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CHOICE OF ENTITY FOR REAL ESTATE OWNERS LIMITED LIABILITY COMPANY VS. S CORPORATION VS. C CORPORATION A Comparison Of These Business Entities Dean A. Rocheleau, J.D., CPA Plante & Moran, PLLC Southfield, Michigan 248-223-3225 Dean.Rocheleau@PlanteMoran.com I. OVERVIEW A. This outline compares the similarities and differences between the three major business entities currently selected by our clients to obtain limited liability protection. Two of the entities provide pass-through taxation treatment but with some significant differences. These are the Limited Liability Company ("LLC") and the S Corporation (“S Corp”). The third alternative, the C Corporation (“C Corp”), is subject to tax on its earnings at the entity level. B. This outline compares the attributes of multiple-owner Michigan LLCs, S Corps and C Corps. The outline primarily addresses issues to be considered when forming a new business entity for a particular client need, not necessarily when deciding whether to convert an existing business entity to an LLC, S Corp or C Corp. C. A checkmark (“”) is used to indicate where the LLCs, the S Corps or the C Corps provide an advantage with respect to a certain attribute. D. Note that all “section” references are to the Internal Revenue Code of 1986, as amended through September 30, 2005. II. GENERAL ISSUES A. Limited liability protection for owners 1. LLCs – One of the principal purposes for forming LLCs is to protect the members’ personal assets from the creditors of the LLC; absent any personal guarantees made by the members, the creditors of LLCs may only satisfy their claims from the assets of the LLC. 2. S Corps – One of the principal purposes for forming S Corps is to protect the shareholders’ personal assets from the creditors of the S Corp; absent any personal guarantees made by the shareholders, the creditors of S Corp may only satisfy their claims from the assets of the S Corp. However, S Corps have more case law testing the limits of the liability protection provided to its owners than do LLCs which are relatively new. 3. C Corps – Same attributes as S Corps. B. Participation of owners in daily management activities 1. LLCs – All LLC members may participate in the daily management activities and may contractually bind the LLC (unlike limited partners in a limited partnership) unless these management rights and obligations are delegated to managers in the Articles of Organization. 2. S Corps – Shareholders who are also employees may participate in the daily management activities and may contractually bind the S Corp as defined in the S Corp by-laws and other governing documents of the S Corp. 3. C Corps – Same attributes as S Corps. C. Familiarity 1. LLCs – Newer and, therefore, unfamiliar to many professionals and clients. They have had very few legal challenges to them so there are less authoritative rulings on them. 2. S Corps – More familiar to professionals and their clients. There is more legal and tax certainty when dealing with S Corps. 3. C Corps – Also more familiar to professionals and their clients, C Corps have a longer tax history than S Corps. As with S Corps, there is more legal and tax certainty when dealing with C Corps. D. Cost and complexity to establish 1. LLCs – More expensive and time consuming to establish. The costs related to evaluating, designing, and forming an LLC and its operating agreement are relatively higher because LLC flexibility requires more analysis for proper structuring. However, the LLC operating agreement typically includes provisions similar to a corporate buy-sell agreement. 2. S Corps – Typically, less expensive to establish because many provisions in the Articles of Incorporation and corporate by-laws are “boiler plate”. An S Corporation election must also be prepared and signed by all shareholders before it is filed (see further discussion in Section II. F. below). The shareholders may or may not enter into buy-sell agreements when establishing the S Corp (although this would be advisable). 3. C Corps – Typically, the least expensive of these three entities to establish because many provisions in the Articles of Incorporation and corporate by-laws are “boiler plate”. There is no taxation election required. The shareholders may or may not enter into buy-sell agreements when establishing the C Corp (although this would be advisable). E. Annual entity formalities 1. LLCs – Not required to hold annual member meetings with associated written minutes of such meetings. LLCs must file an Annual Statement with the Michigan Department of Consumer and Industry Services as well as annual income tax returns. No payroll tax returns are required if there are no employees and only LLC members provide services to the LLC. 2. S Corps – Statutorily required to hold annual shareholder meetings, etc. and the actions decided at such meetings recorded in official written corporate minutes. S Corps must file an Annual Report with the Michigan Department of Consumer and Industry Services as well as annual income tax and payroll tax returns. 3. C Corps – Same requirements as S Corps. F. IRS election requirements 1. LLCs – Permitted to have pass-through taxation as a partnership without making an election; it may elect on Form 8832 to be treated as an association taxable as a corporation. 2. S Corps – Must meet the statutory requirements to be an S Corp, must make an election on Form 2553 within the first 2 ½ months of its tax year to be subject to tax as an S Corp, and must monitor itself and its shareholders to assure that it continues to qualify as an S Corp. 3. C Corps – Income tax is paid at the corporation level on the C Corp’s net taxable income. This is the default treatment if an S Corp election is not made or the corporation is ineligible to be an S Corp. G. Tax year 1. LLCs – Generally required to use the same tax year as the majority of its members. 2. S Corps – Generally required to use a calendar tax year unless they can establish a business purpose to the IRS to use a fiscal tax year. Alternatively, S Corps may elect under Section 444 to use a September, October or November fiscal year; they must make a non-interest bearing deposit with the IRS based on the calculated deferred taxable income. 3. C Corps – Generally, may elect any fiscal tax year. However, personal service corporations must use a calendar year unless they make a Section 444 election which may defer the deductibility of a portion of their shareholder/employee compensation and other expenses paid to a shareholder/employee. III. OWNERSHIP ISSUES A. Minimum number of owners 1. LLCs – Must have a minimum of two members to be classified as a partnership for Federal tax purposes. LLCs owned by a single member may be classified as an association (taxable as a corporation) or disregarded as an entity separate from its owner (i.e., it does not exist for all Federal tax purposes). Income tax issues when changing from a single owner to multiple owner LLC and vice versa. 2. S Corps – No minimum number of owners required to be a separate taxable entity with pass-through taxation. 3. C Corps – No minimum number of owners requirement. B. Maximum number of owners 1. LLCs – May have a limit on the maximum number of partners they are allowed under the publicly traded partnership provisions of Section 7704. Entities with more than 500 members may fall outside the partnership safe harbor and may be taxable as a corporation. 2. S Corp – May not have more than 75 shareholders. Joint owners each count as one shareholder unless they are married to each other. 3. C Corps – There is no maximum number of shareholders limit; entity-level taxation is always available. Publicly-traded corporations are C Corps for this reason. C. Eligible owners 1. LLCs – May be owned by any individual or entity, domestic or foreign. 2. S Corps – Specific restrictions limit permissible shareholders. Generally, only U.S. citizens, resident aliens, estates, qualified retirement plans, Section 501(c)(3) charitable entities, and certain trusts may be shareholders. Only grantor, voting, qualified subchapter S, electing small business, and decedent trusts (for 2 years after the decedent's death) are allowed. Corporations are not allowed to be shareholders unless they are S Corps, own 100% of the stock of the subsidiary corporation, and make a Qualified Subchapter S Subsidiary election. 3. C Corps – Any individual or entity, domestic or foreign, may be a C Corp shareholder (subject to legal restrictions). D. Tiered entity structure 1. LLCs – May own any percentage of a C Corp or another LLC; it cannot own any S Corp stock. 2. S Corps – May be members of an affiliated group. Subsidiaries may not be S Corps unless they are 100% owned by an S Corp parent and a Qualified Subchapter S Subsidiary election is made. 3. C Corps – Similar to an LLC, may own any percentage of another C Corp or an LLC. If a C Corp owns at least 80% of another C Corp, it may elect to file a Federal consolidated income tax return. A C Corp cannot own any S Corp stock. IV. FORMATION AND OPERATIONAL ISSUES A. Limitations on classes of ownership 1. LLCs – Tremendous flexibility permitted in terms of their capital structure. They may issue common equity interests, preferred equity interests, hybrid debt instruments, etc., without jeopardizing their tax status. LLCs may have distribution preferences and special allocations of income or loss. 2. S Corps – May only have one class of stock, although voting differences are permitted. The rights to an allocation of taxable income or loss, and the distributions during operations and upon liquidation, must be identical for each share of stock. 3. C Corps – Similar attributes and flexibility as an LLC. B. Owner contributions of noncash property to entity 1. LLCs – Contributions of noncash property to an LLC are not subject to gain or loss recognition. Exceptions apply if the LLC is treated as an “investment company” or there are actual or deemed distributions to the member under the disguised sale or related tax rules. Subsequent allocations of depreciation, amortization and the gain or loss on the sale of the contributed asset must be specially allocated among the LLC members to reflect the initial difference between the fair market value and tax basis of the assets contributed under Section 704(c). 2. S Corps – Contributions of noncash property to an S Corp are taxable to the contributing shareholder if the related liabilities assumed by the corporation exceed the shareholder’s tax basis in the assets contributed, the contributing shareholders as a group own less than 80% of the corporation, or the S Corp is treated as an “investment company”. Special allocations of taxable income are not required or permitted by S Corps. 3. C Corps – Same tax treatment of noncash contributions by shareholders to the corporation as with S Corps. C. Tax basis of contributed property 1. LLCs – The tax basis, holding period and depreciation method (if applicable) of contributed noncash property to an LLC is the same as those of the contributing member. If any taxable gain is recognized by the contributing member, the LLC will increase its tax basis in the contributed property by the amount of such gain. 2. S Corps – Similar to a contribution to an LLC, the tax basis, holding period and depreciation method (if applicable) of contributed noncash property to an S Corp is the same as those of a contributing controlling shareholder. A similar rule applies if there is gain recognized by the contributing shareholder that increases the tax basis of the contributed assets to the S Corp. 3. C Corps – Same tax treatment as S Corps. D. Treatment of liabilities for basis purposes 1. LLCs – Members include their share of the entity level debt in their tax basis under Section 752. The members may also be able to include it in their at risk amount under Section 465 if the debt is either recourse to the member or is “qualified nonrecourse financing”. 