us into what a family office is and why it is vital for private clients looking to secure the management and legacy of their wealth.

Transcript:

Peter Harper: Hey, guys. (This is) Peter Harper, Managing Director and CEO of the Asena Family Office. For those of you who are not familiar with the business or a multi-family office, we advise foreign family offices and private clients on US direct deals and mergers and acquisitions.

Peter Harper: So today, I wanted to just touch on the definition of a family office. And the reason why I wanted to revisit this is (that) recently, I was on a call with another advisor. The opportunity was referred to through me from one of the top US private banks, you know, (as) we get a bunch of referrals from banking referral partners. And the question was posed quite cynically, I might add, is, “What is a family office anyway?” Right? 

Peter Harper: And I think whenever I hear that question, my immediate reaction is that the person I’m speaking to is kind of threatened by or has had no meaningful interaction with the family office to truly understand what it means to be one, right? And there are multiple facets as to what one means today.

Peter Harper: And the two more important things (are as followed): the first, which is probably more obvious for a lot of folks, is an individual who’s had material success needs a team of people to drive their private investments; (overall), to manage and drive their private investments. So what that looks like is how you would approach a normal business: you’d have a C-suite, a team of people across tax accounting, legal investments, (and) people management to go off and execute on the founder or family success, right? So the normal sort of economic business apparatus to drive the family forward.

Peter Harper: But in my opinion, the most integral piece, right, because in that same question, “What is a family office?”, you know, (conjures the image of) a traditional trusted advisor who is sitting next to a patriarch or an individual. So that one person would say, “Well, all that individual needs is a good advisor, one person to help them drive that forward.”

Peter Harper: The thing that that person’s missing is that without the right framework for a family office apparatus, (then) we feel it’s almost guaranteed that the family money is going to be dispersed on the demise of that individual, right? And the reason for that is there is no family buy-in for future generations to actually help the founder or the patriarch/matriarch build a long-term legacy.

Peter Harper: So, in my opinion, the single most important thing that defines a family office is how they think about legacy, how they think about the concentration and management and value of wealth across multiple generations. So across 100 to 200 years, right?

Peter Harper: And the only way that families can sustain a family office for a long period of time is if future generations care about things other than just money. They care about the family, and they understand why it’s important to keep the family together and flourish and grow as a family. 

Peter Harper: Cheers, guys.

 

Want to learn more? Follow us same time next week for our next episode, sign up for our newsletter for updates, or schedule your consultation with one of our advisors.

–Peter Harper

Family Office Structure

Posted on by Peter Harper

Family Office Structure

After covering business entities and formations such as LLCs and C corporations, let’s look into the growing industry of family offices, how they are formed, and why.

What is a Family Office?

A family office is any collection of dedicated professionals, whether separate from a family business or not, which provide personal and professional services to a family. This usually includes a broad diversification of services where one individual could manage the operational aspects of the family; for example, travel arrangements and asset collections. Other services, such as professional staff managing accounting, estate planning, tax, legal, philanthropic, investment, and administrative matters, are also rendered. 

The size of a family office can consist of as little as only two people or as many as 300 or more.

What is the Purpose of a Family Office?

Families have the ability to create a family office that can support their overall financial needs after a significant liquidity event, such as the sale of a family business. Every family office must reflect the unique component as s the family it serves.

It can provide a wide range of services, including:

  • Investment strategy and management;
  • Tax planning;
  • Estate planning;
  • Philanthropic planning;
  • Family education & multi-generational planning; and
  • Lifestyle management services.

Historical Family Office Structuring

Before 2018, most family offices could not implement their structures particularly tax-efficiently. Family offices used to be structured as limited partnerships or limited liability companies (“LLCs “) and can provide financial services such as tax, investment management, accounting, and concierge services for family members and various family members entities. 

Often, the family members and entities would pay the family office (collectively, the “Family Clients “) through management fees. 

These management fees were, however, deductible by a Family Client only to the point where the fees exceeded 2% of the Client’s adjusted gross income (“AGI “) for the tax year. Deductions for operating expenses, including salaries, office rentals, and payments to any third-party vendors, were likewise limited for many family offices. 

If structured properly, some family offices often avoided most limitations on deductions by claiming status as an active trade or business, thereby taking their deductions in full. However, taking such a position was seen by the IRS as aggressive tax planning to avoid tax, and the IRS had often challenged attempts by single family offices trying to claim that they were a trade or business.

Sections 212 and 162

Historically, expenses incurred by family offices have been deducted under one of the two provisions of the Internal Revenue Code (IRC) listed as:

Section 162 and Section 212
      • Section 162 deductions are applicable toward any active trade or business. Those said deductions taken under Section 162 are most often permitted in full, as the IRS traditionally views the active trade or business requirement strictly. The IRS requires that entities that claim the deduction must be engaged in a for-profit business through the provision of goods or services toward third parties. In the 1930s, the family office working for Eugene Higgins, who was the wealthy heir to a business fortune, had tried to claim all expenses from managing his fortune as either business or trade deductions. From this, the government successfully challenged Higgins’ family office’s position by arguing that the management of one’s wealth cannot be a valid business or trade. 
      • In response to the claim by the government, Congress enacted Section 212, which recognizes that expenses related to managing and enhancing one’s wealth would be legitimate and must be deductible to an extent. The Code put a limit on those deductions towards amounts that went over 2% of AGI. As seen in the government’s historical dislike for family offices operating as a business or trade, most family offices hadn’t been willing to risk an IRS challenge. Instead, they decided to claim any of their deductions solely under Section 212, resulting in many family office owners and their Family Clients being unable to fully deduct expenses.
Important Developments in 2017

Resulting from two key developments occurring by the end of 2017, traditional family office structures had become less viable. Still, at the same time, new structures provide opportunities for much greater tax efficiency. 

The first significant development was due to case law. It involved the case of Lender Management v. Commissioner, where the Tax Court had ruled that a family office had the option to be treated as a business as long as it met specific criteria. The second included the passage from the 2017 Jobs and Tax Cut Act, which disallowed deductions that fall under Code Section 212 and reduced the national corporate tax rate by 14% (35% to 21%).

Lender v. Commissioner

In the case of Lender’s Bagels, the taxpayer’s role belonged to a family office that gave management services to a collection of investment LLCs owned by the family business’s children, grandchildren, and great-grandchildren (Lender’s Bagels).

When determining whether the family office had engaged in a business or trade (therefore fully deducting its expenses), the court noted large amounts of scrutiny if a family relationship had existed between the family office owners and the LLC owners. Despite this, the court had found that the family office could be considered a trade or business. The decision was backed up by several factors that had differentiated the Lender Management operation from other activities conducted by an investor to manage and monitor their own investments:

When reviewing all of the gathered facts that the court discussed (and had led the court ruling in favor of Lender Management), some recommended practices to best treat a Family Office as a business or trade are set out below:

      • The family office must be owned in different percentages and by different people or entities than the assets being managed.
      • The family office manager should be qualified to act as an investment advisor and devote their full time and focus when working for the family office.
      • The family office must continuously operate to make a profit.
      • The family office must always employ full-time employees who are not members of the family, as well as maintain a physical workplace space.
      • Family members must be treated as clients. This includes written client advisory agreements needing to set forth the services to be later rendered and the means of compensation that needs to be executed.
      • The family office must always hold regular meetings with clients and provide transparency during said meetings, including accountings of the office’s investments and other activities.
The Jobs and Tax Cut Act of 2017

Since 2017, The Jobs and Tax Cut Act (also known as the “Tax Act “) has significantly reorganized the federal income tax system for corporations and individuals. For corporations, the income tax rate decreased from 35% to 21%, and for individuals, an enormous number of changes were imposed. Still, the most significant deduction for this discussion and mentioned above was eliminating deduction for expenses that fall under Code Section 212. 

As a result, clients’ payment of management fees towards a family office is no longer considered deductible. Family offices unable to meet Code Section 212’s sufficient criteria will be categorized as a business or trade. They will be given the unappealing inability to receive any deductions for their expenses, even if said expenses are over the 2% of the AGI floor.

