What you should know after you form your entity.
You received advice and decided with the help of your legal and tax advisors. You have a new limited partnership or a new limited liability company. Now what? Where you created the new entity to engage in your new business, keeping the entity separate from your personal accounts is crucial to avoid claims of piercing the veil and personal liability for the actions of the company. Where you created the new entity for family wealth creation, management and protection, it is likewise important to remember the entity is separate from you and your other assets.
The cases you may hear or read about with negative results for owners, members, partners and taxpayers are often the result of the intermingling of assets and failure to adhere to the legal formalities. Recognizing the entity structure and adhering to the entity requirements is crucial to obtain the benefits the entity achieved.
The dangers of ignoring the structure and requirements may be disastrous to your business, family or estate plan. Adhering to the structure and requirements is easy.
Remember the entity account is not your own personal checkbook. These funds belong to the entity and should only pay entity related items. If you need to obtain funds from the entity do so under a plan of distribution made equitably to all entity owners, partners, or members. Open bank accounts in the entity name using the entity’s tax identification numbers. The checks for the entity’s bank account should clearly show the name of the entity and its address. The signature line for the check should clearly demonstrate that you or whoever has signing authority for the entity signs the checks as an authorized representative of the entity. As a casual observer looks at the checks it should be obvious that the check was signed in a representative capacity and not in personal capacity. This is most easily accomplished by adding the entity name above the signature line and then the word “by” in front of the signature line and the phrase “authorized agent” or something similar printed under the signature line.
Remember to keep your personal assets separate from the entity assets. An implied agreement allowing you to use assets of the entity like a vacation home or an automobile without paying fair market value rent can cause all assets of the entity characterized as your personal assets. This can cause harsh consequences dealing with creditors of the entity and taxation to you instead of the entity.
Distributions from the entity must be pro rata to the partners or members according to their ownership percentage interests by the date of the distribution. If your Partnership is owned 1% by a Limited Liability Company General Partner which your trust owns, 79% limited partnership interest by your Living Trust, and 20% limited partnership interest by an irrevocable Gifting Trust, and you wish to receive $10,000 from the Partnership, then a total distribution of $12,500 must be made from the Partnership. One percent or $125 will be paid to the LLC General Partner (and may be immediately thereafter redistributed to your trust if it owns the LLC), 79% or $9,875 will be paid to your Living Trust, and $2,500 will be paid to the Gifting Trust.
If a distribution to all owners is not desired, then withdrawal of funds from the entity may be documented as a loan. Documentation is critical. To satisfy the Internal Revenue Service, creditors, and other owners, a promissory note or similar instrument must memorialize the loan. The loan may be secured or unsecured but must include interest and repayment requirements. Then repayment must be made and documented according to the loan instrument. Discussions with your legal and tax advisors will help you decide what terms and conditions should be included.
If you manage the entity’s assets or provide other valuable service to the entity, the entity may pay you compensation for your service. If the entity pays you compensation for services rendered, then appropriate employment taxes must be paid on the compensation paid to you.
If you wish to make additional contributions of cash or other property to the entity, document the contributions. Adjustments in the ownership interests must be made in the entity records. Your tax and legal advisors can help you with this adjustment. Likewise, if you make gifts of entity ownership interests, you must document the gift on the entity’s records. Often, owners make gifts of ownership interests for estate or income tax purposes. Consult your legal and tax advisors to assure the gift is appropriate to accomplish your desired purpose. Then document the gift to assure it is accomplished properly.
To properly account for the value of the gift of an entity interest, you may need to have an appraisal of the entity interest. This differs from appraising the property owned by the entity. The owners of the entity do not own the entity’s property. You may need to have an appraisal of the entity’s property and then an appraisal of the value of the entity’s ownership interests. The appraisal should be accomplished by a qualified appraiser with experience valuing entity interests. You want to assure the appraiser accounts for fair market value discounts that may be available like lack of control or lack of marketability.
Owners often time their gifts of entity interests to straddle the calendar year. This allows owners to pay for a single appraisal and make annual gifts in two calendar years. You must make the gifts of ownership interest within a reasonable time of the appraisal. You most efficiently use the cost of the appraisal when you get two years of annual gifting from one appraisal. You do this by making a gift of ownership interests effective by December 31 and another gift of ownership interests on or after/January 1.
This is not an exhaustive list but adhering to these guidelines will put you well on your way to maintaining the integrity of your new entity.