2. S Corps – Shareholders do not increase their tax basis or at risk amount by entity level debt, even if it is guaranteed by the shareholders. 3. C Corps – Same tax treatment as S Corps. 4. Tax basis determines whether distributions to owners are taxable or not and the at risk amount determines whether an allocated taxable loss may be claimed by the owner (subject to the “passive activity loss” rules). This only applies to LLCs and S Corps and their owners, not to C Corps and their owners. E. Cash method of accounting 1. LLCs – Permitted to use the cash method of accounting unless the LLC has inventories (subject to a $1 million or less gross receipt exception), is a “tax shelter” (as defined by Section 448), or has a C corporation member (other than a qualified personal service corporation) and the LLC has average annual gross receipts in excess of $5 million. 2. S Corps – Permitted to use the cash method of accounting unless the S Corp has inventories or is a “tax shelter.” 3. C Corps – Not permitted to use the cash method of accounting unless the C Corp has average annual gross receipts (on a three- year lookback basis) of $5 million or less and does not have inventories. A “qualified personal service corporation” may use the cash method of accounting. V. DISTRIBUTION AND TRANSFER ISSUES A. Distribution of cash to owners 1. LLCs – Distributions of cash to members are not taxable unless the amount exceeds a member’s tax basis in the LLC (which includes an allocation of the LLC’s debt). Generally, the excess distribution is taxable as a capital gain (unless the “hot asset” rules of Section 751 characterize the gain as ordinary income). 2. S Corps – Distributions of cash to shareholders are not taxable unless the amount exceeds a shareholder’s tax basis in the S Corp stock (which does not include an allocation of the S Corp’s debt). The excess distrubution is taxable as capital gain. If the S Corp has been a profitable C Corporation with earnings and profits, distributions in excess of the shareholder's share of S Corp earnings are taxed as dividends to the extent of his/her share of C Corp earnings (see discussion below for special rule for post-May 6, 2003 dividends tax rate). Any excess distributions are taxed as discussed above. 3. C Corps – Distributions of cash to shareholders constitute dividends that are taxable as ordinary income to the extent of the C Corp’s earnings and profits. Dividends paid after May 6, 2003 and before January 1, 2009 are taxed similarly to long term capital gains (maximum tax rate of 15% for individual shareholders). Distributions in excess of the C Corp’s earnings and profits are treated as a nontaxable return of invested capital to the extent of the shareholder’s tax basis in the stock. Any excess distributions are taxable as capital gain. B. Distribution of appreciated assets to owners 1. LLCs – Appreciated property may be distributed to an LLC member without the recognition of taxable gain by either the LLC or the distributee member subject to the “deemed sale” rules described in Sections 707(a)(2)(B), 704(c)(1)(B) or 737. 2. S Corps – Taxable gain is recognized at the corporate level when appreciated assets are distributed to the shareholders under Section 311. The gain on this deemed sale is determined by comparing the fair market value of the distributed asset with its tax basis. This gain flows through pro rata to all of the S Corp shareholders. No loss is recognized on the distribution of depreciated assets to an S Corp shareholder. 3. C Corps – Same tax treatment as S Corps except that no gain flows through to the C Corp shareholders; tax on the gain is paid by the C Corp. C. Basis of distributed assets received by owners 1. LLCs – Tax basis, holding periods and depreciation methods (if applicable) of assets received by LLC members are the same as the LLC’s position with respect to the distributed assets. If the distributee member’s tax basis in the LLC membership interest is less than the LLC’s tax basis in the distributed asset, the member’s tax basis in such asset is limited to the member’s lower tax basis in the LLC membership interest. 2. S Corps – Tax basis of assets received by S Corp shareholders equals the fair market value of the assets received. The holding period and depreciation methods (if applicable) start anew to the distributee shareholder. 3. C Corps – Same tax treatment as S Corp shareholders. D. Taxability of transfer of ownership interests 1. LLCs – Members generally recognize capital gain or loss on the sale of their LLC membership interests. Any portion of the gain attributable to the sale of their share of the LLC’s “hot assets” under Section 751 is characterized as ordinary income. A similar “look through” rule applies to any portion of the gain that constitutes “unrecaptured Section 1250 gain” on the sale of depreciable real property; this long term capital gain is taxed at a 25% rate. On a redemption, taxable gain to the distributee member is not recognized until any cash (or marketable securities) received exceeds the member's tax basis in the membership interest. The "unrecaptured Section 1250 gain" on the sale of depreciable real estate does not apply in a redemption (but Section 751 "hot asset" rules apply). LLC distributions in the redemption of an LLC membership interest may be treated as deductible by the LLC and taxable as ordinary income to the member in certain situations under Section 736. 2. S Corps – Shareholders recognize capital gain or loss on the sale of their S Corp stock unless the loss qualifies for ordinary loss treatment under Section 1244. S Corp distributions in redemption of a shareholder’s stock may be recharacterized as dividends (i.e., ordinary income and no reduction in taxable income for the shareholder’s stock basis) if the S Corp was previously a profitable C Corp with earnings and profits and related parties retain more than 50% of the S Corp stock after the redemption. 3. C Corps – Same tax treatment as with the transfer of S Corp stock. E. Inside basis adjustments on redemption or transfers of interests 1. LLCs – May elect under Section 754 to step up the transferee owner’s proportionate share of the tax basis of the LLC’s assets to reflect the difference between the fair market value of the specific assets and their tax basis. This will allow the transferee to receive additional depreciation or amortization deductions or reduce their share of the gain on the sale of specific entity assets. This also applies to a transfer at death and to a redemption of an LLC membership interest. 2. S Corps – Not permitted to adjust the inside basis of assets to reflect a change in the tax basis of transferred stock. 3. C Corps – Same tax treatment as S Corps. F. Special transfer issues 1. LLCs – When there is a sale or exchange of 50% or more of the total interests in an LLC’s capital and profits within a 12-month period, the LLC is deemed to terminate for tax purposes. The LLC is deemed to transfer all of its assets and liabilities to a “new” LLC in exchange for all of the “new” LLC’s membership interests which it immediately distributes to its members (including any new members) in full dissolution of the “old” LLC. This requires the filing of two tax returns for the year of the transfer and requires the “new” LLC to start depreciating its assets anew. The LLC does not terminate for state law purposes. 2. S Corps – Transfers to ineligible shareholders will terminate S Corp status as of the date of the transfer and the corporation will be taxed as C Corp. 3. C Corps – C Corps do not have either of these special transfer issues. VI. SPECIAL C CORP ISSUES A. Accumulated earnings tax – Section 531 imposes a second tax at a 15% rate on unreasonably retained C Corp earnings. If the IRS determines that a C Corp is accumulating cash and other liquid investments (without any justifiable business purposes) that can be distributed as taxable dividends to its shareholders, it can assess this 15% tax in addition to the normal corporate income tax. $250,000 may be accumulated without any justification ($150,000 for personal service corporations). B. Personal holding company tax – Section 542 imposes a second tax at a 15% rate on undistributed personal holding company income. This self- assessed tax is imposed on closely-held C Corps with retained earnings that generate 60% or more of its income from nonactive business activities. C. Separate tax rate structure – C Corps pay income tax on their taxable income at the corporation level. The taxable income is subject to tax based on a graduated rate schedule starting at 15% and having a maximum rate of 39%. This creates another set of graduated tax rates that are separate from the shareholders’ individual graduated rate schedules. In many situations, this results in an overall reduction in the current income tax paid by the C Corp and its owners. Personal service corporations, however, are subject to a flat 35% tax rate on their taxable income. Also, there is no special reduced tax rate on the sale of long term capital gain assets. VII. DISSOLUTION ISSUES A. Entity level taxation 1. LLCs – Recognize no taxable gain at the entity level upon dissolution. 2. S Corps – Recognize taxable gain on the distribution of appreciated property as if the assets were sold at their fair market values. This gain flows through ratably to all S Corp shareholders. The S Corp may also pay corporate level tax if it was a C Corp in the prior ten years and the built-in gains tax applies. 3. C Corps – Recognize taxable gain on the distribution of appreciated property as if the assets were sold at their fair market values. Tax on this recognized gain is paid by the C Corp at its normal tax rates. B. Owner level taxation 1. LLCs – For LLC members, gain is recognized only if the amount of money and marketable securities (with certain exceptions) received exceed their tax basis in their LLC membership interest. Distributions of noncash property are generally nontaxable. 2. S Corps – For S Corp shareholders, the gain recognized by the S Corp flows through to its shareholders. In addition, gain or loss is recognized by the shareholders based on the difference between the fair market value of the net assets distributed and the shareholders’ tax basis in their S Corp stock. 3. C Corps – For C Corp shareholders, the gain recognized by the C Corp on the distribution of appreciated assets does not flow through to its shareholders. C Corp shareholders recognize taxable gain or loss based on the difference between the fair market value of the net assets distributed to them and their tax basis in their C Corp stock. C. Basis of distributed assets received by owners 1. LLCs – Tax basis of noncash assets received by LLC members equals the tax basis in their LLC interest, reduced by any cash or marketable securities received. 2. S Corps – Tax basis of assets received by S Corp shareholders equals the fair market value of the assets received. 3. C Corps – Same tax treatment as S Corp shareholders. VIII. COMPENSATION ISSUES A. FICA or self-employment tax on owners compensation 1. LLCs – Members providing services are compensated through “guaranteed payments”. These guaranteed payments are always subject to self-employment tax (“SE Tax”). In addition, the residual profits of an LLC allocated to its members may be subject to SE Tax whether or not they are distributed. This analysis, based on the current IRS proposed regulations, focuses on whether the LLC member has managerial authority and involvement (500 hours or more annually) similar to a general partner or is a more passive owner similar to a limited partner. Residual profits allocated to a general partner are subject to SE tax, whereas a limited partner’s residual profits are not. The SE Tax rate is 15.3% on the first $90,000 (in 2005) and 2.9% on the excess on guaranteed payments and residual profits. The LLC members receive an “above-the-line” income tax deduction on their individual tax returns for 50% of the SE Tax. 2. S Corps – Employee/shareholders are compensated for services provided to the S Corp through wages. The wages are subject to a combined 15.3% tax on the first $90,000 of wages (in 2005) and 2.9% on the excess. The S Corp pays and deducts one-half the FICA tax and the shareholder-employee pays the other one-half. If an employee’s wages are reasonable, she may be able to avoid the 2.9% Medicare tax on wages over $90,000 if income is distributed pro rata to all S Corp shareholders in lieu of paying additional wages. S Corp shareholders are not subject to FICA tax on their share of residual profits. 