Using C Corporations

The corporate tax rate’s recent change has made using a C corporation serving as a family office much more appealing to families. Unlike other optional entities, C corporations are considered to conduct a business or trade as a primary function of its structure. C corporations are able to deduct their expenses if they are under Code Section 162, so long as they are considered necessary expenses from running the corporation as predicted, with no notable additions. As a result, many families consider converting their family office to a C corporation.

As noted earlier, there are two ways in which deductions are no longer permitted concerning family offices: 

      • The payment towards management fees to the family office by the Family Clients; and 
      • The payment towards expenses by the family office if it is not a trade or business. 

Asena advisors. We protect Wealth.
Contact

How to Build a Family Office

Now that we’ve looked at what a family office is and its past structure, let’s examine standard methods for building your own family office today.

The Two Types of Family Offices

There are two main kinds of family offices that entrepreneurs choose from for various reasons that best suit their financial goals as a company. They are:

‘Single Family Office’ or a ‘Multi-Family Office’?

Single Family office – Wealth owners who possess investable assets exceeding $100 million can choose to form their own wealth management business, known as a single-family office, which oversees all aspects of their financial and human wealth.

Multi-Family Office – A multi-family office (also known as an MFO) is a wealth management firm that provides integrated and highly customized services towards a limited quantity of clients. Participating families with an MFO will have access to a wide array of integrated services.

Steps to Creating a Family Office

The first and most vital step when creating a family office structure is to state the goals of an individual or multiple family members. A family office formation is similar to forming a regular business entity, where developing an organizational structure is the first move.

The next step would be to determine whether you want to establish the family office in-house or have a third party form the structure, hire personnel, and provide/maintain all essential services the family office offers.

Once that evaluation and decision are made, the third step is to choose which assets shall be managed by the family office or be managed by one or more family members. 

Scope and Costs of a Family Office

Like any other new entity, the family office operation and associated costs will need to be assessed before confirming your next step to opening one. Sizes of family offices range from small to very large, depending on the amount of wealth required for management (such as asset management, risk management, wealth management, investment management, etc.) and the types and diversity of assets the money is invested in.

A small family office usually requires six employees and costs anywhere from $1 to $2 million to operate on an annual basis. 

A medium-sized family office often requires 15 people to best operate, with an annual operating budget of $3 to $4 million minimum. 

On the other hand, a large family office would require about 25 employees with an annual budget of $8 to $10 million. When considering a large family office, however, you’d be talking about 40 to 50 employees, along with an operating budget ideally of $14 to $20 million.

What is a Family Office Structure?

Depending on jurisdiction and purpose, a family office’s legal structure can take various forms. The most popular legal structure for a family office in the US is an LLC, then an S Corp, and 3rd a C Corp. A Private Trust company is the least popular structure used. 

When Does It Make Sense to Create a Family Office?

Families who want to start a family office will need at least $100M in investable assets and have the goal to: 

        • Maintain control over assets and the overall decision-making process;
        • Benefit from the overall buying power of the family’s combined assets;
        • Preserve their privacy;
        • Keep the family together;
        • Possess a dedicated team that is devoted to giving key services to achieve long-term goals.
Finding Qualified Advisors Who Work with Family Offices

Advisors are key components to any family office as they provide the expertise that is not available internally in a family office.

Services most utilized by family clients are:

        • Accounting;
        • Investment planning; and
        • Integrated planning.

Interestingly, these three most utilized services are provided jointly by the family office and any external providers.

Selecting the ideal advisor team who will understand your unique needs and be able to support your family always needs careful due diligence on the part of the family.

The Importance of a Family Office Governing Board

A governing board is ideal when driving a company’s success. A family governing board is necessary and mandatory for operating a family office and essential for the family enterprise’s preservation.

Wealthy families sometimes need to comprehend the role and need for a financial services board when managing their wealth, assets, net worth, etc. However, there has been an increased awareness of the importance of such a board in the past few years.

What Should I Consider When Setting Up a Family Office?

Working in wealth management often involves more than just hiring money managers to invest the proceeds of the sale. Preserving wealth requires owners to consider the wealth management process a shared family business. 

What is the Objective of Your Family Office?

Managing a family’s wealth successfully is a complex and unique undertaking, so understanding which financial services to look for or provide for that unique case is necessary before moving forward. 

The job of a family wealth manager is to establish a professional structure for private work to best grow and protect a family’s assets for later generations. Examples of success include asset protection and growth and the peaceful transition of control over assets and wealth from one generation to the next. This can be done by a cohesive group of cousins who are collaboratively managing the original family member’s charitable wishes.

Whatever the measures are for the family wealth manager to execute, the work that comes from managing the family wealth can never be underestimated without negative cost to the family and their family office. That is the reason why many families decide to form a dedicated family office, as it means having a professional way to address the challenges that financial families often encounter.

What is the Scope of Your Family Office?

Individual family requirements will dictate the scale and scope of all operations. Principals are also encouraged to use the following functions to inventory what is carried out today on their behalf, as well as what new or expanded procedures might be carried out in the future. This list of typical basic and advanced functions serves only as a guideline.

What is the Family Office’s Role and What Skills are Needed?

A family office’s most basic yet necessary duty is handling wealth, net worth, and investment management for wealthy families or individuals. Such is a common and most often successful way to grow the wealth already created, as well as transferring the wealth across multiple generations through succession planning.

Aside from the necessary technical credentials of a family office (investment, legal, accounting, etc.) and experience that will be required in the family office role, it is essential to have the following professional characteristics when starting and throughout the family office’s time:

        • Privacy
        • Lack of Ego
        • Teamwork
        • Integrity
        • Communication 
How Will Future Decisions About the Family Office Be Made?

Most governing boards for a family office require an average of four members of the family and one member who is not. Families often include independent, non-family members on their board to either provide the professional experience they need or act as an objective party who supports the execution of the family’s vision and strategy.

What Do You Want in a Partner?

Below are seven vital components that your future partner must have or aspires to achieve before you enter a legal agreement with them:

        • To provide a formal structure for the management and governance of the family’s wealth;
        • To promote the family’s legacy, vision, and values;
        • To coordinate, integrate, and consolidate customized services for the family;
        • To manage economic and personal risks for the family
        • To capitalize on economies of scale gained from consolidated family wealth;
        • To accumulation, such as preferential investment access and lower fee rates; and
        • To maintain confidentiality and privacy of family affairs.

A Framework For Evaluating Family Office Options

After answering the questions above and better comprehending what your family office will look like, it’s time to examine current and future contributions to ensure everything can happen in the formation process.

Step 1: Evaluate Current Expenses (Financial Benefit of New Structure)

Families should quantify and evaluate their current costs, including staff, retained legal/accounting services, direct and indirect investment expenses, technology, infrastructure, and others. They should further review their current effective tax rate and then look at how the effective rate could change under a Lender-like structure. State taxes are essential to examine as well.

This first step should help a number of families quickly decide. Every family is different, but when aggregate expenses are less than $1 million, often it may not make financial sense to form or restructure a family office—and for such families, the outsourcing option may now be more attractive than it was a few years ago. Additionally, families that already have operating businesses may find that the incremental deductions are insufficient to justify a change.

Step 2: Evaluate Family’s Fact Pattern (Feasibility of New Structure)

If the tax savings under a Lender-like structure would be compelling, the next step is determining if such a structure is practical or feasible. There are several hurdles to clear. 

First, does the family’s situation require the family office structure to have a logical basis? A model similar to Lender will make sense for a family with multiple branches, each containing various generations. It is essential to have independent advice for different family members and outside investors within the family office.

There are additional hurdles to qualification as a “trade or business.” For example, it is only sometimes feasible to compensate staff based on a profits interest in the family office. Further, the ideal structure may come at a cost. Finally, the structure may require new or different management skills, and it is crucial for families to know whether that talent is available at a reasonable cost.

