December 2019 Update
Reverse Veil Piercing
Disregarding the separate nature of an LLC and allowing a creditor of a member to reach the LLC’s assets to satisfy a judgment against the member is known as “reverse veil piercing.” In Curci Invs., LLC v Baldwin (2017) 14 CA5th 214, the court held that reverse veil piercing could be available to a judgment creditor of a member who, along with his wife, owned 100 percent of the LLC (distinguishing Postal Instant Press, Inc. v Kaswa Corp. (2008) 162 CA4th 1510). See §1.15.
Rules of Professional Conduct
Unless the attorney reasonably believes that it is not necessary in the best and lawful interest of the organization to do so, an attorney is required under the Rules of Professional Conduct to report to a higher authority of the entity, up to its highest authority, regarding the attorney’s knowledge of any act or refusal to act by a constituent of the organization (such as a manager, director, officer, employee, or member) from whom the lawyer takes direction, if the attorney knows or reasonably should know that the act or failure to act (1) is a violation of a legal obligation to the organization or a violation of law reasonably imputable to the organization and (2) is likely to result in substantial injury to the organization. See Cal Rules of Prof Cond 1.7. See §2.6.
The California court of appeal ruled that 100 percent owners of LLCs that conduct significant business in California are subject to the $800 minimum franchise tax. See Bunzl Distribution USA, Inc. v Franchise Tax Bd. (2018) 27 CA5th 986 (distinguishing Swart Enters., Inc. v Franchise Tax Bd. (2017) 7 CA5th 497). See §3.57.
The IRS issued final regulations under IRC §199A effective February 8, 2019: Treas Reg §§1.199A.1—1.199A.6 and 1.643(f)–1. See 84 Fed Reg 2952. See §4.32A.
The 20 percent deduction under IRC §199A only applies to income from qualified businesses. See IRC §199A(c)(1). A qualified business is any trade or business other than certain specified service trades or businesses (SSTBs) or a trade or a business that consists of performing services as an employee. IRC §199A(d)(1); Treas Reg §1.199A–1(b)(14). The definition of SSTBs specifically includes businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing in securities, partnership interests, or commodities, and any other trade or business where the principal asset is the reputation or skill of one or more of the owners or employees. IRC §199A(d)(2); Treas Reg §1.199A–5(b). Architectural and engineering services were specifically added to the list of qualified businesses; that is, architectural and engineering services are not specified service businesses. See IRC §199A(d)(2). The final regulations provide further guidance for determining whether a particular business is an SSTB. See Treas Reg §1.199A–5. See §4.32C.
Treasury Regulation §1.199A–5(b) defines SSTBs. For example, the performance of services in the field of the performing arts means the performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals in their capacity as such. The phrase does not include the provision of services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts or the provision of services by persons who broadcast or otherwise disseminate video or audio of performing arts to the public, such as persons working at a television station or performing arts center. Treas Reg §1.199A–5(b)(2)(vi). The final regulations do not address whether someone who manages or promotes the artist or provides services to the artist, such as catering, set design, or costumes, would be entitled to the deduction. See §4.32C.
Treasury Regulation §1.199A–5(b)(2)(ii) sets forth the meaning of performance of services in the field of health. Under the regulations, the phrase means the provision of medical services by individuals such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar health care professionals in their capacity as such. The performance of health services does not include the provision of services not directly related to a medical services field, even though the services provided may purportedly relate to the health of the service recipient. For example, the performance of health services does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or the research, testing, and manufacture and/or sales of pharmaceuticals or medical devices. See §4.32C.
The provision of IRC §199A most likely to cause the greatest discord is “any trade or business where the principal asset of such trade or business is the reputation or skill level of one or more of the owners or employees.” IRC §199A(d)(2). Needless to say, it is certainly feasible that many professionals whose reputation attracts customers or clients could fall into this category. Treasury Regulation §1.199A–5(b)(2)(xiv) defines the term “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” as any trade or business that consists of any of the following (or any combination of the following):
A trade or business in which a person receives fees, compensation, or other income for endorsing products or services;
A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or
A trade or business that receives fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
For purposes of the foregoing, the term “fees, compensation, or other income” includes the receipt of a partnership interest and the corresponding distributive share of income, deduction, gain, or loss from the partnership, or the receipt of stock of an S corporation and the corresponding income, deduction, gain, or loss from the S corporation stock. See §4.32C.
