All About Limited Liability Companies (LLC)

Limited liability companies (LLCs) are a popular choice of
entity for small businesses and investment activities.

LLC owners are called members.

·
Single-member LLCs have one owner,
although spouses who jointly own an LLC in a community property state can elect
treatment as a single member LLC for federal income tax purposes.

·
We will call LLCs with two or more
members multimember LLCs.

Key point: LLCs are not corporations. But LLCs can
offer similar legal protection to their members (owners).

Here are the most important things to know about LLCs.

LLCs Offer Legal
Protection

Using an LLC to conduct a business or investment activity generally
protects your personal assets from LLC-related liabilities—similar to the legal
protection offered by a corporation.

As you know, liabilities can arise from simple things—like
the Federal Express guy slipping on the banana peel someone left on your front
steps—or in seemingly endless and complicated ways if you have employees.

Key point. As a general rule, no type of entity
(including an LLC) will protect your personal assets from exposure to
liabilities related to your own professional malpractice or your own tortious
acts.

Tortious acts are wrongful deeds other than by breach
of contract—such as negligent operation of a motor vehicle resulting in
property damage or injuries. The issue of liability protection offered by an
LLC is a matter of state law. Seek advice from a competent business attorney
for details.

Single-Member LLC Tax
Basics

Single-member LLC businesses owned by individuals are
treated as sole proprietorships for federal income tax purposes unless you elect
to treat the single-member LLC as a corporation.

In other words, the default federal income tax
treatment for a single-member LLC business is sole proprietorship status. Under the default
treatment, you simply report all the single-member LLC’s income and expenses on
Schedule C of your Form 1040.

If the single-member LLC business
activity generates net self-employment income, you will report that on Schedule
SE of your Form 1040.

Rental. If the single-member LLC activity is a rental
activity, you report the rental income and expenses on Schedule E of your Form
1040.

Farm or ranch. You report the numbers for a farming
or ranching activity on Schedule F.

Simple. You don’t need to file a separate federal
income tax return for the single-member LLC. And other things being equal,
simple is good.

Three key points

1.
The big federal income tax
advantage of operating as a single-member LLC is extreme simplicity.

2.
The big non-tax advantage is
liability protection, under applicable state law.

3.
As mentioned, you can elect to
treat a single-member LLC as a corporation for federal income tax purposes, but
we don’t recommend that, for reasons we explain later.

Multimember LLC Tax Basics

Multimember LLCs are treated as partnerships for federal
income tax purposes unless you elect to treat the LLC as a corporation.

In other words, the default federal income tax
treatment of a multimember LLC is partnership status. Under
the default treatment, you must file an annual partnership federal income tax
return on Form 1065.

From the Form 1065 partnership return, the LLC issues an
annual Schedule K-1 to each member to report that member’s share of the LLC’s
income and expenses. The member then takes those taxable and deductible amounts
into account on the member’s own return (Form 1040 for a member who is an
individual).

The LLC itself does not pay federal income tax. This
arrangement is called pass-through taxation, because the income and
expenses from the LLC’s operations are passed through to the members who then
take them into account on their own returns. (The same pass-through taxation
concept applies to entities set up as “regular” partnerships under applicable
state law.)

Electing to Treat the LLC
as a Corporation for Tax Purposes

You have the option of electing to treat a
single-member LLC or multimember LLC as a corporation for federal income tax
purposes. You do that by filing IRS Form 8832, Entity Classification
Election, to change the default classification of the single-member LLC or
multimember LLC to the new classification as a corporation.

If your desire is to have your LLC treated as an S
corporation, it can elect S corporation status directly using IRS Form 2553, or
it can elect C corporation treatment on Form 8832 and then S corporation
treatment on IRS Form 2553.

While there may be valid non-tax reasons for electing to
treat an LLC as a corporation, we think tax reasons generally dictate against
taking that step.

If you conclude that there are tax advantages to electing
corporate status, why not just actually incorporate your operation in
the first place? That’s simpler. Keeping your tax matters simple is generally
good policy.

Electing corporate status from the LLC could have unintended
tax consequences. For example, you can potentially collect
federal-income-tax-free gains from selling stock in a qualified small business
corporation (QSBC). But you must own shares and hold them for over five years
to cash in on this super-favorable deal. Can an
LLC membership (ownership) interest count as QSBC stock for this purpose?
Apparently not. It’s not stock.

If you are looking for the QSBC stock break, just set up as
a corporation in the first place.

Here’s another example: a special federal income tax break
allows you to annually deduct up to $50,000 of losses from selling eligible
small business stock, or $100,000 if you’re a married joint filer, and treat
the loss as a tax-favored ordinary loss instead of a tax-disfavored capital
loss.

Can an LLC membership interest count as eligible stock for
this purpose? Apparently not. It’s not stock. Avoid the problem—set up as a
corporation in the first place.

If you would like to discuss your entity choices, please
call me on my direct line at 408-778-9651.

Working at Home? Don’t Overlook These Deductions

Whether you claim a business office in the home or are
simply working at home, say because of COVID-19, you likely have some former
personal assets that you now use for business.

Ah, new tax deductions!

Yep. Say you don’t claim a home-office deduction but
now you are working at home and sitting in the fancy chair you inherited from
your grandmother.

Let’s say you use the fancy chair 85 percent for business
purposes. Can you depreciate 85 percent of that chair?

Yes.

Let’s say that grandma’s estate was appraised and this chair
had a value of $10,000 when you inherited it about a year ago. It’s an antique,
so it’s not gone down in value since you inherited it.