Step 3: Evaluate Likelihood of Success (Durability of New Structure)

Finally, a structure similar to Lender appears both financially and practically attractive and achievable to a family. In that case, the members must still take an honest look at how the office and its structure will likely impact their day-to-day lives and determine whether they are comfortable with adhering to new rules over time. Any new family office structure, as mentioned, will likely require new costs, as well as require new staff and leadership to operate it properly. The extra time to review, hire, and go over financial goals with the office can lead to family members needing to be more entirely unified in taking on these additional requirements. In addition to the new burdens, managing and calculating all the family office’s profits interest is also complicated and may create tension amongst the family. Any changes in how the family members will meet and interact with the family office/each other going forward may also require adjustments.

No two families are financially identical, as every family will react differently to a present or upcoming change in how their investment assets are managed and to any downstream adjustments that will be required to adjust to a new management structure. In every case, a complete understanding of the anticipated changes is necessary for the office’s long-term success.

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

5 Rules for Building a Solid Family Office Structure

Now that you’ve built an overall sense of how to build a family office and ideas of what yours would look like, we must go over the five key rules that come to family office formation listed below. Checking off each throughout your company’s process and final stages will help ensure that the structure is stable and can handle a growing number of unique cases.

When a Mistake Can Cost Millions, Developing a Strong Family Structure is Crucial

Below are common company decisions that are avoidable with ways to secure your new system:

Build a Solid Foundation for the Family Office Structure

A successful family office must be formed through close consultation with experienced legal accountants, advisors, and other counsel. Based on various investments, including private equity, debt finance, venture capital, and real estate, a family office will need to address all legal needs and tax strategies. The office should also work closely with tax experts and transactional attorneys so that structure will handle most investments, analyze and negotiate all terms and conditions surrounding an opportunity, as well as minimizing any adverse tax consequences.

Every factor, such as the company’s mission, goals, role, scope, and lines of accountability of the family office, must always be defined at the moment of formation, followed by being incorporated into the structure of the family office, even if it will be changed later on to meet evolving purposes.

Insulate Wealth

A successful family office is required to manage significant traditional assets and, in many cases with Family Clients, oversee unique assets (ex: residential and vacation real estate, hedge funds, fine art, luxury items (e.g., investment vehicles such as cars, boats, planes, and helicopters), and collectibles). The assets must also be insulated from potential liabilities. 

Cultivate Sustainable Wealth

Every successful family office must be responsible for cultivating sustainable wealth for the family’s future generations. Their unique structure needs to accommodate the utilization of significant financial possibilities such as direct private equity-style investments, generation-skipping trusts for real estate purchases, and other alternative investments that would deploy long-term capital. 

Establishment and Utilization of a Management Company

A management company must employ staff to best provide an array of services for their Client (i.e., the family office and their Family Clients). To perform this expectation, said management company will need to administer the operations, execute and/or oversee all of the professional and consulting services, and handle many other matters that the family office will require.

Family Office Compliance

Most importantly, a family office is required always be vigilant about compliance. That way, it can insulate each entity from other holdings incurring any liabilities. Compliance also includes required filing and maintaining all books and records for every family member and any related entities.

With a team of experienced advisors, a successful family office will be able to create and maintain a financial structure that can maximize any short and long-term investment possibilities with little to no exposure to extraordinary liabilities, so family wealth is safeguarded.

Organizational Structure of Single Family Offices

Typical roles within single family offices include:

Executive Team at Our Single Family Office Organizational Chart

Usually, the core team of a single family office consists of a few partners in key positions. A Chief Executive Officer (CEO) leads the whole investment firm, a Chief Investment Officer (CIO) is responsible for investment decisions, a Chief Financial Officer (CFO) is responsible for tax and financial topics, and a Chief Operating Officer (COO) who is responsible for daily operations. The partners are directly in touch with family members or a representative family board. Smaller single family offices even only consist of the executive team, while larger SFOs with billions of assets under management have several sub-divisions. 

Investment Teams at Single Family Offices

Usually, the specialized investment teams are led by directors who have already served in leading positions at investment firms for many years. They are, in turn, working together with a few talented investment associates and analysts. The Chief Investment Officer (or CEO, depending on the size and structure of the SFO) supervises the investment teams and is in steady exchange with them. Investment decisions are either made or brought to the family investment committee/investment board when the deal size is more extensive.

Which investment teams exist and how they are structured heavily depends on the investment focus of the family office. Very often, the following teams exist:

        • Financial Investments;
        • Real Estate;
        • Private Equity and Venture Capital; and
        • Other Investment Teams – Many more possible asset classes have their own investment teams: renewables, arts, impact investing, etc.
Back Office: Functions at Single Family Offices: Accounting, Public Relations, etc.

The back office supports the family’s daily work and necessary operational functions. Possible teams are:

        • Accounting, Tax, and Risk Management;
        • HR and Operations;
        • Public Relations;
        • Portfolio Management; and
        • IT

FAQs

Let’s reiterate a couple of important family office structure need-to-knows:

How Much Does a Family Office Cost?

The cost of each family office will be dependent on many vital variables, such as the size of the family, the quantity of staff, and the nature of the family’s overall investments.

The complexity of said office is the key predictor of cost for a family office. Receiving an “all in” cost of wealth management must have detailed consideration surrounding the family office’s costs, the fees paid towards ideal advisory firms (e.g., accountants, attorneys, etc.), and towards investment costs (e.g., outsourced CIO, custody, investment management fees, investment consultant, etc.). 

What are Critical Issues to Consider in Managing a Family Office?
        • Balanced leadership and governance;
        • Effective communication;
        • Board oversight;
        • Succession and contingency planning; and
        • Continuous operational improvements.

People Also Want to Know…

How Much Money Do You Need to Have a Family Office?

The recommended starting amount for families who want is at least $100M via investable assets.

What is the Purpose of a Family Office?

Families can create an office to support all of their overall financial needs after a significant liquidity event, with every family office being unique as the family it serves.

How is a Family Office Formed?

Opening and operating a family office, or expanding upon the financial services of an existing family office, requires careful consideration and planning to properly manage and protect a family’s wealth so it can flourish over time. As with any organization, a family office’s relative success or failure relies on effective governance.

 

 

To learn more about family offices, reserve your consultation with one of our advisors, as well as joining us starting next week for the first episode of our Family Office Vlog Series…

–Shaun Eastman

–Peter Harper

Multi-Member LLC

Posted on by Peter Harper

Multi-Member LLC

In our previous articles, we have discussed the single-member LLC and the advantages and disadvantages of owning and operating such an entity, not to mention its default tax treatment. Today, we will be discussing what it means to form and control a multi-member LLC (MMLLC), which is simply a limited liability company with more than one member. 

Understanding Multi-Member LLCs?

While there are similarities between a single-member LLC (SMLLC) and an MMLLC, there are also many differences. But before we elaborate on the details and differences between the two, it may be beneficial to talk more about the history of this entity type. 

History of Multi-Member LLC

Even though the first state to authorize the creation of the LLC was Wyoming in 1977, it was in 1996 that all 50 states in the U.S. had LLC statutes. Through Revenue Ruling 88-76, the IRS decided in 1988 that Wyoming LLCs were taxable as partnerships. And even today, this is the default tax treatment of an LLC with more than one member – a partnership. 

What is a Multi-Member LLC?

This type of LLC has two or more owners ( or members) that share control of the company. Unless electing S Corporation tax treatment, there can be an unlimited quantity of members within a multi member LLC. The LLC may also decide on how (and what percentage of) profits and losses shall be distributed among its members, customarily done through its operating agreement.

Who Can Form a Multi-Member LLC?

Members can be either individuals, corporations, or even other LLCs. 

How Multi-Member LLCs Work

Now that we have discussed a bit about the history of this entity type and what it is, it is time to explain how such entities work. 

Ownership

This LLC is comprised of two or more owners ( or members) that share control over the company. The LLC is its own legal entity that is separate from its owners. Unless it decides to elect for S Corporation tax treatment, there could be an unlimited number of members within an MMLLC. The LLC may decide on how (and what percentage of) profits and losses shall be distributed among its members.