3. C Corps - Employee/shareholders are compensated for services provided to the C Corp through wages. The wages are subject to a combined 15.3% tax on the first $90,000 of wages (in 2005) and 2.9% on the excess. The C Corp pays and deducts one-half the FICA tax and the shareholder-employee pays the other one-half. B. Owner fringe benefits 1. LLCs – Fringe benefits are taxable to LLC members. The LLC may either deduct the cost of the fringe benefits and treat them as guaranteed payments to the LLC member or may specifically allocate this nondeductible cost to the LLC member who received these fringe benefits. LLC members are allowed to deduct 100% of health insurance premium expense in arriving at their adjusted gross income on their individual income tax returns. 2. S Corps – Employee/shareholders who own 2% or more of the corporation are treated as partners in a partnership and, therefore, must follow the rules that apply to LLC members. However, the S Corp deducts these fringe benefits and treats them as wages that are included on the employee/shareholders’ Form W-2. 2% shareholders are also allowed to deduct 100% of health insurance premium expenses. 3. C Corps – Employee/shareholders of C Corps not subject to tax on their fringe benefits (as described below). The C Corp deducts the cost of these fringe benefits. 4. The fringe benefits covered by this rule include any benefits received under a health or disability plan, the cost of the first $50,000 of group term life insurance on the owner, and meals and lodging furnished for the convenience of the employer. C. Retirement benefits 1. LLCs – Limited to making $42,000 maximum annual contribution per participant to all defined contribution plans. More-than-10% owners are no longer prohibited from borrowing from their retirement plans. 2. S Corps – Limited to making $42,000 maximum annual contribution per participant to all defined contribution plans. More– than–5% owners are no longer prohibited from borrowing from their retirement plans. 3. C Corps – Limited to making $42,000 maximum annual contribution per participant to all defined contribution plans. Owners may borrow, and pay annual interest on, the lesser of $50,000 or one-half of their nonforfeitable accrued benefits. D. Receipt of ownership for services provided 1. LLCs – If an LLC member receives a capital interest in the LLC in exchange for services provided or to be provided, the LLC member will recognize taxable income to the extent of the fair market value of the capital interest received. The taxable income recognition may be delayed if there is a temporary substantial risk of forfeiture. If the LLC member receives a future profits only interest in the LLC in exchange for services, there is generally no taxable income to the LLC member currently. See Revenue Procedure 93-27 for limitations. 2. S Corps – Receipt of S Corp stock in exchange for services provided or to be provided is currently taxable to the recipient under Section 83. The income recognition may be delayed if there is a temporary substantial risk of forfeiture. The taxable amount is based on the fair market value of the stock received. The S Corp may be permitted a deduction for the amount of and at the time that such income is recognized by the shareholder unless this amount is required to be capitalized under the Code (e.g., the services are in the nature of start-up or organizational costs). 3. C Corps – Same tax treatment as the S Corp and its shareholders. IX. MICHIGAN TAX ISSUES A. Michigan single business tax on the entity 1. LLCs – Subject to an entity level tax of 1.9% on its apportioned adjusted tax base. There is a credit for conducting business as an unincorporated business ranging from 10 to 20% depending on the amount of the LLC’s business income. 2. S Corps – Subject to an entity level tax of 1.9% on its apportioned adjusted tax base. There is a credit for conducting business as an S Corp ranging from 10 to 20% depending on the amount of the S Corp’s business income. 3. C Corps – Subject to an entity level tax of 1.9% on its apportioned tax base. Because the C Corp shareholders do not pay Michigan income tax on the C Corp’s taxable income, there is no comparable credit available. B. Michigan income tax on the owners 1. LLCs – Individual members are subject to a 3.9% income tax (in 2005) imposed on their guaranteed payments and share of residual profits (allocated to Michigan) flowing through from the LLC whether or not the profits are distributed. 2. S Corps – S Corp shareholders are subject to a 3.9% income tax (in 2005) imposed on their share of S Corp profits (allocated to Michigan) that flow through from the S Corp whether or not the profits are distributed. 3. C Corps – C Corp shareholders are not subject to Michigan income tax on the C Corp’s taxable income. EXHIBITS 1. Comparison of Business Entities – Income Tax Aspects 2. Entity Structuring Considerations Checklist 1 EXHIBIT 1 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS A. - General Issues C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1. Limited Liability Protection for Owners Yes Yes Yes Limited partners have limited liability; General partners do not No No except for malpractice and negligence committed by other owners No 2. Owners May Participate in Management Yes Yes Yes Limited partners risk losing limited liability if they participate in management Yes Yes Yes 3. Pass-Through Taxation No Yes Yes Yes Yes Yes N/A 4. Entity Level Taxation Yes Generally not, but some former C corporations are subject to tax on recognized built-in gains, and excess net passive investment income No No No No N/A 2 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS A. - General Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 5. IRS Election Required No Yes No No No No N/A 6. Tax Return Default Classification Form 1120 Form 1120 S Form 1040, Sch. C or Sch. E if one owner. Two or more owners- Form 1065 Form 1065 From 1065 Form 1065 Form 1040, Sch. C or Sch. E 7. Tax Year Any year permitted (except PSC) Generally calendar year Tax year of majority of members Tax year of majority of partners Tax year of majority of partners Tax year of majority of partners Generally calendar year 3 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS B. - Ownership Issues C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1A. Maximum Number of Owners No limit on number of shareholders 75 Limited by publicly traded partnership rules (500 partner limit) Limited by publicly traded partnership rules Limited by publicly traded partnership rules Limited by publicly traded partnership rules One 1B. Minimum Number of Owners One One One. Single member LLC’s are disregarded for tax purposes Two Two Two One 2A. Corporation May be an Owner Yes No unless S Corp. owns a Qualified Subchapter S Subsidiary (100% ownership + election) Yes Yes Yes Yes N/A 2B. Partnership May be an Owner Yes No Yes Yes Yes Yes N/A 4 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS B. - Ownership Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 2C. LLC May be an Owner Yes No Yes Yes Yes Yes N/A 2D. Trust May be an Owner Yes Only Grantor, Voting, Qualified Subchapter S, Electing Small Business, and Decedent (for 2 years after death) Yes Yes Yes Yes N/A 2E. Nonresident Alien May be an Owner Yes No Yes Yes Yes Yes Yes 2F. Qualified Retirement Plan May be an Owner Yes 401(a) entities only Yes Yes Yes Yes N/A 2G. Tax-exempt Entity May be an Owner Yes 501(c)(3) entities only Yes Yes Yes Yes N/A 5 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS B. - Ownership Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 3. Type of Entity Professionals May Use Professional Corporation Professional Corporation Professional Limited Liability Company No General Partnership Limited Liability Partnership May practice without an entity 4. Affiliation Permitted Yes Yes- QSSS election available for 100% owned subsidiary Yes Yes Yes Yes N/A 6 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS C. - Formation and Operational Issues C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1. Differentiation of Owners’ Rights Permitted Yes Voting right differences only permitted Yes, if specified in the operating agreement. Absent an operating agreement, each member has one vote and equal distribution rights Yes Yes Yes N/A 2. Contributions to Entity No recognition on transfer of property only if transferors are in control of the corporation and liabilities are not in excess or tax basis of assets contributed No recognition on transfer of property only if transferors are in control of the corporation and liabilities are not in excess of tax basis of assets contributed No recognition on transfer of property by member No recognition on transfer of property by partner No recognition on transfer of property by partner No recognition on transfer of property by partner N/A 7 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS C. - Formation and Operational Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 3. Treatment of Entity’s Liabilities for Basis Purposes No basis increase for share of liabilities No basis increase for share of liabilities Basis increase for share of liabilities; decrease in share of liabilities treated as cash distribution Basis increase for share of liabilities; decrease in share of liabilities treated as cash distribution Basis increase for share of liabilities; decrease in share of liabilities treated as cash distribution Basis increase for share of liabilities; decrease in share of liabilities treated as cash distribution Basis increase for liabilities 4. Cash Method of Accounting Not allowed unless gross receipts less than $5 million, or a personal service corporation Permissible unless a tax shelter or have inventories (exception for service business with gross receipts less than $10 million) Permissible unless a tax shelter, have inventories, or have a C corp. member and have gross receipts of more than $5 million ($10 million service business exception) Permissible unless a tax shelter, have inventories, or have a C corp. partner and have gross receipts of more than $5 million ($10 million service business exception) Permissible unless a tax shelter, have inventories, or have a C corp. partner and have gross receipts of more than $5 million ($10 million service business exception) Permissible unless a tax shelter, have inventories, or have a C corp. partner and have gross receipts of more than $5 million ($10 million service business exception) Permissible unless have inventories ($10 million service business exception) 8 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS C. - Formation and Operational Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 5. Accumulated Earnings Tax Possible 15% corporate level tax on unreasonable accumulations of earnings ($250,000 may be accumulated without reason- $150,000 for personal service corporations) No A.E.T. exposure No A.E.T. exposure No A.E.T exposure No A.E.T. exposure No A.E.T. exposure No A.E.T. exposure 9 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS D. - Distribution Issues C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1. Distributions of Cash from Entity Taxable dividends to extent of earnings and profits; tax-free basis return; excess is capital gain Not taxable to extent of shareholder’s basis; excess is capital gain (if always an S corporation) Not