In the final regulations under §199A, the IRS declined to adopt a position that all rental real estate activity is deemed to be a trade or business for purposes of §199A. However, the final regulations provide that rental real estate (as well as licensed intangible property) will be treated as a trade or business under §199A if the property is rented to a trade or business conducted by the taxpayer-individual or a related pass-through entity that is commonly controlled with the individual under Treas Reg §1.199A–4(b)(1)(i). See Treas Reg §1.199A–1(b)(14). The regulations also have special rules for single-member LLCs whose owners are treated as conducting the business directly. See Treas Reg §1.199A–6. See §4.32C.
In addition, under a proposed safe harbor in IRS Notice 2019–07, 2019–09 Int Rev Bull 740, dated January 18, 2019 (a proposed revenue procedure), rental real estate is treated as a trade or business entitled to the IRC §199A deduction if at least 250 hours of “rental services” are performed each taxable year with respect to the real estate enterprise. Eligible services include services performed by an owner and employees, agents, and independent contractors of the owner. Rental services eligible for the safe harbor include (1) advertising to rent or lease the property or properties; (2) negotiating and executing leases; (3) verifying information from prospective tenants; (4) collection of rents; (5) daily operation, maintenance, and repair of the property or properties; and (6) supervision of employees and independent contractors. Eligible rental services do not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate. The IRS generally requires that separate books, records, and bank accounts be maintained to reflect income and expenses for each real estate enterprise and that the taxpayer or tax return preparer sign a statement under penalty of perjury that the taxpayer satisfies this safe harbor. See §4.32C.
Treasury Regulation §1.199A–2 provides guidance in the form of a three-step procedure for calculating the W-2 wages of a trade or business that are properly allocable to qualified business income (QBI). See also IRS Notice 2018–64, 2018–35 Int Rev Bull 347 (Aug. 8, 2018). First, each individual or related pass-through entity must determine its total W-2 wages paid for the taxable year under the rules in Treas Reg §1.199A–2(b)(2). That subsection defines W-2 wages as the amounts described in IRC §6051(a)(3) and (a)(8) paid with respect to employment of employees. Second, each individual or related pass-through entity must allocate its W-2 wages between or among one or more trades or businesses in accordance with the rules in Treas Reg §1.199A–2(b)(3). Third, each individual or related pass-through entity must determine the amount of the W-2 wages with respect to each trade or business that are allocable to the qualified business income of the trade or business (or aggregated trade or business) under the rules in Treas Reg §1.199A–2(b)(4). See §4.32E.
Separate business treatment could pose a problem for taxpayers that maintain many legal entities or an affiliated service company that provides management, accounting, purchasing, marketing, and similar service activities for a group of operating companies. The pass-through deduction by its terms applies to each business and not to business activities. Unlike the net investment income rules of IRC §1411, the pass-through deduction rules in IRC §199A do not refer to the passive activity loss rules. Thus, the final regulations under §199A do not allow real estate professionals to elect to treat rental real estate as a single trade or business, as is possible under the passive activity loss rules. The preamble to the final regulations states that the IRS generally believes that an entity cannot have two or more trades or businesses unless the entity could use different accounting methods under IRC §446 and Treas Reg §1.446–1. Under those rules, each business must maintain a complete and separable set of books and records. The final regulations set forth a set of aggregation rules, which are elective (Treas Reg §1.199A–4). See §4.32F.
Joint taxpayers whose income is $315,000 or less or single taxpayers whose taxable income is $157,500 or less are entitled to the §199A deduction. IRC §199A(b)(3)(A). On a joint return, the benefit is phased out between $315,000 and $415,000 of taxable income; for a single taxpayer, the benefit is phased out between $157,500 and $207,500 of taxable income. IRC §199A(b)(3)(B). The $157,500 amount is called the “threshold amount” and is subject to an inflation adjustment in tax years following 2018. IRC §199A(e)(2). The IRS has published the inflation-adjusted amounts for tax years beginning in 2019; business owners with taxable incomes below $321,400 (if married filing jointly) or $160,725 (if single) are permitted to take the special deduction under §199A without regard to the limit for certain service businesses. Rev Proc 2018–57, 2018–49 Int Rev Bull 827. See §4.32H.
The Bipartisan Budget Act of 2015 (Pub L 114–74, 129 Stat 584) changed the way the IRS will conduct audits of partnerships and LLC tax returns. The new rules (and the IRC citations to them in §5.16A) became effective for tax years beginning on or after January 1, 2018, although drafters of operating agreements should consider the effect of the rules before that date because most LLCs formed in the several preceding years were still in existence in 2018. The new rules apply to all partnerships and LLCs, except those that are qualified to elect out and affirmatively do so for a given year. See IRC §6221(b). The IRS has issued final regulations to implement the new rules, effective February 27, 2019. See 84 Fed Reg 6468, 6530. The final regulations affect partnerships and LLCs for taxable years beginning after December 31, 2017, and ending after August 12, 2018, as well as partnerships and LLCs that make the election to apply the new rules for certain earlier taxable years specified in the regulations. These regulations are in addition to the final regulations, effective August 9, 2018, concerning the “partnership representative” (discussed below). See 83 Fed Reg 39331. See §5.16A.