Personal Asset Protection

An MMLLC offers asset protection for the owners’ personal assets because it is a separate legal structure. Indeed, the biggest reason why many people form an MMLLC is the limited liability that it offers its owners. Specifically, the owners’ personal assets cannot be appropriated to pay the debts of the LLC. Owners may, however, be held personally responsible within certain situations (such as when they “pierce the corporate veil”), and in this scenario, they would potentially incur personal liability. 

Profit Distribution to Owners

MMLLC owners are entitled to a distributive share of the profits in the entity, and typically, these profits are in proportion to the percentage interest each owner has in the company. Using this example, if one member owns 70 percent of a multi-member LLC and another member owns 30 percent, then the first person will be entitled to 70 percent of the company’s profits, and the second person will be entitled to 30 percent of the company’s profits. Since the LLC is a flexible entity structure, you can divide profits and losses by way of a particular allocation using something other than the percentage of membership interest. In this scenario, each member might be entitled to a percentage of profits that is different from their percentage of ownership in the business. However, again, this should be clearly stated. While an LLC is not required to distribute profits to its owners, the entity’s owners will still be on the hook for reporting their share of the LLC profits and then paying tax on these profits. 

Income Tax Treatment

The default tax treatment of an MMLLC is similar to that of an SMLLC in that it is a pass-through entity, with the profits being allocated to the owners and thus flowing through to their personal tax returns. How it is different is that instead of the income, expenses, and profits being reported on a Schedule C (as for an SMLLC), the income, expenses, and profits are reported on Form 1065 (partnership tax return), and each member of the LLC receives a Schedule K-1 (and must then report this information on their personal return) reporting their share of the LLC’s profit or loss. 

Federal Income Taxes and the Multi-Member LLC

A multi-member LLC’s default federal tax treatment is that of a partnership. And, just like a single-member LLC, an MMLLC does not pay taxes on its business profits. Instead, the owners (members) individually pay tax, which is based on their share of the profits, on their personal returns. As stated in the previous section, an MMLLC is required to file a Form 1065 (partnership return), and each member receives a K-1, on which they will see their profits or losses associated with the partnership. Finally, each member must then report the profits on Schedule E of their personal return Form 1040. In terms of taxes payable, members will need to pay not only federal taxes but also (Social Security and Medicare) on their share of the LLC’s earnings.

You may then decide that you like that an MMLLC is a pass-through entity but that you hate paying so much self-employment tax. In this scenario, the owners could file Form 2553 for the MMLLC to be taxed as an S Corporation, whereby the profits and losses are still passed through to members’ individual returns (filed via Schedule E of Form 1040). However, the difference here is that the owners must only pay a self-employment tax on their wages and salaries, not on their profit distributions. Typically, the owners would pay themselves a salary, and then whatever profit was left over would flow through to their personal returns. 

However, an MMLLC’s owners may decide to have the entity not be treated as a partnership. In this scenario, members can elect to have their business taxed as a C-Corp, so the entity will no longer be a pass-through entity. It will pay corporate tax on its profits (presently, the federal corporate tax rate is 21%). To do this, owners must file Form 8832 to change the default tax treatment of the entity. 

State Income Taxes and the Multi-Member LLC

This is where things can vary quite a bit. At the state level, tax laws can vary for LLCs. For instance, some states levy fees on LLCs, such as a minimum or franchise tax. Contrary to its name, a franchise tax is not assessed against a business operating as a franchise. A franchise tax is charged to LLCs, corporations, and partnerships into the form of a fee for the concession to form and conduct business in that state. 

Who Manages a Multi-Member LLC?

What is excellent about this entity structure is its flexibility. Members of an MMLLC get to decide how it is structured and who manages the entity. Some MMLLCs elect one or more members, or even a third party, to manage the business. This type of MMLLC is called a manager-managed MMLLC. On the other hand, if the LLC members are running the entity equally, the entity is called a member-managed MMLLC. 

Involvement

If two or more individuals are managing the company, then you should be able to demonstrate that each manager is involved with the company’s business decisions and operations. 

Formation

Multi-member LLC members can be individuals (whether they are Americans or not, and whether they live in the U.S. or not), corporations, or other LLCs. It is important to note that LLCs have organized on a state level, not the federal level.  

Compliance

MMLLCs are required to file Form 1065 (unless they elected to be taxed as an S Corporation, which requires a Form 1120-S filing, or a C Corporation, which requires a Form 1120 filing) as well as potentially a state return. 

Bankruptcy

When an individual declares bankruptcy, the court possesses the power to seize a large quantity of assets, including those related to the LLC. However, if the LLC is multi-member, the court cannot seize company assets without the unanimous agreement of other LLC members, as this would result in the court taking one person’s assets because of another’s misconduct.

Divorce

There are scenarios in which spouses own a multi-member LLC. Thus, couples often meet in court to divide their assets when a divorce occurs. It is good practice to stipulate how much of the company each member owns (or spouse, in this case). In this scenario, the court may rule that each spouse will retain the share stated in the operating agreement.

Asena advisors. We protect Wealth.
Contact

 

Management Options

Again, one of the best things about an LLC is its flexibility. Thus, with an MMLLC, you can decide how the business is managed.

Member-Managed LLC vs. Manager-Managed LLC

As described previously, in a member-managed LLC, the members participate in running the business. As such, when making big decisions, such as entering into contracts or purchasing expensive equipment, the majority approval of all its members is necessary.  

In a manager-managed LLC, on the other hand, the members are able to agree on electing a manager, either one particular LLC member or members, or even a third party, to whom they grant authority to manage the business’ day-to-day decisions and operations. 

Basic Steps to Form a Multi Member LLC

While every entity is different, and you may take slightly different steps in forming an entity, the below are best practices and should be followed at a minimum. 

Choose a Business Name.

The new LLC name needs to be distinguishable from all other registered entities for tax purposes. You can start searching on the Secretary of State’s business search tool.

Apply for an EIN (Employer Identification Number).

As LLCs are pass-through entities, an application for a new EIN number needs to be obtained if the LLC will be multi-member or if the election is made by its members to be taxed as a corporation.

File Your LLC’s Articles of Organization.

While it may differ from state to state, this document needs to meet articles of organization, such as detailing the name and address of the LLC, the contact details and names of the owners, the application date, and a description of the new business.

Create an Operating Agreement.

This internal document needs to be drafted by members and will set out the rules for ownership and management of the newly formed LLC. It will detail what will happen if additional members are introduced to the LLC, if the LLC will be liquidated, or if members leave the LLC.

Apply for the Necessary Business Licenses and Permits.

Suppose the nature of the business requires the LLC to obtain business licenses or permits to operate. In that case, the relevant agencies need to be contacted to ensure that the licenses or permits are transferred from the sole proprietor to the newly formed LLC.

Open a Separate Bank Account for Your Business.

A bank account for any new business needs to be opened in the name of your LLC to ensure a clear separation between the LLC funds and the members’ personal funds. This also eases the management of assets and allows for more accurate recordkeeping.

Ongoing Compliance Obligations

As with any business entity, owning a multi-member LLC means that there are certain obligations that its members must adhere to. Some of those include renewing any licenses or permits (if required), paying state franchise fees, filing entity tax returns, updating the state the LLC is organized in if there are significant changes, filing an annual report, and so forth.

What are the Benefits of a Multi-Member LLC?

There are numerous benefits to owning an MMLLC. One is limited liability, as an LLC is considered a separate entity from its members. Subsequently, members are not personally liable for the business’s debts and other legal liabilities (i.e., they have limited liability protection). Further, members of LLCs include the business profits in their individual returns because the LLC is classified as a pass-through entity. Additionally, members may be able to apply the 20% pass-through deduction to business profits.

What are the Drawbacks of a Multi-Member LLC?

At the same time, there can be a few drawbacks to having such an entity. Members of LLCs receive units in proportion to their contribution/LLC agreement, and these units are more challenging to transfer than stocks in a corporation. This difficulty in transferring ownership is one of the reasons that external investors/venture capitalists prefer investing in corporations over LLCs.

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

 

Why Should I Have a Multi-Member Operating Agreement?