taxable to extent of member’s basis; excess is capital gain Not taxable to extent of partner’s basis; excess is capital gain Not taxable to extent of partner’s basis; excess is capital gain Not taxable to extent of partner’s basis; excess is capital gain N/A 2. Distributions of Property from Entity Distribution of appreciated property results in taxable gain at the corporate level and to the distributee shareholder (based on FMV of assets distributed) Distribution of appreciated property results in taxable gain passing through pro-rata to shareholders (based on FMV of assets distributed) No gain recognition on a distribution of property until the member disposes of the property (unless a disguised sale) No gain recognition on a distribution of property until the partner disposes of the property (unless a disguised sale) No gain recognition on a distribution of property until the partner disposes of the property (unless a disguised sale) No gain recognition on a distribution of property until the partner disposes of the property (unless a disguised sale) N/A 10 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS D. -Distribution Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 3. Inside Basis Adjustments on Redemption of Interest (Sec. 734 & 754) No adjustment in basis of assets due to redemption of stock No adjustment in basis of assets due to redemption of stock Special election to adjust basis of LLC assets to reflect value of assets distributed in excess of redeemed member's basis Special election to adjust basis of partnership assets to reflect value of assets distributed in excess of redeemed partner's basis Special election to adjust basis of partnership assets to reflect value of assets distributed in excess of redeemed partner's basis Special election to adjust basis of partnership assets to reflect value of assets distributed in excess of redeemed partner's basis N/A 4. Owner Basis Reduction Rules Basis reduced for distributions in excess of taxable earnings and profits Basis reduced for distributions first, then losses Basis reduced for distributions first, then losses Basis reduced for distributions first, then losses Basis reduced for distributions first, then losses Basis reduced for distributions first, then losses Basis reduced for distributions first, then losses 11 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS E. - Transfers and Dissolution C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1. Transfer of Ownership Interest Capital gain or loss; if Sec. 1244 stock, loss is ordinary Capital gain or loss; if Sec. 1244 stock, loss is ordinary Capital gain or loss except for pro rata share of ordinary income assets (Sec.751) Capital gain or loss except for pro rata share of ordinary income assets (Sec.751) Capital gain or loss except for pro rata share of ordinary income assets (Sec.751) Capital gain or loss except for pro rata share of ordinary income assets (Sec.751) Capital gain or loss except for gain or loss on ordinary income assets 2. Special Transfer Issues Sec. 1202- 50% of gain exclusion if certain stock held > 5 years (based on 28% LTCG rate) Transfer to ineligible SH terminates S Corp. status Transfer of 50% of profits and capital interests terminates tax partnership Transfer of 50% of profits and capital interests terminates tax partnership Transfer of 50% of profits and capital interests terminates tax partnership Transfer of 50% of profits and capital interests terminates tax partnership None 12 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS E. - Transfers and Dissolution (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 3. Inside Basis Adjustments on Transfer of Interest (Sec. 743 & 754) No adjustment in basis of assets to reflect change in basis of transferred stock No adjustment in basis of assets to reflect change in basis of transferred stock Special election to adjust basis of LLC assets to reflect change in basis of transferred membership interest Special election to adjust basis of partnership assets to reflect change in basis of transferred partnership interest Special election to adjust basis of partnership assets to reflect change in basis of transferred partnership interest Special election to adjust basis of partnership assets to reflect change in basis of transferred partnership interest N/A 4. Dissolution Issues: A. Entity Level Gain recognized on distribution of appreciated assets; corporate level tax paid Gain recognized on distribution of appreciated assets; corporate level tax paid only if built-in gains tax applies Generally, no gain recognized at LLC level Generally, no gain recognized at partnership level Generally, no gain recognized at partnership level Generally, no gain recognized at partnership level N/A 13 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS E. - Transfers and Dissolution (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship B. Owner Level Capital gain or loss recognized based on FMV of net assets > basis of stock Gain recognized by corporation flows to SHs; capital gain or loss recognized based on FMV of net assets > increased basis of stock Gain recognized only if money received exceeds tax basis in LLC Gain recognized only if money received exceeds tax basis in partnership Gain recognized only if money received exceeds tax basis in partnership Gain recognized only if money received exceeds tax basis in partnership N/A C. Basis of Assets Received Fair market value Fair market value Basis in assets equals basis in LLC interest Basis in assets equals basis in partnership interest Basis in assets equals basis in partnership interest Basis in assets equals basis in partnership interest N/A 14 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS F. - Compensation Issues C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1. Owner/ Employee Compensation Reasonable wages (too high?) Reasonable wages (too low?) Guaranteed payments Guaranteed payments Guaranteed payments Guaranteed payments Draws 2. FICA or Self- employment Tax on Owner’s Wages Social security tax of 6.2% on $90,000 Medicare tax of 1.45%; both employer and employee Social security tax of 6.2% on $90,000 Medicare tax of 1.45%; both employer and employee Manager subject to self-employment tax of 15.3% on $90,000, 2.9% on excess of guaranteed payments and residual profits; non- managers only subject on guaranteed payments if there is a manager and <500 hours of service provided Self- employment tax of 15.3% on $90,000, 2.9% on excess of guaranteed payments and residual profits; limited partners only subject on guaranteed payments Self- employment tax of 15.3% on $90,000, 2.9% on excess of guaranteed payments and residual profits Self- employment tax of 15.3% on $90,000, 2.9% on excess of guaranteed payments and residual profits Self- employment tax of 15.3% on $90,000, 2.9% on excess earnings 15 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS F. - Compensation Issues (continued) C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 3. Owner Fringe Benefits Health and disability insurance tax-free to owner/ employees Taxable to > 2% owner/ employee; 100% of health insurance is pre-AGI deduction on Form 1040 Taxable to members; 100% of health insurance is pre-AGI deduction on Form 1040 Taxable to partners; 100% of health insurance is pre-AGI deduction on Form 1040 Taxable to partners; 100% of health insurance is pre-AGI deduction of Form 1040 Taxable to partners; 100% of health insurance is pre-AGI deduction on Form1040 Taxable to owner; 100% of health insurance is pre-AGI deduction on Form 1040 4. Retirement Benefits $42,000 maximum annual contribution per employee $42,000 maximum annual contribution per employee $42,000 maximum annual contribution per member $42,000 maximum annual contribution per partner $42,000 maximum annual contribution per partner $42,000 maximum annual contribution per partner $42,000 maximum annual contribution 16 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS F. - Compensation Issues (continued) 5. Ownership for Services FMV of stock taxable when received by SH for services (or when substantial risk of forfeiture lapses) FMV of stock taxable when received by SH for services (or when substantial risk of forfeiture lapses) No tax if profits only interest received; FMV of capital interest taxable when received (or when substantial risk of forfeiture lapses) No tax if profits only interest received; FMV of capital interest taxable when received (or when substantial risk of forfeiture lapses) No tax if profits only interest received; FMV of capital interest taxable when received (or when substantial risk of forfeiture lapses) No tax if profits only interest received; FMV of capital interest taxable when received (or when substantial risk of forfeiture lapses) N/A 17 COMPARISON OF BUSINESS ENTITIES INCOME TAX ASPECTS G. - Michigan Tax Comparison C Corporation S Corporation Limited Liability Company Limited Partnership General Partnership Limited Liability Partnership Sole Proprietorship 1. Michigan Single Business Tax 1.9 % tax on apportioned adjusted tax base 1.9% tax on apportioned adjusted tax base; credit of 10% to 20% based on business income 1.9% tax on apportioned adjusted tax base; credit of 10% to 20% based on business income 1.9% tax on apportioned adjusted tax base; credit of 10% to 20% based on business income 1.9% tax on apportioned adjusted tax base; credit of 10% to 20% based on business income 1.9% tax on apportioned adjusted tax base; credit of 10% to 20% based on business income 1.9% tax on apportioned adjusted tax base; credit of 10% to 20% based on business income 2. Michigan Income Tax 3.9% tax imposed on owner/ employee wages and dividends 3.9% tax imposed on owner/ employee wages and share of pass-through income 3.9% tax imposed on members guaranteed payments and share of pass-through income 3.9% tax imposed on partners guaranteed payments and share of pass- through income 3.9% tax imposed on partners guaranteed payments and share of pass- through income 3.9% tax imposed on partners guaranteed payments and share of pass- through income 3.9% tax imposed on owner’s income Revised October 2005 (Rates and Limits Shown are for 2005) EXHIBIT 2 ENTITY STRUCTURING CONSIDERATIONS CHECKLIST Entity Choices Main Alternatives: Other Alternatives: C Corporation Limited Partnership S Corporation General Partnership Limited Liability Company Limited Liability Partnership Sale Proprietor (Nonentity) Entity Advantage LLC S Corp C Corp N/A Ownership Interests Economic Differences Voting or Control Differences Receipt of Ownership for Services Provided (IRC §83) Buy-Sell Restrictions on Transfers Written vs. Oral Agreements/Side Agreements Owner Liability Protection Isolation Risk/Single Purpose Entity Tax Consequences/Reporting Precontribution Liability Exposure Liability Exposure During Operations Liability Protection Maintenance Post-termination Liability of Owners Entity Advantage LLC S Corp C Corp N/A Contributions Contribution of Appreciated Property Contributions Subject to Liabilities Exceeding Contributor’s Basis Basis of Assets to Entity Allocation of Pre-Contribution Gain (IRC §704(c)) Contribution of Past or Future Services (IRC §83) Sale vs. Contribution of Property Impact on Real Estate Transfer Tax and Property Tax Assessment Post-Formation Additional Contributions of Capital or Property Financing Owner Loan to Entity Lender Requirements Influencing Structure Entity Borrowing: Owner Tax Basis: Share of Entity Liability - Recourse vs. Nonrecourse (IRC §752) Owner Guarantees Owner Deduction of Loss - Basis Limits; At Risk Rules (IRC §465) Tax Treatment of Interest Expense Entity Advantage LLC S Corp C Corp N/A Distributions to Owners/Allocations to Owners Cash Distribution to Owners Non-Cash Distributions to Owners Tax Basis and Holding Periods to Owners Intended Tax Deferred Exchange of Property Received by Owners (IRC §1031) Allocation of Cash Flow vs. Taxable Income or Loss Special Allocations of Tax Items Cash