Frequently Asked Questions About LLCs and Section 199A
Attorney John Cunningham, the author of the paragraphs that follow, is nationally recognized for his comprehensive knowledge and experience in the fields of both LLC practice and section 199A practice. Wolters Kluwer Law & Business, a major international legal and tax information service, has published authoritative books by him in both of these fields. John is one of the few professionals able to meet simultaneously both the LLC needs and the section 199A needs of business owner clients. He provides these clients with the fee economies, speed and thoroughness of LLC and section 199A one-stop-shopping.
II. LLCs and Section 199A—Overview
Because of their superior law and tax, LLCs are, by a substantial margin, the entities of choice for most single-owner and multi-owner closely-held businesses in every U.S. jurisdiction. Thus, all owners of these businesses should have at least a basic knowledge of LLCs.
However, because maximizing their federal income tax deductions under new Internal Revenue Code section 199A (further described below) is critical to all LLC members, LLC owners also need to have at least a basic understanding of these extraordinary deductions.
In addition, owners of non-LLC businesses, such as corporations, who want to maximize their section 199A deductions will often be able to do so only through a sophisticated use of LLCs. Thus, these owners must understand not only section 199A but also LLCs.
LLC expertise and section 199A expertise differ greatly from one another. However, for owners of closely held businesses, they are, as indicated above, profoundly interdependent and mutually supportive.
III. LLCs—Basic Questions and Answers
Set forth below are basic questions and answers about LLCs. The most comprehensive source of practical information about LLC law and tax is Attorney John Cunningham’s book entitled Drafting Limited Liability Company Operating Agreements, published by Wolters Kluwer Law & Business.
1) WHAT IS AN LLC?
“LLC” is an abbreviation for limited liability company. LLCs are a type of legal entity that are formed under a state-law statute by filing with secretaries of state or similar state officers official documents called by names such as “articles of formation.”
2) WHAT IS A “LEGAL ENTITY”?
A legal entity is an organization that is able to act in its own name, hold property in its own name, and sue and be sued in its own name.
3) DO THE LAWS OF ALL STATES AUTHORIZE LLCs?
Yes, the laws of all states authorize both single-member and multi-member LLCs.
4) WHICH ARE THE BEST LLC ACTS?
Many lawyers consider the Delaware Limited Liability Company Act to be the best LLC act, and attorney John Cunningham has formed many Delaware LLCs.
5) HOW ARE LLCs TAXED FOR FEDERAL INCOME TAX PURPOSES?
- Single-member LLCs (i.e., those with just one owner) can be subject to federal income tax as sole proprietorships, S corporations or C corporations.
- Single-member LLCs owned by entities can be taxed as divisions of their member, as C corporations, or a “qualified Subchapter S Subsidiaries.”
- Multi-member LLCs can be taxed as C corporations, S corporations or partnerships.
6) FROM A NON-TAX VIEWPOINT, ARE LLCs BETTER THAN OTHER TYPES OF ENTITIES?
Generally, yes. For example, they are better than state-law business corporations because they are simpler and more flexible and because they provide better asset protection. In general, businesses should be operated as state-law business corporations only if they are public companies or if they plan to go public.
7) WHAT ARE LLC OPERATING AGREEMENTS, AND ARE THEY NECESSARY FOR SINGLE-MEMBER AND MULTI-MEMBER LLCs?
- For single-member LLCs, operating agreements are agreements between these LLCs, their members, and any managers or assistant managers they may have. They are useful to their members because, among other things, they can help to prevent veil-piercing.
- For multi-member LLCs, operating agreements are virtually indispensable not only to lessen the risk of veil piercing but also to prevent and resolve disputes among the members.
8) WHAT IS “VEIL PIERCING”?
Veil piercing is a judge-made doctrine under which the liability shield of an LLC may be disregarded and its members may be personally liable for claims against it if, among other things, the LLC is used for fraudulent purposes or lacks adequate start-up capital or fails to maintain books and records separate from those of its owners.
9) WHAT STATUTORY ASSET PROTECTIONS DO LLCs PROVIDE?
These protections vary from one LLC act to another. However, most acts provide three kinds:
- They provide liability shields, which protect members from claims against their LLCs unless the members themselves have engaged in the misconduct leading to the claims.
- They provide charging order protections, which limit the remedies of creditors of debtor-members to certain distributions otherwise available to the debtor-members.
- They provide “pick-your-partner” protections, which prevent creditors from obtaining judicial orders transferring debtor-members’ membership rights to the creditors.
10) DO YOU NEED AN LLC LAWYER TO FORM A MULTI-MEMBER LLC?