It could be argued that any entity should have one. Still, it becomes crucial for a multi-member LLC to have an LLC operating agreement, if for no other reason than to avoid ambiguity in the ownership and management structure, profit distribution, and even what happens when/if the company is liquidated or its members leave. 

What Should a Multi-Member Operating Agreement Include?

Certain sections are crucial to include. Those include the following:

Article I: Company Formation

This section deals with the formation of the company itself, and it should include information on the list of members and the company’s ownership structure. In addition, it should outline whether the members have equal or different amounts of ownership.

Article II: Capital Contributions

This section covers each member’s initial capital contribution in starting the LLC, whether the contribution is in cash or other assets that are contributed to the business. The total value of the contributions should be clearly listed. 

Article III: Profits, Losses, and Distributions

This section describes how profits and losses are allocated (whether they are ownership percentages or some special allocation) and whether the profit distributions are on an annual basis or more often. 

Article IV: Management

This section addresses managing the company (whether the firm is member-managed or manager-managed) and how each member will vote, with a transparent system of appointing managers and how individual members will be assigned other specific duties. 

Article V: Compensation

This section discusses the topic of compensation. For instance, if the LLC is to be taxed as a corporation, any members can receive a salary for the labor they have performed in the business, along with profit distributions. If the LLC is to be taxed as a partnership, members receive distributions on the basis of their ownership interest in the company.

Article VI: Bookkeeping

The agreement should be clear on whether and which LLC member/members can check the LLC’s books and records, such as financial documents and board meeting minutes.

Article VII: Transfers

This section discusses removing or adding new members to the LLC. Additionally, it states if and when members of the LLC can transfer their ownership in the company. Finally, this section should also clearly specify what happens in the event of death, bankruptcy, or divorce. It cannot be expressed enough on the importance of accounting for these types of scenarios, as, despite everyone’s best efforts, business and life are unpredictable, and in order to protect each member’s share and business interests, these situations and how to handle them should be stated in this document. 

Article VIII: Bank Account

This is something that gets overlooked often but is quite apparent. As stated previously, this is essential for any new business to ensure a clear separation between the LLC funds and the members’ personal funds. Additionally, this eases the management of assets and allows for more accurate recordkeeping.

Article IX: Dissolution

This section explains the circumstances if the LLC may be dissolved, and if so, the process of terminating the LLC should all the members vote to end it. 

How are Multi-Member LLCs and Their Owners Taxed?

What is the tax status for an MMLLC? A domestic LLC possessing at least two members is usually classified as a partnership for federal tax reasons unless it decides to file Form 8832 to be elected for treatment as a corporation. Each partner must pay taxes separately on the grounds of their operating agreement. Most agreements favor having the taxes corresponding to the membership interest. This means that each LLC member is required to pay taxes on their share of the LLC’s profits whether or not they receive their share of those profits. Unlike a corporation, even if a member or members have the need to leave profits in their LLC for any tax purposes, they can be liable for any income tax for their proportionate share of the LLC’s income. However, as discussed previously, the LLC that is classified as a partnership will be required to file Form 1065, U.S. Return of Partnership Income, with the IRS, as well as provide their members with a K-1 (a breakdown of each member’s profits and losses), and can be subjected to the same filing and reporting requirements as partnerships. Each state could use different tax regulations for an LLC, and the income derived by the LLC and be attributed towards a member or members can be taxed at the state level if it is sourced or derived from that state.

How Do I Pay Myself from a Multi-Member LLC?

You do not get paid a salary as the member/owner of an MMLLC. Instead, you pay yourself by withdrawing the profits made by the LLC as and when needed. This is also referred to as an owner’s draw.  

Single-Member vs. Multi-Member LLC

There are numerous differences between an SMLLC and an MMLLC. Some of those differences are discussed below.

LLC taxes

The default tax treatment of an SMLLC is that the owner must report the business’s profits and losses onto a Schedule C of IRS Form 1040 as personal income, and the small business itself does not report or pay taxes independently (nor does it file its own tax return). The LLC owner must also make payments onto self-employment taxes (Social Security and Medicare) on any and all taxable income coming from the business. 

An MMLLC, on the other hand, is required to file a return (Form 1065) and provide its members a Schedule K-1 form, which contains information the members will need to file their personal returns. Like with an SMLLC, business owners are subject to federal income tax, FICA taxes, and possibly even state income tax. 

Liability protections

Both SMLLCs and MMLLCs have liability protection by default. 

Multi-Member LLC vs. Partnership

Even though the default tax treatment for an MMLLC is for it to be taxed as a partnership, there remain differences between an MMLLC versus other entities that may also have more than one member.

Multi-Member LLC vs. LLP

While individuals can own MMLLCs, corporations, and other LLCs, a limited liability partnership (LLP) can only be owned by individuals. Further, in many states, an LLP can only be formed by certain professions, such as doctors and attorneys. On the other hand, multi-member LLCs can be created by and for nearly any profession. Finally, an LLP cannot change its tax classification, whereas MMLLCs can elect to be taxed as a partnership or corporation. 

Multi-Member LLC vs. LP

In a limited partnership (LP), general partners have unlimited liability and are personally liable for the business, whereas limited partners receive liability protection. In an MMLLC, all members have liability protection. Further, in an LP, only general partners can manage the business, whereas, in an MMLLC, all members can manage the business. 

Is it Better to be a Multi-Member LLC?

Generally speaking, it is more advantageous to be structured as an MMLLC than as an LLP or LP, for the reasons stated in the previous section. However, your needs (or the requirements set forth by your state for your industry/profession) may require you to go with something other than an MMLLC.

Which One is Right for Your Business?

This is a difficult question to answer within the confines of an article. You will have to consider your business’s unique goals, business structure, industry, and profit margin, among other things, to determine which entity type is best. However, this article hopefully elucidates many advantages of a multi-member LLC. 

Multi-Member LLC FAQ

Here are some quick additional facts about MMLLCs you should consider:

Does a Multi-Member LLC Need an EIN?

Yes, it does. The entity will need an EIN to do things such as file an income tax return. 

Can a Multi-Member LLC become a Single-Member LLC?

Yes, it can. The only official condition is the sale of the membership interest surronding the leaving member(s) towards the remaining member, as well as the filing of a new tax election form. 

How Do You Dissolve a Multi-Member LLC?

There are numerous steps you must take in order to ensure that your LLC is properly dissolved. Most MMLLCs will have to perform actions such as:

    • voting by members to dissolve the LLC;
    • filing a final return;
    • filing an Articles of Dissolution with the state the entity is doing business in;
    • settling any outstanding debts; and
    • distributing assets to LLC owners/members. 
For more advice on starting your own multi-member LLC, reserve a consultation with one of our advisors in our Contact Us section to the right.

Arin Vahanian

Peter Harper

Entity Classification Election

Posted on by Peter Harper

Entity Classification Election

Following our previous discussion about entity changes with check-the-box regulations, let’s go into another process that entrepreneurs and executives are likely to consider with the tax season fast approaching: the entity classification election.

What is the Purpose of Entity Classification Election?

The purpose of the entity classification election is to enable business entities to avoid the default tax classification applied by the IRS for federal income tax purposes. Business entities receive a default tax classification, which can result in paying for more federal taxes than necessary. If your entity is eligible to use the entity classification election form, you can change your tax election status and potentially lower your tax liability.

For example, a U.S. corporation can avoid double taxation by using the CTB regulations, and it also benefits foreign eligible entities by avoiding potential double taxation. For example, an entity in India could be classified and taxed differently in the U.S. than in India, such as a tax treaty or an income tax treaty. The CTB rules, therefore, provide the entity in India to elect its entity classification for U.S. tax purposes with that said tax treaty. 

The entity set up in India can also use the tax treaty, along with any treaty benefits included, to qualify for lower dividend withholding taxes if it elects to be taxed as a corporation in the U.S. 

A Parent company in the U.S. can also use the CTB rules to benefit from the tax treaty with India and avoid double taxation. 

What Is A Business Entity Classification?