Flow Preferences to Owners Transfer of Owner Interests Entity Look-Through Rules (Ordinary Income (IRC §751) / 25% LTCG (IRC §1(h)) Buy-Sell Restrictions and Terms Entity Basis Adjustments on Death, Sale or Redemption of Owner Interest (IRC §754) Termination of Tax Status Securities Law Limitations Lender Restriction Estate and Gift Tax Impact of Transfer Entity Advantage LLC S Corp C Corp N/A Operations Management/Participation by Owners and Nonowners Self-Employment Tax/FICA Allocation of Income Tax Between Entity and Owners Hiring of Employees and Independent Contractors Obtaining Local Government Approvals for Projects Special Entity Tax Considerations Retirement Plan Considerations Employee Benefit Plan Considerations Dissolution/Liquidation Priority of Liquidating Distributions Recognition of Gain at Entity Level Recognition of Gain by Owners Basis of Assets Received Control Over Liquidation Process Title Insurance Issues Conflict of Interest Who is your client? Protection for the attorney, CPA and other advisors Communication and documentation with all parties 1 CHOICE OF ENTITY FOR REAL ESTATE ACTIVITIES REAL PROPERTY LAW SECTION HOMEWARD BOUND SERIES NOVEMBER 3, 2005 TAX PLANNING FOR REAL ESTATE OWNERS Dean A. Rocheleau William B. Acker Richard A. Shapack SCENARIO I - REAL ESTATE RENTAL FOLLOWED BY REFINANCING Sisters Kim and Karen Kash, who just inherited a substantial amount from their deceased mother, have decided to buy a shopping center. This center has been run down and has lost its anchor tenant and has only 30% occupancy. The sisters, one who is a real estate leasing agent, believe they can refurbish this shopping center, acquire an anchor tenant and increase the occupancy to at least 90% in a two year period. At that time, they hope to refinance this property and take out part of their invested capital. ISSUE: What type of business entity would be most appropriate for this shopping center venture? SCENARIO I - REAL ESTATE RENTAL FOLLOWED BY REFINANCING ISSUE: What type of business entity would be most appropriate for this shopping center venture? Entity allowing flow-through taxation. Traditionally general partnership; now a limited liability company should be considered for limited liability protection. Need sufficient tax basis and at-risk amounts to deduct losses during lease up period. Passive activity loss rules may limit deductibility of losses if sisters are not full time real estate professionals. Real estate rental operation is exempt from self-employment tax. Tax impact of distributing refinancing proceeds favors LLC or partnership. May want a special allocation of wages to sister in the real estate business. 2 SCENARIO I - REAL ESTATE RENTAL FOLLOWED BY REFINANCING ISSUE: What type of business entity would be most appropriate for this shopping center venture? CHOICE: Limited liability company best facilitates claiming losses currently and distributing refinancing proceeds tax-free in the future. SCENARIO II - REAL ESTATE DEVELOPMENT/OUTSIDE INVESTOR Five individuals are breaking away from Draconian Development Co. to start their own development business. They believe they can profitably develop a parcel of land into 130 residential lots that they will sell to builders. Because they do not have sufficient capital to fund this project themselves, they have asked Conrad Cash to be an investor in their project. Conrad will be a financial owner but not involved in the management of this development project. ISSUE: What entity would you recommend to this development group? SCENARIO II - REAL ESTATE DEVELOPMENT/OUTSIDE INVESTOR ISSUE: What entity would you recommend to this development group? Flow-through taxation entity probably better choice-this is not an entity that will have a long duration. Limited liability protection, especially for Conrad, is important. Special allocations (preferred return) between Conrad Cash and the other five owners may be required. Participation in management: 5 general partners or LLC managers? Tax aspects of the receipt of an ownership interest for services for 5 developers. (Tax rules more favorable in a LP or LLC vs. Corporation). Self-employment tax, especially for Conrad Cash, should be minimized. Tax impact of distributing appreciated property to redeem a disgruntled owner some time in the future or of remaining lots at the end of the project. (S corporations is a taxable distribution; typically tax free if from an L.P. or L.L.C.) 3 SCENARIO II - REAL ESTATE DEVELOPMENT/OUTSIDE INVESTOR ISSUE: What entity would you recommend to this development group? CHOICE: Limited liability company because of flow-through taxation, better operational tax treatment, and flexibility provided by it. SCENARIO III - DEVELOPMENT OF LONG-TERM HOLD PROPERTY Fillmore Farmer has farmed a piece of land on the edge of town for over thirty years. The suburban sprawl has finally reached Fillmores property and he has decided to retire from farming and develop his farmland into residential lots. Fillmore believes he can hire an experienced developer to develop the property for him but believes he may have to give this developer a piece of the deal. ISSUE: What entity would you recommend that Fillmore use for this development? SCENARIO III - DEVELOPMENT OF LONG-TERM HOLD PROPERTY ISSUE: What entity would you recommend that Fillmore use for this development? Entity allowing flow-through taxation would be preferred. Limited liability protection is key for development activities. Preserving long term capital gain treatment on the sale of the farmland; Fillmore should sell the property to the development entity at its current fair market value to receive long term capital gain treatment (cannot sell to an LP or LLC or will not get capital gain treatment if Fillmore owns more than 50% of purchasing entity). If selling property, Fillmore will want installment reporting treatment, since cash flow will be deferred until the end of the development. (Installment reporting rules more restrictive if Fillmore owns more than 50% of development entity). Is the experienced developer eligible to be an S corporation shareholder? Flexibility in development entity for special allocations may be desired (not permitted in an S corporation). F.I.C.A or self-employment tax concerns, especially if Fillmore is not involved in management. If Fillmore wants to be involved in day-to-day management, he cannot be a limited partner. Tax impact of distributing appreciated lots to either owner in the future will depend on entity selected ( taxable distribution if an S corporation; typically tax-free if from an L.P. or L.L.C). Possible Section 754 advantage in an L.P. or L.L.C. if Fillmore should die during development project. 4 SCENARIO III - DEVELOPMENT OF LONG-TERM HOLD PROPERTY ISSUE: What entity would you recommend that Fillmore use for this development? CHOICE: If Fillmore is selling land to the entity to obtain long term capital gain treatment on the appreciation in the land, S corporation is the choice. If Fillmore will contribute the land to the new entity and forego long term capital gain treatment, choice would be an L.L.C. SCENARIO IV - DEVELOPMENT OF UNNEEDED LAND WITH AN UNRELATED DEVELOPER Michigan Manufacturing Company, an S corporation, has held vacant land that is contiguous to their plant for over 20 years. The new management team of 2M has ruled out expansion plans and has decided to build and lease an industrial building on this vacant property. 2M does not have any development nor leasing expertise. They believe that it would be best to joint venture with an individual who has the unique combination of development expertise and the financial wherewithal to either finance or fund this development project. ISSUE: What entity would you suggest for this development? SCENARIO IV - DEVELOPMENT OF UNNEEDED LAND WITH AN UNRELATED DEVELOPER ISSUE: What entity would you suggest for this development? Limited liability protection is important to protect 2Ms assets even though 2Ms shareholders assets are protected). 2M cannot be an investor in an S corporation unless it can be a Qualified Subchapter S Subsidiary. Should subsidiary be a C corporation, partnership or LLC? (No consolidation for tax purposes unless 2M becomes a C corporation and 80% of corporate subsidiary is owned by 2M.) Special allocations of cash flow or tax attributes may be important. Disguised sale concern in a partnership/LLC if there is a special allocation of cash to 2M; not applicable to S or C corporations. Section 704(c) rules on contribution of appreciated property by a partner - must specially allocate gain on sale to 2M. 5 SCENARIO IV - DEVELOPMENT OF UNNEEDED LAND WITH AN UNRELATED DEVELOPER ISSUE: What entity would you suggest for this development? CHOICE: If formed as a joint venture with another individual or corporation, use an L.L.C. to provide flexibility and flow-through taxation. SCENARIO V - 2 UNRELATED CLIENTS DEVELOPING A SHOPPING CENTER Dave Davis, a long time client of yours, has held a piece of vacant land that he has always wanted to develop into a shopping center. Dave has had success in refinancing this vacant property over the 30 year period that he has held it and the amount of the debt ($300,000) now exceeds the $100,000 cost of this property. The property is currently worth $600,000 and Dave has found tenants to lease 60% of the center. Dave has asked you to recommend a developer to help him build this office center. He would like to give the developer a piece of the center in return for a lower developers fee. You believe that Bill Builder, a long time developer client, would be interested in doing this deal ISSUE: What type of entity would you recommend that Dave and Bill use and should you represent both of your long time clients in this venture? SCENARIO V - 2 UNRELATED CLIENTS DEVELOPING A SHOPPING CENTER ISSUE: What type of entity would you recommend that Dave and Bill use and should you represent both of your long time clients in this venture? Limited liability protection is important. Contribution of appreciated land to entity - Section 704(c) issue in a LLC or LP - avoid by using an S corporation? Tax impact of debt in excess of tax basis of property contributed to an S or C corporation. Tax aspects of the receipt of ownership interest in exchange for services. May desire to have special allocations to either Dave or Bill. Daves involvement in day-to-day management; FICA or self-employment tax to Dave and Bill. Conflict of interest representation issue must be addressed. If Section 704(c) applies, which method would you recommend (due to conflict)? 