Depreciating a Formerly Personal Asset

When you convert the fancy chair to 85 percent business use,
the law sees you as placing the item in service in your business at that time.
That means you can begin depreciating the asset and claiming your tax
deductions.

To determine the basis to use for depreciation, use the
lesser of

• fair market value on the date of conversion from personal
  to business use, or
• adjusted basis of the property (generally the amount you
  paid for the asset plus the cost of any improvements).

With the fancy chair, your adjusted basis is the inherited
value.

But say you bought the chair for $8,000. Suppose it was
worth $10,000 when you converted it to personal use. You would use the $8,000
figure to determine your depreciation deductions.

Bonus Depreciation and Section 179 Expensing

Unfortunately, unlike assets directly purchased for your
business, you may not use Section 179 to immediately expense assets that you
convert from personal to business use.

Bonus Depreciation Is a Different
Story

If you acquire bonus depreciation qualified property for
personal use after September 27, 2017, and convert it to business use this year
(or anytime before 2027), you must use 100 percent bonus depreciation if you
don’t elect out of it.

Example. You purchased an antique clock for $9,300 in
January 2018. Yesterday, you placed the clock in business service by moving the
clock from your entryway to your home office. If you don’t make a formal
election in your tax return to elect out of bonus depreciation, you must claim
a $9,300 depreciation deduction on the antique clock this year.

Basis When You Sell

There’s a trick to basis when you sell converted
property—you use a different rule for calculating losses than you do for
calculating gains:

• Losses. To calculate losses, use your adjusted
  basis (conversion basis as discussed above minus depreciation).
• Gains. To calculate gains, use original cost basis
  minus post-conversion depreciation. In most cases, original cost gives you
  a higher basis and thus less tax. So don’t accidentally use adjusted
  basis.

Note. For inherited assets, your cost basis is the
estate value (generally, the date of death value).

Clarifying Examples

Let’s say you bought a personal use desk/credenza/bookcase
set for $8,000 and then converted it to business use when its fair market
value had fallen to $6,000. Here are the tax consequences for three different
sales scenarios (to make the examples clear, we ignored depreciation):

• Loss. If you sell the desk/credenza/bookcase set for
  $4,000, you have a $2,000 deductible loss ($6,000 – $4,000). Note. This
  is much better than if you sold the desk/credenza/bookcase set as a
  personal asset, which would create a zero deductible loss.
• Gain. If you sell the desk/credenza/bookcase set for
  $10,000, you have a $2,000 gain ($10,000 – $8,000).
• Gray area. If you sell the set for $7,000, you have
  neither gain nor loss on the sale. That’s a decent result—it means no
  taxes for you (but no deductible losses either).

If you have personal assets that you now use for business
and want to make them tax deductible, call me on my direct line (408-778-9651)
and we’ll implement a plan for those new deductions.

Two Correct Ways to Deduct Your Home Office with a Partnership

With the COVID-19 experience, you and your partners may be
doing a lot of work from home or even working from home primarily. Is the
home-office deduction in the mix?

If you operate your business as a partnership, you have two
ways to correctly deduct your home-office expenses.

If you have a tax-deductible home office and operate as a
partner in a partnership, you have two ways to get a tax benefit from the home
office:

1. Deduct the cost as an unreimbursed partner expense (UPE),
   or
2. Get reimbursement from your partnership via an accountable
   plan (think expense report).

Unreimbursed Partner
Expense

As a partner in a partnership, you generally can’t deduct
any of the partnership expenses on your individual tax return—the partnership
should pay for and deduct its own business expenses.

But if your partnership agreement or business policy forces
you to pay for the expense out of pocket with no reimbursement available, then
you can deduct the business expense in full on your individual tax return as a
UPE.

Because the UPE is a trade or business expense, it also
reduces your self-employment tax.

Deducting UPE is even better than taking a typical Schedule
C home-office deduction because you can deduct your full home-office expense even
when the partnership has a tax loss for the year.

Here are the two steps to claiming your UPE deduction:

1. Find your deduction amount using Form 8829 (but don’t
   include it with your tax return).
2. On a separate line on Schedule E, line 28, enter “UPE” in
   column (a) and the expense amount in column (i).

Accountable Reimbursement
Plan

The other option for realizing your home-office deduction is
to have your partnership reimburse you for your home-office expenses under an
accountable plan.

When your partnership does this, the reimbursement is

• tax-free to you, the partner, and
• tax deductible to the partnership, which reduces your
  share of the taxable net income from the partnership.

Here are the three steps to obtaining the reimbursement:

1. Find the reimbursement amount using Form 8829 (including
   depreciation).
2. Submit your reimbursement request with appropriate
   documentation within the time frames required by your partnership’s
   accountable plan policy.
3. Receive a reimbursement check from your partnership.

Why Reimbursement Is Best—Example

John is a 20 percent partner in Rainbow, LLC, which is a
partnership for federal tax purposes. He’s in the 24 percent federal tax
bracket (for this example, we’ll ignore the self-employment tax).

Let’s assume John uses Form 8829 and calculates his home-office
deduction as $4,000.

If John deducts the $4,000 as UPE, it puts $960 in his
pocket (24 percent of $4,000).

But if John receives an accountable plan reimbursement from
the partnership, it puts $4,192 in his pocket:

• $4,000 as a tax-free reimbursement, and
• $192 from reduced pass-through income (24 percent of $800,
  which is 20 percent of the $4,000 partnership expense).

If you are a candidate for the home-office deduction and
want to pursue this deduction, please call me on my direct line at 408-778-9651.