A business entity is any entity that is recognized for federal tax purposes that is not correctly classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Code regarding the entity’s classification. A business entity is classified as either a C-Corporation, partnership, or disregarded entity for federal tax purposes. 

Here is how you can remember:

Association – For purposes of the CTB regulations, an association can be an eligible entity that’s taxable as a corporation by election or under the default rules for foreign eligible entities, as discussed below.

Business entity – A business entity is any entity recognized for federal tax purposes that is not accurately classified as a trust under Regulations section 301.7701-4. Or they are otherwise subject to special treatment under the Code regarding the entity’s classification. 

Corporation – For federal tax purposes, a corporation is any of the following: 

    • A business entity is organized under a federal or state statute or a federally recognized Indian tribe statute if that same statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. 
    • An association.
    • A business entity is organized under a state statute if the statute describes or refers to the entity as a joint-stock company or joint stock association. 
    • An insurance company. 
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute. 
    • A business entity that is wholly owned by a state or any political subdivision or is wholly owned by any entity described in Regulations section 1.892-2T, such as a foreign government.
    • A business entity that can be taxable as a corporation under a provision of the Code other than section 7701(a)(3). 
    • A foreign business entity as listed on page 7 of Form 8832. 
    • An entity is created or organized under tax laws of more than one jurisdiction (an example can be a business entity that has multiple charters) if the entity will be treated as a corporation with respect to any of the jurisdictions. For examples, see Regulations section 301.7701-2(b)(9).

Asena advisors. We protect Wealth.
Contact

What is an Entity Classification Form?

This federal tax form allows certain businesses to select whether they want to be taxed as a corporation, partnership, or disregarded entity for future tax purposes and protected under tax law. 

What is IRS Form 8832?

You can use IRS form 8832 to choose to have:

      • A corporation with more than one owner is treated as a partnership for tax purposes.
      • A corporation with a single owner is treated as a ‘disregarded entity for tax purposes.
      • A partnership is treated as a corporation for tax purposes.
      • A ‘disregarded entity is treated as a corporation for tax purposes.

Which Businesses Can Use Form 8832?

Only businesses that are considered eligible entities can use Form 8832. The following are regarded as eligible entities:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs; and
      • Certain types of foreign entities

Not every type of business can use Form 8832 to change their business’s tax classification. The following can be considered businesses eligible for filing Form 8832:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs
      • Explicit types of foreign entities (Page 5, Form 8832)

The above entities can use Form 8832 to elect to be taxed as a C corporation, partnership, or sole proprietorship.

If you’re currently a limited liability company (LLC) taxed as a corporation, you can use Form 8832 to revert to a previous tax classification.

Eligible businesses that don’t fill out the form will be taxed based on their default tax status. If you are content with your current or default tax classification, do not fill out Form 8832.

Remember that your business can only change its tax classification once every five years.

Who is Not Eligible to File Form 8832?

Sole proprietors, domestic corporations, and foreign corporations are listed in IRS Regulations 301.7701-2(b)(8). 

How Do You Fill Out Form 8832?

Form 8832 is a straightforward form to fill out and only requires the entity’s name, address, and tax identification number, followed by making an election by checking the relevant box and the signature of the entity’s eligible owner, member, partner, or officer.

Before you begin filling out your form, you need to gather some information. Take a look at what to have handy for Form 8832:

      • Business name, address, and phone number
      • Employer Identification Number (EIN)
      • Owner’s name and Social Security number (if the business only has one owner)

There are two parts to the form: Election Information (Part I) and Late Election Relief (Part II). Part I asks a series of questions on your tax status election. Depending on your answers, you may be able to skip some lines.

Part II is for businesses seeking late election relief only. To be eligible for late election relief, all of the following must apply:

      • The IRS denied a previous Form 8832 filing because you didn’t file on time.
      • You haven’t filed your taxes because the deadline hasn’t yet passed, or you’ve filed your taxes on time.
      • You have reasonable cause for not filing your form on time.
      • It has been less than three years and 75 days from your requested effective date.

Is Form 8832 Complicated?

No. The required information you need to know is: 

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)

Who Must File Form 8832?

Keep in mind that it is not a mandatory form at all. It provides eligible entities the option to change their default classification should they wish. 

What Information is Required?

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)
        • Owner’s name and Social Security number if the business only has a single owner

Where Should It Be Filed?

        • The form can not be filed electronically. 
        • If you are living as either a resident or non-resident in the U.S., you will have to mail it to the appropriate IRS office in your state.
        • If you are a resident or non-resident in a foreign country, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Where Do You Send the Form?

This will depend on the location your entity is residing in a domestic or foreign location:

        • If you live in the U.S., you’ll mail it to the appropriate IRS office in your state.
        • If you live in a foreign country as a resident or non-resident, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Once your specific office receives your form, they will notify you immediately whether it has or hasn’t been accepted. A final determination notice of the election change will be sent to you within 60 days of the acceptance decision.

What’s the Form 8832 deadline?

Because Form 8832 is not mandatory, it doesn’t have a deadline per se. It can be filed at any point by an eligible entity. There are, however, specific but basic rules to take note of. When you file the form, you can include the date the change will take effect. 

Broadly, an election specifying an eligible entity’s classification will not take effect more than 75 days before the election is filed, nor can it take effect later than 12 months after the election is filed. However, an eligible entity may be able to apply for an exemption and receive a late election relief in certain circumstances.

How Long Does It Take to Prepare?

The IRS estimates that 17 minutes are required to prepare the form. However, this doesn’t take into account the time it will take to learn and understand the applicable tax law.

What Else Should I Know About Form 8832?

It is essential to know the difference between Form 8832 and Form 2553. Both forms allow certain businesses to request a new tax classification. However, the major difference is the type of tax classification you request.

Form 8832 authorizes businesses to request to be taxed as a corporation, partnership, or sole proprietorship, whereas Form 2553 is the form corporations and LLCs use to elect S-Corp tax status. 

The check-the-box regulations authorize entities to elect to change their U.S. tax classification, though a change in tax classification, no matter how achieved, has tax consequences. This applies to U.S. and International business owners.

Essentially there are three ways to accomplish a classification change:

        • An elective classification change by filing IRS Form 8832.
        • An automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners.
        • An actual conversion, wherein an entity merges into, or liquidates and forms, an entity that has the desired classification.

Suppose a corporation elects to be classified as a partnership. In that case, it will be deemed to have distributed all its assets and liabilities to shareholders in liquidation. The shareholders are considered to contribute all the distributed assets and liabilities immediately after that to a newly formed partnership. An entity will be deemed to have liquidated under §331 or §332, and the deemed liquidation will be treated like it were an actual liquidation for tax purposes.  

An entity not regarded as eligible will first need to convert into an eligible entity before making the check-the-box election. 

Lastly, an actual conversion can be implemented.

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

Why to Use Form 8832

Businesses receive a default tax classification, which can result in paying more business taxes than necessary. If you’re eligible to utilize the entity classification election form, you can change your tax election status and potentially lower your liability on a tax return, saving you money and building more tax credit.

Why Comply?

Even though this form is not mandatory, this will be an advantage for some taxpayers to decide whether their entity will be taxed as a partnership (one with multiple owners), as a corporation, or disregarded for tax purposes (single owner entity) and taxed like a proprietorship.

What is the Best Tax Classification for an LLC?

An ideal tax classification for a limited liability company (LLC) will depend on if you’d like your business profits should be taxed at your personal income tax or corporate tax rates. If you would rather use your personal tax rates instead, you can classify it as a disregarded entity or as a partnership. If not, you can classify it as a corporation instead.

An LLC can be taxed in several ways for the business and its owner to save on taxes. Below are ways how an LLC can be taxed, how your business can benefit from being taxed as an S corporation or as a corporation, and how you can elect this tax option:

An LLC can be considered as a disregarded entity, similar to the way sole proprietorships are treated, or can be taxed as a partnership if it has multiple members. Those are the most usual classification for LLCs, with each case having the profits ultimately taxed as a part of every member’s personal income.

