Using a California LLC in Advanced Estate Planning
And while every owner and each business is unique, the reasons for choosing a business entity are usually the same. You want to reduce your personal liabilities and minimize your taxes. But many people need to learn that an LLC can be part of an advanced estate planning strategy.
Business Entities: What are Your Choices?
Even though businesses have federal income tax obligations, business entities are state creations.
Whether you want to start a California LLC, a partnership, or a corporation, you must complete the applicable forms and file them with the State of California Franchise Tax Board and the required fees. And California law determines your obligations and protections under the various business entities you can choose from.
The main business entities in California are partnerships, corporations, and LLCs.These entities impact how you run your business but also affect your estate planning. Finding a qualified California estate planning attorney familiar with business and business formations is a wise move.
A partnership is formed when people or companies carry on a business venture as co-owners for profit. The three types of partnerships are general (GP), limited (LP), and limited liability (LLP).
Liability is a significant disadvantage of partnerships, and one of the main reasons most new business owners form LLCs. But partnerships offer one excellent tax advantage: the flexibility to allocate taxable income among the partners disproportionately. But these tax allocation rules are complex, and a good time to call in a qualified California attorney and accountant.
General Partnership (GP)
A general partnership is easy to form in California. Although having a written partnership agreement is a sound business practice, California does not require it. And when you do have a written partnership agreement, filing it with California is optional.
One of the dangers of a partnership is it can be created unknowingly. If two people engage in a business venture and agree to share profits and losses, they may be deemed a partnership. Since each partner is personally liable for the obligations of the other, this business entity can be extremely risky.
But partnerships pay no taxes because the income, gains, and losses are passed through to the partners. And the IRS allows a disproportionate allocation of taxable income between the partners.
Limited Partnership (LP)
A limited partnership usually has one or more "general partners" and one or more "limited partners." The general partner(s) customarily operate and manage the business. The limited partners have an ownership share of the company but are prohibited from managing the partnership. But the advantage to being a limited partner is they are usually not personally liable for partnership debts.
Unlike a general partnership, a California limited partnership is required to file the partnership with the state. But, like a general partnership, it can disproportionately allocate taxable income or losses among the partners.
Limited Liability Partnership (LLP)
Certain licensed professionals choose a limited liability partnership LLP. While every state is different, in California, LLP partners must be licensed attorneys, architects, or accountants. Generally, the limited partners are not responsible for the partnership's debts, obligations, or liabilities from negligence, malpractice, or other misconduct by another partner or employee.
A corporation is a more formal business entity than a partnership or an LLC. Corporations must register in California, pay annual and yearly fees, and file the required forms. Corporations also maintain formal records, including articles of incorporation, meetings, minutes, resolutions, by-laws, shares, and more.
And running a corporation is also more formal, with an elected board of directors, officers, shareholders, and employees. The shareholders usually elect a Board of Directors, who then hire the company's officers. The officers operate the company and hire employees. Most large corporations, like Walmart, Amazon, and Apple, have thousands of shareholders and are C-corps.
But double taxation is a problem for small companies that choose to be a C-corp. When Walmart makes a profit, they pay corporate income taxes. For 2022, Walmart's income tax obligation is $4.7 billion. And then, depending on the Board of Directors, Walmart will send out dividends to its shareholders, who are responsible for paying taxes on the dividend income. So Walmart pays tax on the profit, and the shareholders pay tax on the dividend. The same money is taxed twice.
But in a small corporation, the owner or his family might own all the shares. Suppose the family business is operated as a C-corp. In that case, there will be double taxation before the owners can keep the profit.
First, the company pays taxes on any profit. Then if the owners issue themselves a dividend, they must also pay taxes on the dividend income. The owners and their small companies pay taxes twice on the same income.
But the IRS has a provision to help smaller corporations. If the company qualifies, it can be taxed under the IRS S-corp rules. The company's income and losses pass directly through the corporation to the shareholders. The income and deductions are passed through to each shareholder in proportion to their ownership and reported on their personal income tax returns. So, there is no tax at the corporate level and no double taxation.
This is a considerable tax saving, and the company still maintains the advantages of a corporate structure.
The IRS rules for qualifying for S-corp taxation are
Must be a domestic corporation
May be individuals, certain trusts, and estates; but
May not be partnerships, corporations or non-resident alien shareholders
No more than 100 shareholders
Only one class of stock
What Are LLCs?
A Limited Liability Company, LLC, is a state-created entity designed to help small businesses. It gives liability protection like a corporation and pass-through taxation benefits like a partnership. And having very few formal requirements makes it the most popular entity for small businesses.
Here are some main benefits of an LLC.