No, but a competent LLC lawyer can, among other things, draft an operating agreement for your LLC that will define and protect your LLC membership rights and will teach you how to avoid veil-piercing.
11) DO YOU NEED AN LLC LAWYER TO FORM A SINGLE-MEMBER LLC?
Generally yes, because even a single-member LLC should have a written operating agreement, and only a well-trained LLC lawyer can enable you to plan, negotiate and draft that agreement competently.
12) DO YOU NEED A CPA OR OTHER TAX PROFESSIONAL TO HELP YOU FORM A SINGLE-MEMBER OR MULTI-MEMBER LLC?
Yes, because one of the most important decisions in forming both single-member and multi-member LLCs is the decision as to the federal income tax regimen that will govern the LLC. To decide this question, you will need the assistance of either an accountant or a lawyer with expertise in federal income tax law and Social Security Tax and Medicare Tax law. In addition, with the advent of new Internal Revenue Code section 199A on January 1, 2018, your tax professional must have comprehensive section 199A expertise.
IV. Frequently Asked Questions About Section 199A
Preliminary note. The most comprehensive source of practical information about section 199A is Attorney John Cunningham’s book entitled Maximizing Pass-Through Deductions Under Internal Revenue Code Section 199A—a Section 199A Practice Manual, published by Wolters Kluwer Law & Business. Set forth below are the most basic questions and answers about section 199A.
1) WHAT ARE THE MOST BASIC THINGS I SHOULD KNOW ABOUT SECTION 199A?
- Section 199A provides federal income tax deductions to owners of pass-through businesses of 20 percent or more from their business income. Owners include both passive and active owners and both U.S. and foreign owners. Section 199A can save business owners thousands of dollars of federal income taxes every year.
- Pass-through businesses comprise sole proprietorships, S corporations and entities taxable as partnerships. Most multi-member LLCs are taxable as partnerships.
2) WHAT KINDS OF TAXPAYERS ARE ELIGIBLE FOR SECTION 199A DEDUCTIONS?
- S corporations
3) WHEN DID SECTION 199A BECOME EFFECTIVE?
January 1, 2018
4) WHY DID CONGRESS ENACT SECTION 199A?
Effective January 1, 2018, the top federal income tax rate for C corporations decreased from 35% to a flat rate of 21 percent. Before January 1, 2018, pass-through businesses had a roughly 10% federal income tax rate advantage over C corporations. The purpose of section 199A was to preserve that advantage.
5) HOW LONG WILL SECTION 199A BE IN EFFECT?
Under the terms of section 199A, the section will expire at the end of 2025. However, there is a good chance that before 2026, Congress will extend the section indefinitely.
6) DO ALL TAXPAYERS THAT ARE ELIGIBLE FOR SECTION 199A DEDUCTIONS RECEIVE THE SAME DEDUCTION?
No. There are seven different categories of eligible taxpayers, and a different rule governs the deduction available to taxpayers in each of these categories.
7) IS SECTION 199A COMPLEX?
Yes, some tax professionals believe that it is among the most complex and difficult provisions in the entire Internal Revenue Code.
8) WHY IS SECTION 199A SO COMPLEX?
- It has several basic purposes, which can conflict with one another.
- It is written in dense “taxese.”
- A number of its key provisions are extremely complex, and the meaning of several other provisions is very unclear.
- There are 150 pages of section 199A regulations.
- Many business owners must substantially restructure their individual, business and federal tax arrangements in order to maximize their deductions and, in some cases, even to receive them. Planning and implementing the proper restructuring is often difficult, and requires extensive expertise.
9) WHAT ARE THE MOST FREQUENT TYPES OF RESTRUCTURING THAT ARE NECESSARY TO MAXIMIZE SECTION 199A DEDUCTIONS?
- Many taxpayers whose businesses are a single-shareholder or multi-shareholder S corporation must convert them to a sole proprietorship or partnership in order to maximize their section 199A deductions.
- Many other taxpayers whose businesses are sole proprietorships or partnerships must do the reverse—they must convert their businesses to single-shareholder- or multi-shareholder S corporations to maximize their section 199A deductions.
10) HOW DO INDIVIDUALS WHO BELIEVE THEY ARE ENTITLED TO SECTION 199A DEDUCTIONS CLAIM THESE DEDUCTIONS?
They must do so on Line 9 of the new Form 1040. The Internal Revenue Service instructions for Line 9 provide only very limited guidance as to the amount that individuals should claim, and these instructions are silent about the possible need for restructuring—and arguably even misleading.