It’s also possible for an LLC to be considered a corporation. If so, the entity will have to pay corporate taxes instead of passing profits through to each member’s personal income tax return.

To be taxed as a corporation, use the entity classification election or IRS Form 8832. The election for being taxed as a new entity will go into effect on the date entered on line 8 of Form 8832. However, the election cannot take effect over 75 days before the date the election is filed, nor will it take effect any later than 12 months after it is filed.

The form includes a consent statement that may be signed by all or one member on behalf of all other members. If one member does sign, there needs to be some record in a company membership meeting that all members have approved this specific election.

For single-member LLCs, you will need to provide the name(s) and owners’ Social Security number. The same will be applied for multi-member LLCs, but with an Employer ID Number instead of Social Security number. 

You can fill out an IRS Form 2553 in order to be taxed as an S corporation, also known as an election by a Small Business Corporation. To start a new tax classification for a year, you will need to file by March 15, which will be effective for the entire year. You must also include all necessary information about each shareholder: name and address, Social Security number, the date the owner’s tax year ends, shares that they owned, and a consent statement.

For any change to a corporation, you must note the following: when your election to corporate status goes into effect, the IRS will determine that any and all liabilities and assets from the previous business (whether it was a partnership or a sole proprietorship) will be added to the corporation in exchange for shares of the corporate stock.

By default, the IRS can tax a multi-member LLC as a partnership since LLCs don’t have a separate IRS tax category.

If you want to convert your LLC’s tax status from a partnership to a corporation while not changing the LLC’s legal form, you will only need to file an IRS Form 8832 (taxed as a C corporation) or an IRS Form 2553 (to be taxed as an S corporation). 

Note that once an LLC has elected to change its classification, it cannot elect again to change its classification for the 60 months after the election’s effective date. 

Any election for changing a partnership classification to a corporation shall be treated like the partnership provided all of its liabilities and assets to the corporation in exchange for stock. The partnership is then immediately liquidated by distributing the stock to its partners.

IRS Form 8832: Q&As

If you have any further questions about Form 8832 and if this is the best decision for your business, please feel free to contact us at Asena Advisor for a private consultation or check out the IRS’ entity classification election page, which will have a digital copy of the form. Click here to check the latter.

Speak with one of our consultants to learn more about how Entity Classification Election can help you.

Shaun Eastman

Peter Harper

US-AU DTA: Article 13 – Alienation of Property

Posted on by Peter Harper

INTRODUCTION

When it comes to the alienation of property, it is usually standard practice to give the taxing rights to the state which, under the DTA, is entitled to tax both the property and income derived from it. 

Article 13 provides rules for the taxation of certain gains derived by a resident of a Contracting State. In general, the Article makes provision for the following: 

  1. gains from the alienation of real property may be taxed where the real property is located;
  2. gains derived from the alienation of ships or aircraft or related property may be taxed only by the State of which the enterprise is a resident, except to the extent that the enterprise has been allowed depreciation of the property in computing taxable income in the other State; and
  3. gains from the alienation of property referred to in paragraph 4 (c) of Article 12 (Royalties) are taxable under Article 12. 

Gains with respect to any other property are covered by Article 21 (Income Not Expressly Mentioned), which provides that gains effectively connected with a permanent establishment are taxable where the permanent establishment is located, in accordance with Article 7 (Business Profits), and that other gains may be taxed by both the State of source of the gain and the State of residence of the owner. Double taxation is avoided under the provisions of Article 22 (Relief from Double Taxation).

INTERPRETING ARTICLE 13 OF THE DTA – ALIENATION OF PROPERTY 

Article 13(1) states that income or gains derived by a resident of one country from the alienation of real property in the other country may be taxed in that other country.

For example, if a US resident derived income or gains from the disposal of real property located in Australia, that income or gain may be taxed in Australia.

The meaning of the phrase ‘income or gains’ was clarified by the Protocol. Article 2(1)(b) (Taxes Covered) was amended to include a specific reference to Australian capital gains tax to ensure that capital gains are within the scope of the DTA. 

Article 13(2) defines the term ‘real property’.

For purposes of the US, Article 13(2)(a) provides that the term ‘real property situated in the other Contracting State’ includes a ‘United States real property interest and real property referred to in Article 6 which is situated in the United States’. 

Accordingly, the US retains its full taxing rights under its domestic law.

For purposes of Australia Art 13(2)(b) provides that real property includes the following:

  1. real property referred to in Article 6;
  2. shares or comparable interests in a company, the assets of which consist of wholly or principally of real property situated in Australia, and
  3. an interest in a partnership, trust or estate of a deceased individual, the assets of which consist wholly or principally of real property situated in Australia.

Article 6 includes within the definition of real property a leasehold interest in land and rights to exploit or to explore for natural resources.

Shares or comparable interests in a company, the assets of which consist wholly or principally of real property, and an interest in a partnership, trust or deceased estate are also deemed to be real property in terms of Article 13(2)(b)(ii) and 13(2)(b)(iii).

Article 13(3) states that income or gains arising from the alienation of property (other than real property covered by Article 13(1)) forming part of the business assets of a permanent establishment of an enterprise or pertaining to a fixed base used for performing independent personal services may be taxed in that other state. 

This article also applies where the permanent establishment itself (alone or with the whole enterprise) or the fixed base is alienated and corresponds to the rules for the taxation of business profits and income from independent services in Article 7 and Article 14 respectively. 

Asena Advisors is the only multi-disciplinary (Accounting and Legal) international CPA firm in the United States that specializes in U.S. -Australia taxation.
Contact

Article 13(4) makes provision for exclusive taxing rights of income and capital gains by the residence country from the alienation of ships, aircraft or containers operated or used in international traffic. It is also important to note, that this applies even if the income is attributable to a permanent establishment maintained by the enterprise in the other Contracting State.

Article 13(5) applies to the taxation of deemed disposals when ceasing your tax residency in a contracting state. This is also referred to as an exit tax. This article states that where an individual, has a deemed disposal event in their residence state due to ceasing residency, they can elect to be treated for the purposes of the taxation laws of the other state as having alienated and re -acquired the property for an amount equal to its fair market value at that time.

This rule has two significant consequences –

  • Firstly, if the individual is subject to tax in the other Contracting State on the gain from the deemed sale of the asset a foreign tax credit for tax on the deemed sale will be available pursuant to Article 22.
  • Secondly, the deemed sale and repurchase will result in the individual resident in the other Contracting State having a “stepped up” cost base equal to the fair market value of the property.

Article 13(6) states that where a resident of one state elects to defer taxation on income or gains relating to property that would otherwise be taxed in that state (upon ceasing to be a resident) only the state where they subsequently become a resident can tax the deferred gain. 

Article 13(7) makes provision for any other capital gains not covered by Article 13. These capital gains are to be taxed in accordance with the domestic laws of each country.

Article 13(8) lastly clarifies the taxation of real property which consists of shares in a company or interests in a partnership, estate or trust as referred to in Article 13(2)(b) is deemed to be situated in Australia.

CONCLUSION 

There have been numerous disputes regarding the application of this Article and reference to case law is extremely important. Especially in relation to limited partnerships and or indirect ownership through a chain of companies of Australian real property.

Make sure you understand how Article 13 can impact your potential liquidity event when planning to dispose of your business.  

We strongly recommend seeking professional advice when it comes to this Article and our team of International Tax specialists at Asena Advisors, will guide you on how to approach and interpret Article 13. 

We strongly recommend seeking professional advice when it comes to Article 12. As always, our team of International Tax specialists at Asena Advisors will guide you on how to approach and interpret Article 12. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 10 – Dividends

Posted on by Peter Harper

INTRODUCTION

For purposes of this week’s blog, it will be beneficial just to recap on the purpose of a DTA. The major purpose of DTA is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Due to the fact that DTAs often modify US and foreign tax consequences substantially, the relevant DTA must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction.

Article 10 of the US/Australia DTA is a great example of this. 

This week we will be looking at the tax implications of declaring a dividend in the context of Article 10 of the US/Australia DTA.