6 SCENARIO V - 2 UNRELATED CLIENTS DEVELOPING A SHOPPING CENTER ISSUE: What type of entity would you recommend that Dave and Bill use and should you represent both of your long time clients in this venture? CHOICE: Limited liability company because of flow-through taxation, flexibility of entity, and avoid taxable income on contribution of land subject to debt by Dave. SCENARIO VI - ESTATE PLANNING WITH FAMILY-OWNED RENTAL REAL ESTATE Wanda Wealthy owns a warehouse and vacant land a quarter-mile from where the Michigan Department of Transportation is seriously considering adding a new interchange to I-75. Wandas grandson, Wellington, recently attended a presentation regarding the use of entities to reduce estate and gift taxes. Wanda would like you to meet with Wellington and her to discuss how this concept would apply to her warehouse and vacant land. ISSUE: What entity would you recommend be used to help Wanda save estate and gift taxes? SCENARIO VI - ESTATE PLANNING WITH FAMILY-OWNED RENTAL REAL ESTATE ISSUE: What entity would you recommend be used to help Wanda save estate and gift taxes? Better alternatives are LP and LLC (no general partnership, S corp or C corp). May want limited liability protection for all owners (Corporate G.P. if LP is used). Wanda will want to retain control. Wanda may want one or more of her children or grandchildren to be involved in the management of this entity. Wanda would like to maintain privacy about her affairs. Wanda would like the real estate to be protected from creditors of her children and grandchildren. Wanda would like to give the maximum amount of this entity to her children and grandchildren, using her unified credit equivalent, but not paying any current gift tax. Wanda may want to differentiate between current distribution rights to herself, to her children, and to her grandchildren. Availability of valuation discounts - Wanda is quite conservative and does not want to have any problems with the IRS. 7 SCENARIO VI - ESTATE PLANNING WITH FAMILY-OWNED RENTAL REAL ESTATE ISSUE: What entity would you recommend be used to help Wanda save estate? CHOICE: Limited liability company because there is no general partner with liability exposure and because Michigan L.L.C. is better than L.P. for valuation discounts on transfers of ownership interests. * William B. Acker is a shareholder and director of the Kemp Klein Law Firm. He is a member of the Council of the Real Property Law Section, and the Chairperson of the Section’s Federal Tax Aspects of Real Estate Transactions Committee. He concentrates on business and estate planning, tax dispute administrative appeals and tax litigation, including planning for real property transactions. He has authored articles for the Journal of Taxation, State Bar Journal, the Section’s Real Property Review, the Tax Section’s “Michigan Tax Lawyer,” and other professional publications. He has often lectured in the Real Property Law Section’s Homeward Bound series, the Tax Section’s After Hours Tax Seminars, and has lectured for the Real Property Section of the ABA and ICLE. Mr. Acker is a member of the ICLE Real Property Advisory Board. FAMILY ENTITIES: SELECTED FUNDAMENTALS REAL PROPERTY ATTORNEYS NEED TO KNOW By: William B. Acker* I. Family Limited Partnerships/Family Limited Liability Companies. Generally, a family entity is organized under state law as a limited partnership (“FLP”) or a limited liability company (“FLLC”) exclusively or predominately owned by family members, and capitalized by contribution by taxpayer(s) (“TPs”) of assets they choose to dedicate and grow for the benefit of their family. FLPs have been used for many years for many of the non tax purposes described later in this outline, and prior to income tax reforms by some taxpayers to shift income to younger generation beneficiaries in lower income tax brackets, while preserving the benefit of losses from FLP owned real estate (prior to the reforms under the Tax Reform Act of 1986) or FLP owned business operations to the older generation taxpayers. 1 The “kiddie tax” income tax reform provisions 2 stymied a significant measure of income shifting by requiring inclusion of the income of a child under 14 years of age on the child’s parent’s income tax returns. The demise of income shifting seemed to diminish interest in FLPs until later developments in estate tax case law and IRS rulings permitted separate valuation for estate tax purposes of undivided interests in assets owned 1 Commissioner v. Tower, 327 U.S. 280 (1946); Commissioner v. Culbertson, 337 U.S. 733 (1949). 2 by family members. This sea change in valuation techniques opened the door for minority interest, lack of marketability and other “discounts,” that offer estate planners a means of leveraging lifetime gift transfers of family entity ownership interests. Today, for simplicity, choice of entity, and other reasons, most family entities seem to be formed as FLLCs, at least in Michigan. This outline will refer to family entities as FLLCs, which are subject to federal tax treatment as partnerships, and will comment from a conservative viewpoint. TPs and their tax counsel will need to decide how to plan for IRS attacks on FLLCs and how to react to the present status of issues and case law concerning FLLCs. II. Primary Reasons Why A Client Forms an FLLC. A. Transfer of Wealth to Beneficiaries. TPs plan to transfer wealth by giving ownership interests in their assets to their beneficiaries, and thereby remove the gifted portion of their assets from their taxable estate. Without an FLLC, gifting of direct ownership split interests can soon involve unduly awkward dealings with trustees, custodians and other third parties, and be complex to track. If assets to be gifted are owned by an FLLC, gifting of fractional member ownership interests is simplified. Preferably, the gift is accomplished by written assignment of an FLLC interest. Transfer of a fractional interest in an FLLC has the effect of a transfer of both a portion of: 1. Current Assets, and 2. Future Appreciation of Current Assets. Gifted FLLC member interests may be held by a trustee of an irrevocable trust established for TPs’ beneficiaries. B. Control of Assets Contributed to an FLLC. By managing or participating in management of the FLLC, TPs can maintain control of, or influence: 2 Section 1(g) of the Internal Revenue Code of 1986, as amended (“Code”). U.S. Treasury Regulation (“Reg.”) §1.1(i), and see Code §59(j). 3 1. Management of Real Property, Business Assets, and Portfolio Investments. 2. Determination of Management/Investment Objectives. 3. Determination of Amount and Timing of Accumulations/ Distributions. C. Preserve Family Wealth. TPs may seek to maintain accumulations of assets for the long term benefit of TPs and their younger generation beneficiaries, and thus to assure family security and wealth. D. Liability Limitation. Use of an FLLC may discourage potential creditors from seeking recourse to FLLC interests. III. Funding FLLCs In Exchange For Member Ownership Interests. A. Funding on Formation of FLLC. All transfers of all assets contributed to the FLLC should be made by written formal assignments, or by deeds properly recorded. Sample basic FLLC formation contribution transactions are described below: 1. Scenario 1: TPs contribute one half of the total value of assets contributed on formation to the FLLC, and receive 50% of the member interests issued on formation, split between two classes of ownership interests, a voting class “A” and a non voting class “B. TPs’ children contribute the other 50% of the total value of assets contributed, and receive like class “A” voting and class “B” non voting ownership interests, aggregating the remaining 50% of the FLLC’s outstanding ownership interests. 2. Scenario 2: TPs contribute all of the assets contributed on formation to the FLLC, and receive 100% of the member interests issued on formation, split between class “A” voting and class “B” non voting member interests. 4 B. Post Formation Funding of Capital Contributions. An FLLC may provide for member TP, and/or TP’s member or non member beneficiaries, to contribute additional assets after initial capitalization of the FLLC. If any non prorata funding is contemplated or admission of a new member may occur, FLLC member ownership interests must be issued. IV. Transfers of Wealth to Beneficiaries: Gifts of FLLC Member Ownership Interests. A. Gifting FLLC Member Ownership Interests. Under either sample formation scenario, TPs interested in transferring FLLC member ownership interests to their beneficiaries may transfer most of the FLLC’s value by gifting class “B” member ownership interests, and when participation in control is to be transferred, by gifting class “A” member ownership interests. TPs should sign written formal assignments of FLLC member interests. 1. Present Interest Gifts. In making yearly gifts under the gift tax annual exclusion, Code §2503(b), the gift must be a “present interest.” The FLLC voting or non voting member interests transferred by gift may, depending on the provisions of the FLLC and/or the nature of the FLLC’s assets, not be treated as “present interests,” and thus not qualify for the gift tax annual exclusion. Hackl v, Commissioner, 118 TC 279, No. 14 (2002) (gifted member interests must confer on the donee current substantial economic or other benefit from use, possession or enjoyment of the property under Code §2503(b)). In Hackl, the transferring TP was named in the operating agreement to be the lifetime manager, and controlled distributions, withdrawals and dispositions of the donee member’s FLLC ownership interests. To seek to avoid this result, each assignment could include a time limited “put” right for the donee to require the donor to purchase the gifted FLLC member ownership interest at fair market value. The “put” right would grant the donee a 5 “present interest” in the nature of a “Crummey” right that should be respected by the IRS. The “put” right should have typical “Crummey” lapsing provisions. If the donees’ interests are held in an irrecovable trust for benefit of the donees, the donees should have the right to exercise the “put” right and/or cause the trustee to do so. 2. Taxable Gifts/Utilizing “Applicable Credit Amount.” Taxable gifts of class “A” voting member ownership interests, whether to give increased participation or establish controlling interests, may be desired to provide some or all of the younger generation beneficiaries more management responsibilities. Substantial gifts of non voting class “B” member ownership interests may be desirable to shift value. B. Post Death Transfers of FLLC Member Ownership Interests. TPs may provide in their estate planning documents for testamentary transfers to the FLLC. V. FLLC Purposes. A. Non-Tax Purposes. An FLLC’s non tax purposes should be expressed in the FLCC operating agreement. Bongard v. Commissioner, 124 TC No. 8 (2005). This helps document and establish the “substance” of the non tax reasons for formation and operation of the FLLC, evidences that formation was not solely for tax purposes and bolsters the argument that TPs’ funding contributions were not “transfers” for federal estate purposes, to arguably preclude application of Code §2036(a)(1) and (2). See Church, 85 AFTR 2d 2000-804 (W.D. Tex 2000). Where significant non tax business or other financial reasons for the FLLC are evident, FLLCs formalities are followed (see D.2 below), and contributors receive FLLC member ownership interests proportionate to the value of assets contributed, the formation contribution transaction may qualify under the ‘bona fide sale of interest for adequate and full consideration’ exception to the application of Code §2036(a)(1) and (2), which could otherwise apply to bring back the transferred interest into the 6 TPs’ taxable estate. Bongard, supra. Estate of Stone, III, TCM 2003-309 (note, however, that the beneficiaries in Estate of Stone made meaningful formation contributions of assets). A non tax purpose is important because on formation, FLLC contributors receive FLLC member ownership interests that are often less marketable than the assets they contribute, due to typical FLLC operating agreement restrictions and state law restrictions. If the FLLC has no business or other non tax purpose except to save taxes, the IRS may argue that the reduction in marketability translates into a gift to TPs’ beneficiaries on formation that constitutes a “transfer” for federal estate tax purposes, and the inclusion provisions of Code §2036(a) may apply. Estate Schauerhammer, TC Memo. 1997-242; Estate of Thompson, TC Memo 2002-206; Kimball v. U.S., 244 F. Supp. 2d 700 (N.D. Tex. 2003), reversed by 371 F.3d 257 (5 th Cir. 2004). The following are examples of non tax reasons for the establishment and operation of an FLLC. 1. Pooling Financial Investments. Combining investment assets aligns family investment and management decision making. Forming a partnership solely for investment purposes is sufficient for federal partnership income tax purposes, without the necessity of the partnership engaging in the active conduct of a separate business. Rev. Rul. 75- 523. See Reg. 1.701-2(a). 2. Centralized Management, Dedication and Growth of Family Wealth. Sheer convenience and manageability of investments results from use of FLLC. Establishing long term family wealth building goals will drive and focus management and investment goals. 