Under IRC §6225(c)(2)(B), an LLC member may pull in the adjustments by (i) paying the tax due with respect to its share of the adjustments; (ii) agreeing to take into account, as required by the IRS, the adjustments to its tax attributes; and (iii) providing such additional information as the IRS may require with respect to the LLC’s imputed underpayment. This so-called pull-in election (also referred to as the pull-in procedure) does not require participation of the other partners or members and allows the LLC to reduce its imputed underpayment by the amounts paid by the members who pull in. The election must be made by the LLC (and proof of the member’s payment submitted) within 270 days after the date of the IRS notice of adjustment. See IRC §6235(a)(2). See §5.16A.
Effective August 9, 2018, the IRS issued final regulations governing the designation and authority of the partnership representative. See Treas Reg §§301.6223–1, 301.6223–2. See §5.16A.
California Secretary of State
The California Secretary of State has instituted a service (called Bizfile California) that allows a user to fill out and file articles of organization (Form LLC-1) online. See https://www.sos.ca.gov/business-programs/bizfile/. Once a user starts the process for formation of an LLC online, the Bizfile service displays a series of screens that ask for the information needed to complete the articles of organization. When the user enters a name for the proposed LLC, the service performs a preliminary name check for exact name matches to see if the name is available. A final name review determination is performed after submission.Once the name is selected, the Bizfile service displays the other fields that appear on the print version of the articles of organization (Form LLC-1) (see §7.14). The service uses an address look-up tool to check the validity of the initial street address of the designated office in California as well as the address for the agent for service of process. The service is designed to reduce the number of rejections of filings for failure to provide required information. The Bizfile service allows a user to select a future file date for the LLC-1. Although the online submission of an LLC-1 via Bizfile California is instantaneous, the LLC-1 is not deemed filed until reviewed and accepted by the Secretary of State, and that process typically takes several days. The file date and time for an LLC-1 submittted through Bizfile California is the date and time that the eligible document is received by the Secretary of State. 2 Cal Code Regs §29102(b)(1). The user pays the online filing fee with a credit card. The user will receive a free copy of the filed articles of organization via e-mail. At the time of filing, the user can elect to have a certified copy for an additional $5.00 fee. See §7.13A.
A document eligible for expedited filing may be submitted electronically through the Secretary of State’s website. Any such documents submitted outside the regular business hours of the Secretary of State will be deemed to have been received, for file date purposes, when received by the Secretary of State. The Secretary of State’s response time, however, will not begin until the beginning of the next business day. 2 Cal Code Regs §21905(j). See §7.26.
Cancellation of LLC
An LLC that has filed a certificate of cancellation will continue to exist for the purpose of winding up the affairs of the LLC, prosecuting and defending actions by or against it in order to collect and discharge obligations, disposing of and conveying its property, and collecting and dividing its assets. See Corp C §17707.06(a); DD Hair Lounge, LLC v State Farm Gen. Ins. Co. (2018) 20 CA5th 1238, 1243. Corporations Code §17707.08(b)(i) states that a certificate of cancellation is to be filed on completion of the winding up of affairs in accordance with Corp C §17707.06. Corporations Code §17707.08(c) states that, on filing a certificate of cancellation, an LLC is canceled and its “powers,” rights, and privileges shall “cease.” The ambiguity among the certificate of dissolution, the certificate of cancellation, and the applicable authority of the manager is likely to be addressed in future legistation. Pending that correction, some commentators have noted a possible loss of liability protection for actions occurring after the filing of a certificate of cancellation. However, the language of Corp C §17706(a) expressly authorizes continued actions by the LLC. See DD Hair Lounge, LLC v State Farm Gen. Ins. Co., supra. See §13.2A.