Limited Personal Liability
While a corporation has shareholders and shares of stock, an LLC has members and membership interests. But like a corporation, an LLC is a separate legal entity from its owners.
With a sole proprietorship, you are personally liable for its debts and obligations. You are also usually personally liable for the partnership debts and obligations with a partnership. And if your business partner or employee is accused of negligence, your personal assets are at risk.
But an LLC is a separate entity responsible for its obligations and debts. Although you might lose the money you invested in the LLC, your personal assets can't be used to collect on the debts of the LLC.
LLCs Have Less Paperwork
Corporations offer limited liability but must follow certain corporate formalities, which can be cumbersome for small businesses. There are annual shareholder meetings, reports and fees to the state, recordkeeping, minutes, by-laws, votes, resolutions, and more.
LLCs are less formal and are not required to have annual meetings or file annual reports with the state.
An LLC can Choose its Tax Classification
While LLCs are responsible for federal tax obligations, the IRS does not recognize the LLC as a tax classification.
Business owners are often confused and believe their states and the IRS view business entities the same. They don't.
For example, many business owners believe that an S-corp and an LLC are the same thing. They are not.
An LLC is a business entity. An S corp is an IRS tax classification. The S-corp status is used to reduce a business's tax burden in certain circumstances.
The good news is that the LLC's owners can choose how they want to be taxed by the IRS. The IRS allows the LLC to be taxed as if it were a sole proprietorship, a partnership, or a corporation. And suppose the LLC meets the S-corp requirements listed above. In that case, it can enjoy the benefits of pass-through taxation and avoid the double taxation of a C-corp.
When you form a Califonia LLC, you must let the IRS know how you want to be taxed by filing IRS Form 8832, "Entity Classification Election." You may elect to have your LLC taxed as a partnership, an S-corp, or have your LLC income disregarded for tax purposes and added to your personal income. If you don't file Form 8832 within 75 days of starting your business, the IRS will use its default rules and choose your tax classification.
LLCs and Advanced Estate Planning
An LLC can be a superior business formation entity choice for running your business, getting asset and liability protection, and enjoying the benefits of pass-through taxation.
But LLCs offer strategic flexibility when used in advanced estate planning, including control and discounted valuation.
Control. For example, you can establish a family LLC and fund it with assets, cash, and investments you want to pass along to family members. Instead of gifting assets directly to family members during your lifetime, you can gift minority membership interests in the LLC. At the same time, since you have the majority of the interests, you still maintain control of the LLC and the assets.
Discount. Gifting membership interests in a small family LLC differs from gifting shares of Walmart or other large corporations. When you transfer assets like CDs, shares of stocks on a regulated exchange, or even real estate, these assets have an easily determined value.
But with a membership interest in a family LLC, it is challenging to determine the value since it is not easily traded, bought, or sold. And transfer restrictions in the LLC Articles of Organization may make the membership interest even more difficult to sell or transfer.
Therefore, the value of the LLC interests transferred to heirs can be steeply discounted, often up to 40% of their market value. Even when your LLC owns real estate or other assets, you are not transferring the assets. You are transferring a membership share of the LLC that owns those assets, and the discounted valuation applies.
Using an LLC in combination with other estate planning tools, like living and irrevocable trusts, can be the basis of a powerful estate planning strategy. Since all states have different business and estate laws, you should use a qualified estate planning attorney when choosing how to use an LLC in your estate planning.
Should an LLC be Part of Your Estate Planning?
A California limited liability company, LLC, is a flexible business entity that you can use to run your business and help in your estate planning. You get liability protection and tax advantages. And when you gift membership interests, you maintain control and get deep discounts in the valuation.
Should an LLC be part of your estate planning strategy?
Choosing the best estate planning tools and strategies for you and your family is complex and confusing for most families. What type of business entity should you choose? Which type of trust is best for you? How do you maximize your asset and liability protection while minimizing your taxes?
These are important decisions that can seem overwhelming. Advanced planning with a qualified California estate planning attorney is always the best option.
Let us help you choose the best options for you, your family, and your business.
At San Diego Legacy Law, our trust attorneys work closely with clients to evaluate their personal goals and available assets before incorporating trusts into their estate plans. Our founder, attorney Nicole D'Ambrogi, holds an LLM in International Taxation with concentrations in Financial Services and Wealth Management, which allows her to strategically analyze the many variables that can affect your ability to meet your estate planning goals instead of focusing on simple document preparation.
San Diego Legacy Law serves clients throughout San Diego and those in La Jolla, Del Mar, Rancho Santa Fe, El Cajon, Poway, Spring Valley, Chula Vista, Santa Rosa, Petaluma, Novato, and Healdsburg.
Contact us today to schedule a consultation to discuss your estate planning and asset protection needs.