INTERPRETING ARTICLE 10 OF THE DTA – DIVIDENDS

Dividends are distributions made by a company of something of value to a shareholder. Both the US and Australia levy withholding tax when a dividend is paid to a foreign shareholder. 

Under US domestic tax law, a foreign person is generally subject to 30% US tax on the gross amount of certain US-source income. All persons (‘withholding agents’) making US-source fixed, determinable, annual, or periodical (FDAP) payments to foreign persons generally must report and withhold 30% of the gross US-source FDAP payments, such as dividends.

Under Australian domestic tax law, dividends paid to an Australian non-resident recipient is subject to a flat withholding tax to the extent they are unfranked and are otherwise not assessed in Australia.

Article 10 however limits the tax that the source country may impose on these dividends payable to beneficial owners’ resident in the other country.

Article 10(1) preserves the right of a shareholder’s country of residence to tax dividends arising in the other country by permitting Australia or the US to tax its residents on dividends paid to them by a company that is resident in the other Contracting State.

Article 10(2) allows the Contacting State of the company to tax dividends to which a resident of the other Contracting State is entitled subject to the limitations in Article 10(2) and 10(3). 

Important to note is that Article 10(2) also requires that if either the US or Australia significantly modifies their laws regarding taxation of corporations or dividends they must consult with each other to determine any appropriate amendment to Article 10(2).

Article 10(2)(a) stipulates that where the shareholder who is beneficially entitled to the dividend is a company resident in the other Contracting State and directly owns shares representing at least 10% of the voting power of the company paying the dividend then the withholding tax rate is limited to 5% of the gross dividend.

The term ‘beneficially entitled’ is not defined in the DTA and therefore the domestic law of the country imposing the tax should be considered. 

The term ‘voting power‘ is also not defined but must be determined to ascertain if the 10% shareholding test is satisfied. 

The US Department of Treasury’s technical explanation of the Protocol that replaced Art 10 of the Convention states the following:

“Shares are considered to be voting shares if they provide the power to elect, appoint or replace any person vested with the powers ordinarily exercised by the board of directors of a US corporation.”

In Australia voting power is considered to refer to the voting power on all types of shares and not only in relation to the power to replace members of the board of directors. 

In determining the voting power for the purposes of Article 10(2) only shares that are held ‘directly’ by the beneficial shareholder can be taken into account. 

Accordingly, indirect interests are not to be taken into account. However, the US Department of Treasury’s technical explanation of the Protocol when discussing Article 10(2) states the following:

“Companies holding shares through fiscally transparent entities such as partnerships are considered for purposes of this paragraph to hold their proportionate interest in the shares held by the intermediate entity. As a result, companies holding shares through such entities may be able to claim the benefits of sub-paragraph (a) under certain circumstances. The lower rate of withholding tax applies when the company’s proportionate share of the shares held by the intermediate entity meets the 10 percent threshold. Whether this ownership threshold is satisfied may be difficult to determine and often will require an analysis of the partnership or trust agreement.”

The voting power test in Article 10 is therefore likely to be applied differently in the US and Australia unless the reference to “beneficially entitled” is interpreted to override the requirement that the payee company holds the shares “directly”.

Article 10(2)(b) limits the withholding tax rate on dividends derived by a resident from shares held in a company resident in the other Contracting State to 15%. Accordingly, this rate will apply to individuals, trusts, partnerships and companies that cannot rely on Article 10(2)(a) or the exemption in Art 10(3) discussed below.

Article 10(3) is quite often misinterpreted. This Article stipulates that a shareholder company resident in the US or Australia is exempt from withholding tax on dividends if it owns 80% or more or the voting power of the company paying the dividends for a 12-month period ending on the date the dividend is declared. However, the exemption is subject to the shareholder company being:

  (a) a qualified person as defined in Article 16(2)(c), or

  (b) entitled to benefits under the Limitation of Benefits Article.

In contrast to Article 10(2), voting power for the purposes of Article 10(3) is limited to shares that are held “directly” by the beneficial shareholder and therefore excludes indirect ownership through corporate chains. 

Asena Advisors is the only multi-disciplinary (Accounting and Legal) international CPA firm in the United States that specializes in U.S. -Australia taxation.
Contact

The shareholder company will be a “qualified person” if:

1. its principal class of shares is listed on a recognized stock exchange and is regularly traded on one or more stock exchanges. A recognized stock exchange is a recognized stock exchange under Australian or US law and any stock exchange agreed by the ATO and IRS as explained in Article 16(6), or

2. at least 50% of the vote and value of the shares in the shareholder company must be owned directly or indirectly by five or fewer companies that are listed on a recognized stock exchange as defined in Article 16(6). Importantly in addition, where the shares in the shareholder company are held indirectly, each intermediate owner must be a resident of either Australia or the US.

Where a shareholder company is not a qualified person the exemption from withholding tax may still be available provided that the ATO or IRS makes a determination under Article 16(5). 

Article 10(4) provides that dividends paid by a Regulated Investment Company (RIC) or Real Estate Investment Trust (REIT) are not eligible for the 5% maximum rate of withholding tax in Art 10(2)(a) or the exemption from withholding tax in Art 10(3). Accordingly, the 15% withholding rate will generally apply to these entities.

Article 10(5) excludes from the general source country withholding tax limitations under Art 10(2), (3) and (4) dividends paid with respect to holdings that form part of the business property of a permanent establishment as defined in Article 5 or fixed base situated in the source country. 

Article 10(6) defines “dividends” to mean income from shares and amounts subject to the same taxation treatment as income from shares under the laws of the country where the company making the distribution is a resident.

In Australia the rules for defining what constitutes equity in a company and what constitutes debt are set out in ITAA97 Div 974 of the ITAA 1997 that apply from 1 July 2001. 

In the case of the US, the term dividends include amounts treated as a dividend under US law upon the sale or redemption of shares or upon a transfer of shares in a reorganisation. Further, a distribution from a US publicly traded partnership, which is taxed as a corporation under US law, is a dividend for purposes of Article 10. However, a distribution by a US LLC is not a dividend for purposes of Article 10 if it is not taxable as a corporation under US law.

Article 10(7) states that where a company which is resident for example in the US and derives profits or income from Australia, Australia is not permitted to tax dividends paid by the company unless either:

1. the person beneficially entitled to the dividends is a resident in Australia; or

2. the shares in respect of which the dividends are paid is effectively connected with a permanent establishment in Australia.

Therefore, Article 10(7) overrides section 44(1)(b) of the ITAA 1936 which permits Australia to tax dividends paid to non-residents to the extent of profits derived from sources within Australia. 

Similarly, it overrides the ability of the US to impose taxes under Code s 871 and Code s 882(a) on dividends paid by foreign corporations that have a US source under Code s 861(a)(2)(B).

Article 10(7) also provides that the Contracting States cannot impose tax on a company’s undistributed profits even if the dividends are wholly or partly paid out of profits in the relevant Contracting State unless Article 10(8) applies.

However, Article 10(7) does not restrict a State’s right to tax its resident shareholders on undistributed earnings of a corporation resident in the other State. The authority of the US to impose the foreign personal holding company tax, the taxes on subpart F income and on an increase in earnings invested in US property, and the tax on income of a passive foreign investment company that is a qualified electing fund is in no way restricted by this provision.

Article 10(8) permits Australia and the US to impose a branch profits tax on a company that is a resident in the other State. This tax is in addition to other taxes permitted by the Convention.

Currently, Australia does not impose a branch profits tax. However, if Australia were to impose such a tax, the base of such a tax would be limited to an amount analogous to the US dividend equivalent amount.

Article 10(9) lastly provides that the branch profits tax permitted by Article 10(8) shall not be imposed at a rate of withholding tax exceeding the maximum direct investment dividend rate of withholding tax of 5% in Article 10(2)(a).

CONCLUSION 

As you can see, Article 10 of the DTA is comprehensive and one should be cautious when applying it to a specific situation. 

Our team of International Tax specialists at Asena Advisors, advise numerous clients and corporations on their international structuring and how to make sure it is done in the most tax effective way. 

Shaun Eastman

Peter Harper