There is a reason professional service providers such as CPAs, EAs and lawyers have to go through continuous education and testing to be licensed to practice. And if you’re unlicensed, you tend to stay away from things you aren’t an expert in.
For example, unless a licensed attorney has an LLM designation, they usually stay away from detailed tax matters, and CPAs and EAs should probably stay away from giving detailed legal advice. The same holds true for entity document preparation services.
I received an email from one of these services recently. On the website, they had an FAQ section explaining all of the different entities they could form: corporations, LLCs, sole-proprietorships, d/b/a’s and general partnerships. For each, they listed the pros and the cons. For instance, for LLCs, some of the pros were flexibility, ease of formation and lack of yearly requirements like meetings. Some of the cons were flow-through taxation, self-employment taxes and that investors don’t like to invest in LLCs because of the flow-through and lack of requirements corporations have.
In my experience, people who invest in a disregarded entity, such as the default classification of an LLC, don’t mind the flow-through, as it is passive income or loss. Further, the flexibility is determined by the governing document, or Operating Agreement. This agreement can state anything you want it to. Further, LLCs can elect any taxation type they want.
The site then goes on to mention which states you should incorporate in. No surprise here: Delaware and Nevada are at the top of the list. The main reason for Delaware is privacy and their business-friendly court system. Nevada is listed for privacy reasons.
Let’s put common sense into the equation for a second. I am incorporated in Delaware, but my business is located in Florida. I will have to register in Florida as a foreign entity, which not only makes me list the officers or members, but creates the horrible term “nexus.”
I now have a nexus in Delaware and Florida, meaning I have to comply with the taxation rules of both states. Further, if my business is located in Florida and I am sued, Delaware has no jurisdiction, but the Sunshine State does. In short, what have I accomplished?
The site goes on to mention that LLCs are pass-through entries. Typically, if I own real estate, it doesn’t matter. However, if I decided to change my tax type to a C-corporation, the membership units can be converted to Section 1245 stock. If I hold the stock for 10 years and sell it for $10 million or less, I pay no taxes.
We have all been brainwashed to think C-corporations have double taxation. However, with all sorts of fringe benefits and retirement plans, double taxation rarely comes into play.
Let’s say I have investors, and the Operating Agreement is supposed to state that certain members are to receive certain allocations. As a document preparation service, placing that terminology in an Operating Agreement is an unauthorized practice of law! The best they can do is give you a boiler plate agreement.
So, what’s the takeaway here? Be careful of which services you choose, and make sure the professionals you are working with are licensed. Otherwise, you might get someone who makes a mess out of a complicated situation and doesn’t really understand the ins and outs of complex laws.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...