3. Involving and Training Younger Beneficiaries. Educating and aiding the younger generation beneficiaries in the course of their participation in management and investment of the FLLC’s assets can be an important “hands on” family opportunity valued by TPs. 4. Business Judgment Rule. 7 The Business Judgment Rule offers protection for FLLC management, particularly regarding operating business and investment decision making. 5. Economies of Scale. Investment cost efficiencies may become available. 6. Private Placement Accredited Investor Qualification. The large value of some FLLC portfolios may assist in qualifying the FLLC as an accredited investor under securities laws and otherwise for alternative investments and private placements. 7. Litigation Avoidance. FLLC operating agreement may include an arbitration provision, although care should be taken to limit the scope of matters covered to matters that may be finally determined by arbitration. 8. Liability Limitation. Asset protection planning may involve placing the unsavory taste of a limited liability interest between family wealth and unknown potential future creditors. State law charging orders, and even foreclosure of member interests may provide discouraging targets for creditors. B. Tax Purposes. The fundamental federal transfer tax purpose for establishing and operating an FLLC is to organize and facilitate the transfer and removal of the value of FLLC ownership interests from the TPs’ taxable estate for federal estate tax purposes. This accomplishes removing from exposure to federal estate tax both the current value and future appreciation of the TPs’ assets contributed to the FLLC. The primary tax motivation most often discussed by FLLC commentators is to leverage the value of the assets removed from TPs’ estate from estate tax exposure, by claiming valuation discounts, primarily for minority interest and lack of marketability of the gifted FLLC member ownership interests. Generally, the so called “discounts” are really valuation adjustments to the member ownership interest’s proportionate share of the total value of the FLLC’s assets, 8 made to reflect the impact in the marketplace of the member ownership interest’s lack of marketability and minority stature. VI. Checklist. The following circumstances should be recognized, and call for further review and analysis. A. Funding FLLC Only with Investment Assets. Taxpayers’ tax advisor must use care to avoid prohibited diversification of investments assets on contributions to the FLLC. Code §721(b). Taxpayers’ members should contribute already widely diversified or identical assets. See Reg. §1.351-1(c). The Tax Court seems to doubt that any non-tax motivations can exist for funding an FLLC solely with untraded marketable securities, absent operating real property or other ongoing business operations. Strangi (II), 302 F.2d at 380. B. Death Bed FLLCs. Much of the bad law emerging from decided cases in recent years has been from death bed last minute FLLCs, where many of the following checklist items have been present. See Estate of Bigelow, TCM 2005-65 (2005), Strangi (IV), 96 AFTR 2d 2005-5230 (CA5 2005). C. Creating Misleading Evidence of Primary Motivations for Tax Purposes. Unprivileged communications touting or calculating estimates of tax benefits as preeminent or primary motivations for creating or operating FLLCs may build evidence for IRS attack. As lethal, is unprivileged witness testimony of any sort of agreement, whether stated or implied, to act contrary to the separateness of the FLLC’s assets or non tax purposes of the FLLC, which may provide a foundation for IRS Code §2036 arguments that the contributing TPs reserved an interest in the contributed property. 9 D. Creating Facts Supporting the Existence of a Direct or Implied Agreement to Retain Control and/or Economic Benefit for Contributed Assets. Indicia of the probability of the existence of an express, implicit or implied agreement that TPs would continue to enjoy control over, and/or economic benefits (e.g., distributions) from, assets contributed to the FLLC after contribution must be avoided, or the value of the FLLC interest in contributed assets may be included in a contributing members’ estate for federal estate tax purposes under Code §2036. Strangi v. Commissioner, (IV), supra. Strangi, (IV) indicated that the agreement must be made at the time of transfer and be that the transferor TP will retain “substantial present economic benefit” from the contributed property. Substantial uncertainty remains under Code §2036. See Strangi, (II), TCM 2003-145 (2003). 1. Funding FLLC with Too Much of Taxpayers’ Assets. FLLC’s funded with virtually all of TPs’ assets, make implausible any premise that TPs would do so without an express or implicit assurance or agreement that TPs would receive income/capital from FLLC to provide for their personal expenses. The IRS will argue that this amounts to a reservation of interest under Code §2036. a. Example: Funding an FLLC with 90-99% of TPs’ assets, and not leaving enough income producing and/or other assets to support TPs at their accustomed standard living for at least the rest of their life expectancy, and also to provide for post death expenses). Strangi, (IV), supra. b. Funding with TPs’ personal use property. c. TPs control or cause the timing and/or amount of distributions to be determined based not on the FLLC’s operational, management or accounting considerations, but rather coincidental with, or based on the timing and/or amount of, the personal expenses of TPs. d. TPs’ control, or cause the FLLC’s manager to make, distributions for TPs or even other beneficiary members, on a non pro rata basis. 10 Arguably, this concern does not include routine mandatory distributions for member’s tax obligations resulting from FLLC allocations of its income tax consequences. e. TPs rely on FLLC distributions for TPs’ personal living expenses (by periodic payments, as needed, or otherwise), or TPs’ post death funeral and estate expenses. Strangi, (IV), supra. f. TPs’ personal residence is contributed to the FLLC and even worse, TP uses the residence without paying rent or an arms length lease. 2. Failure to Follow FLLC Formalities. Failure to operate, account for and control the FLLC as a separate entity under state law and the FLLC’s operating agreement, and the failure to have the FLLC act by and through formal FLLC manager/board decisions under state law and the operating agreement. Example indicia of such failures follow. a. Assets contributed are not actually assigned to the FLLC. b. Capital contributions are not actually allocated to the capital account of the contributor. Income, loss, gain or credit is not allocated pro rata to capital accounts of FLLC members. Distributions on liquidation are not required to be made based on capital accounts. Reasonable compensation is not paid to service provider and/or managing FLLC members. c. Separate bank/brokerage accounts are not promptly established. d. Failure to document formal FLLC decision making/voting per FLLC operating agreement, including all major actions and decisions by formal FLLC consent action or written minutes. e. No change occurs upon formation of FLLC in management or in investment practices. 1. Management goals or practices should be consistent with the objectives of the FLLC owner. See Bongard, supra. 2. Investment style/identity of professional investment advisor or money manager. Changes in investment time horizons and investment 11 decision techniques should be considered to suit the goals of the FLLC owner, as appropriate. f. TPs transfer assets to FLLC and the assets are allocated all or in part to other members’ capital accounts. To qualify for valuation discounts, a gift needs to be of an FLLC member interest. An allocation of TPs’ contributions to their beneficiary members’ capital account would be a taxable capital shift, and would be a gift of assets with no discounts. Shepherd v. Commissioner, 285 F.3d 1258 (11 th Cir. 2002), aff’g 115 TC 376 (2000). g. TPs Retain Too Much Control Over the FLLC. Retention of too much control can lead to inclusion of TPs’ contributed assets in TPs’ taxable estate at their date of death value, and probably would eliminate any discounts. Code §2036, Strangi, (IV), supra. 1. TPs should not retain discretion as to the timing and amount of distributions. To counter retention of control arguments, mandatory pro rata distributions of available cash should be required, arguably subject to the managing TP’s determination of the amount of reserves for the goals and operation of the FLLC. The FLLC operating agreement should state an enforceable standard for the FLLC manager’s determination of reserves and the needs of the FLLC’s business. See Rev. Rul. 73-143. Note, however, that by mandating distributions and attempting to avoid the IRS’ attack on TP’s control, the price may be significant reductions of discounts, and reduced creditor protection. 2. TPs should not control dissolution or liquidation, which should be determined by vote of all members. 3. Retention of voting control. A mere retention of the right to vote on distributions or dissolution/liquidation of the FLLC may cause inclusion of TPs’ property contributed to the FLLC in a deceased TP’s estate for federal estate tax purposes. See Code §2036(a)(2), Reg. §20.2036-1(b)(3). However elimination of TPs’ control over distributions and dissolution/liquidation may ease this concern. Some of the following suggestions to avoid this may have income tax consequences. 12 i. TP could transfer all of TP’s voting FLLC member interest to TP’s spouse, so that TP retains no voting control. This may eliminate concern as to property contributed by TP to the FLLC. Note however, this transfer will result in the transferring TP ceasing to be entitled to receive distributions from the FLLC, and TP’s spouse will be free to dispose of the transferred member interest. ii. TP could transfer all of TP’s voting FLLC member interest to TP’s beneficiaries, and thus retain no voting control. TP may make taxable gifts that could, to the extent exceeding TP’s available applicable credit amount, result in gift tax. Obviously, any transfer before its time may have undesirable family control implications. iii. TP could transfer all of TP’s voting FLLC member interest to an irrevocable trust for the benefit of TP’s beneficiaries, and retain certain rights to render the transfer an incomplete gift. One such power is a lifetime limited power of appointment. Reg. §25.2522-2(c). iv. TP could transfer all of TP’s voting FLLC member interest to a lifetime QTIP trust. Code §2523(f)(5)(A)(i) would arguably prevent the inclusion of the member interest in TP’s taxable estate. This alternative allows TP to act as, or pick an independent trustee of the lifetime QTIP trust and control the disposition of the property after TP’s spouse’s death. h. FLLC operating agreement provisions entitling TPs to solely determine the FLLC’s manager, or failing to provide a limit to the FLLC manager’s term without a provision for removal and/or replacement. The FLLC operating agreement should provide all members to vote to determine the manager. i. Failure to prohibit amendment of the FLLC operating agreement by other than unanimous consent of all members. See Sidney E. Smith III v. U.S., _______ (USDC No. 02-264 ERIE). j. Failure to gift only capital investments. It is not sufficient to gift a profits interest. Reg. §1.704(e)(1)(v). 13 k. FLLC operating agreement provisions should confirm that TP, as donor and manager is subject to a fiduciary duty. See Strangi, (IV), supra. l. Failure to timely maintain accurate FLLC books and records, including FLLC financial accounting. E. Taxpayers’ Claim Inadequately Documented Gift Valuations and Discounts. Valuing FLLC member ownership interests for transfer tax purposes requires an appraisal of the assets owned by the FLLC, and a second appraisal of the FLLC member ownership interests that builds on the first, and establishes a basis for any “discounts.” F. Taxpayers’ Claim Excessive “Discounts.” All discounts are based on an appropriate analysis by the appraiser of the operating agreement, and no expectation is universally appropriate, however, aggressive discounts are often evident after analysis of the FLLC operating agreement and the appraiser’s report. 