Employee Versus Independent Contractor Status
California has limited the ability of an employer to characterize workers as independent contractors rather than employees. In Dynamex Operations W., Inc. v Superior Court (2018) 4 C5th 903, the California Supreme Court clarified the standard to be used in determining a worker’s status for purposes of Industrial Welfare Commission wage orders. The court adopted a three-part “ABC” test, which (4 C5th at 955)
presumptively considers all workers to be employees, and permits workers to be classified as independent contractors only if the hiring business demonstrates that the worker in question satisfies each of three conditions: (a) that the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of the work and in fact; and (b) that the worker performs work that is outside the usual course of the hiring entity’s business; and (c) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
For further discussion of Dynamex, see Garcia v Bardet Transp. Group, LLC (2018) 28 CA5th 558; Advising California Employers and Employees (Cal CEB). See §13.40A.
Delaware Series LLCs
As the Delaware legislature evolves to meet the needs of the business community, it has amended its Limited Liability Company Act to allow for the formation of registered series of members, managers, limited liability company interests, or assets. See 6 Del C Ann §18–218. If an LLC agreement provides for the establishment of one or more series, then a registered series may be formed. A registered series is formed by filing the certificate of registered series in the office of the Delaware Secretary of State. The name of the LLC, the address of its registered office in Delaware, the notice of the limitation of liabilities of the registered series, and the name of the registered series must be set forth in the certificate of registered series. The name of the registered series must begin with the name of the LLC itself, and also be distinguishable from the name of other business entities formed or organized, registered, or qualified to do business in Delaware. See §15.3A.
Substitution of Living Trust as Partner or Member
Han v Hallberg (2019) 35 CA5th 621, petition for review granted (Aug. 21, 2019, No. S256659) 2019 Cal Lexis 6316, involved a general partnership rather than an LLC, but its holding could be applicable in LLCs. In Han, the partnership agreement had been amended to allow one of the partners, a Dr. Hallberg, to assign his partnership interest to his living trust and to substitute Dr. Hallberg in his capacity as the trustee as a general partner in place of Dr. Hallberg as an individual. Dr. Hallberg died later, and litigation followed concerning whether his death triggered the buyout provisions in the agreement that applied in the event of a partner’s death. The court held that the assignment of Dr. Hallberg’s partnership interest to his living trust effectively substituted the trustee as a general partner, as authorized by the partnership agreement amendment. Dr. Hallberg’s death was therefore not the death of a partner and did not trigger the agreement’s buyout provisions. The court also held that the substitution of a successor trustee did not cause dissociation of the trust-partner from the partnership, regardless of whether the partner was identified as the trust or as the trustee. See §16.28.
Administrative Cancellation of LLCs and Abatement of Franchise Taxes
RULLCA was amended, effective January 1, 2019, to add new Corp C §17713.10.1 to address the problem of inactive LLCs with no assets, but which continue to accrue tax, interest, and penalties. Section 17713.10.1 establishes a procedure by which a domestic limited liability company may be administratively canceled if the company’s powers, rights, and privileges have been suspended by the Franchise Tax Board for at least 60 continuous months in accordance with Rev & T C §23301. The Franchise Tax Board initiates the procedure by giving notice to the LLC at its last known address and to the Secretary of State. If the LLC does not make a written objection within 60 days, the LLC will be administratively canceled, as evidenced by a certificate of the Secretary of State. If the LLC is canceled administratively, the LLC’s liability for the minimum franchise tax, interest, and penalties will be abated, as well as the penalties for not filing a statement of information. Corp C §17713.10.1(h). No administrative or civil action may be taken or continued to collect those liabilities. However, an administrative cancellation will not discharge the LLC’s liability to creditors or any liability of members. For example, an administrative cancellation would not affect the liability of members who received an illegal distribution. See §16.44A.
Limited liability companies that have been administratively canceled (see §16.44A) are now allowed to seek abatement of unpaid minimum franchise taxes, interest, and penalties under Rev & T C §23310, effective January 1, 2019. The statutory procedure for abatement is available to an LLC that is a “qualified entity” under the statute. The term “qualified entity” includes an LLC that satisfies either of the following two conditions:
The entity never did business in California at any time after its formation; or
The entity was previously doing business and has filed all of its returns for the tax years prior to its cessation of doing business.
The abatement procedure is initiated by the LLC, which must certify, under penalty of perjury, that for the relevant tax years it was not doing business, has ceased doing business, and does not have any remaining assets in the business. See §16.44C. A condition of the abatement is the cancellation of the LLC by the Secretary of State prior to the abatement. The abatement would not apply to any year before the LLC’s cessation of doing business in California. For further information concerning the abatement procedure, see https://www.ftb.ca.gov/help/business/administrative-dissolution-cancelation.html. The FTB form required to be submitted is illustrated in §16.44C and is available at https://www.ftb.ca.gov/forms/misc/3716-PC.pdf. See §16.44B.