483694v1 OPERATING AGREEMENT for SAMPLE FAMILY, L.L.C., a Michigan limited liability company by and among JOHN DOE TRUST JANE DOE TRUST ABC TRUST, BCD TRUST, CDE TRUST, DEF TRUST and EFG TRUST (the "Members") PREPARED BY RICHARD A. SHAPACK FOR THE REAL PROPERTY SECTION HOMEWARD BOUND SERIES NOVEMBER 3, 2005 Operating Agreement for Sample Family, L.L.C. ii THE INTERESTS DESCRIBED AND REPRESENTED BY THIS OPERATING AGREEMENT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933 (THE "ACT" OR ANY APPLICABLE STATE SECURITIES LAWS ("STATE ACTS") AND ARE RESTRICTED SECURITIES AS THAT TERM IS DEFINED IN RULE 144 UNDER THE ACT. THE SECURITIES MAY NOT BE OFFERED FOR SALE, SOLD, OR OTHERWISE TRANSFERRED EXCEPT PURSUANT TO AN EFFECTIVE REGISTRATION STATEMENT OR QUALIFICATION UNDER THE ACT AND APPLICABLE STATE ACTS OR PURSUANT TO AN EXEMPTION FROM REGISTRATION UNDER THE ACT AND APPLICABLE STATE ACTS, THE AVAILABILITY OF WHICH IS TO BE ESTABLISHED TO THE SATISFACTION OF THE COMPANY. OPERATING AGREEMENT for SAMPLE FAMILY, L.L.C., a Michigan limited liability company TABLE OF CONTENTS Article I - Organization................................................................................ 1 1.1 Formation...............................................................................................1 1.2 Name ......................................................................................................1 1.3 Purposes................................................................................................1 1.4 Duration .................................................................................................2 1.5 Registered Office and Resident Agent ...................................................2 1.6 Principal Place of Business ...................................................................2 1.7 Intention for Company ...........................................................................2 1.8 Number of Members...............................................................................2 1.9 Definitions..............................................................................................2 Article II - Books, Records and Accounting ............................................ 5 2.1 Books and Records................................................................................5 2.2 Fiscal Year Accounting ..........................................................................5 2.3 Reports ..................................................................................................5 2.4 Member's Capital Account .....................................................................6 2.5 Company's Designated Tax Matters Member .........................................8 Article III - Capital Contributions............................................................... 9 3.1 Membership Interest ..............................................................................9 3.2 Initial Contribution .................................................................................9 3.3 Loans .....................................................................................................9 3.4 Ownership of Company by Members ................................................... 10 3.5 Interest on and Return of Capital Contribution .................................... 10 Operating Agreement for Sample Family, L.L.C. iii Article IV - Allocations and Distributions ..............................................10 4.1 Definition of Net Cash Flow.................................................................. 10 4.2 Allocation of Net Profits and Losses.................................................... 11 4.3 Distribution of Net Cash Proceeds ....................................................... 13 4.4 Allocation of Residual Profits and Losses ........................................... 13 4.5 Interpretation........................................................................................ 14 Article V - Disposition of Membership Interests...................................14 5.1 Restrictions on Transfer....................................................................... 14 5.2 Rights of Assignee(s)........................................................................... 15 5.3 Non-Registration .................................................................................. 16 5.4 Right of First Refusal ........................................................................... 16 5.5 Acquisition of Manager's Interest......................................................... 17 5.6 Limitation upon Withdrawal of a Member............................................. 18 5.7 Transfer Election.................................................................................. 18 5.8 Price on Involuntary Sales ................................................................... 19 5.9 Discounts ............................................................................................. 19 5.10 Interest ................................................................................................. 19 5.11 Time of Closing .................................................................................... 19 Article VI - Meetings of Members............................................................19 6.1 Voting................................................................................................... 19 6.2 No Required Meetings.......................................................................... 20 6.3 Place of Meetings................................................................................. 20 6.4 Notice of Meetings ............................................................................... 20 6.5 Meeting of all Members ........................................................................ 20 6.6 Record Date ......................................................................................... 20 6.7 Quorum ................................................................................................ 20 6.8 Manner of Acting.................................................................................. 21 6.9 Proxies ................................................................................................. 21 6.10 Action by Members Without a Meeting ................................................ 21 6.11 Waiver of Notice ................................................................................... 21 Article VII - Management and the Rights, Powers and Obligations of the Manager............................................................22 7.1 Management Vested With the Manager................................................ 22 7.2 Limitations on Manager Authority........................................................ 24 7.3 Member Activities ................................................................................ 24 7.4 Annual Operating Plan ......................................................................... 24 7.5 Reimbursement; Operating Expenses ................................................. 25 7.6 Compensation...................................................................................... 25 7.7 Transactions with Affiliates.................................................................. 25 7.8 Other Activities Permitted .................................................................... 26 7.9 Officers ................................................................................................ 26 7.10 Failure to Take Action .......................................................................... 26 7.11 Standard of Care; Liability.................................................................... 26 Operating Agreement for Sample Family, L.L.C. iv 7.12 Changes in Manager ............................................................................ 26 7.13 Removal of a Manager.......................................................................... 27 7.14 Limitations on Liability of Members and Managers.............................. 27 Article VIII - Separateness/Operations Matters.....................................28 Article IX - Exculpation of Liability: Indemnification ...........................29 9.1 Exculpation of Liability......................................................................... 29 9.2 Indemnification .................................................................................... 29 Article X: Effect of Bankruptcy, Death or Incompetency of a Member .............................................................................................30 Article XI - Dissolution and Winding Up ................................................30 11.1 Dissolution ........................................................................................... 30 11.2 Winding Up .......................................................................................... 30 11.3 Return of Capital .................................................................................. 31 Article XII - Miscellaneous Provisions ...................................................31 12.1 Representations and Warranties.......................................................... 31 12.2 Federal Income Tax Elections .............................................................. 32 12.3 Consent of Member.............................................................................. 32 12.4 Further Execution................................................................................. 32 12.5 Opportunity for Independent Representation, Separate Counsel and Conflicts of Interest ....................................................................... 33 12.6 Fees to Prevailing Parties .................................................................... 33 12.7 Waiver of Partition................................................................................ 33 12.8 Jurisdiction and Choice of Law............................................................ 33 12.9 Notices ................................................................................................. 34 12.10 Binding Effect ...................................................................................... 34 12.11 Alternate Dispute Resolution / Arbitration............................................ 34 12.12 Words - Gender and Number ............................................................... 35 12.13 Article Headings................................................................................... 35 12.14 Severability .......................................................................................... 35 12.15 Counterparts ........................................................................................ 35 12.16 Confidentiality ...................................................................................... 35 12.17 Power of Attorney ................................................................................ 36 12.18 Estoppel Certificate.............................................................................. 36 12.19 No Third Party Rights ........................................................................... 37 12.20 Rule Against Perpetuities..................................................................... 37 12.21 Waivers, Defaults, and Joint Exercise of Rights .................................. 37 12.22 Amendments........................................................................................ 37 12.23 Entire Agreement ................................................................................. 37
