Carefully choose where you form your LLC.  LLC laws vary a lot from state to state, and in material ways. Choosing unwisely or uninformed could subject you and your LLC to greater risks of loss and liability. However you may feel about the issue as a matter of policy, you, as a business owner/manager have a choice. You should be informed and choose wisely.

            This entry focuses on creditor remedies where the debtor is a member of an LLC. Most LLC Acts establish rules that define how and under what circumstances a creditor can effectively lien the LLC interest held by the debtor. That lien, called a charging order, allows the creditor to receive distributions from the LLC that would otherwise have gone to the debtor. In addition, all states provide mechanisms by which the creditor can influence whether and when those distributions are made. In some cases, the creditor can force the LLC to be liquidated.

            While every state’s laws provide creditor remedies, the laws vary greatly from state to state. The variance is particularly great as to creditor remedies available where the debtor is the sole member of an LLC. This post focuses on these remedies. Some states set a relatively low hurdle for the creditor to access the LLCs assets. Other states (notably Delaware and Maine) require a creditor to clear a high hurdle. The creditor must show that the LLC veil should be pierced.

            John seeks to collect on a judgment against Bob. However, Bob does not have much cash or other assets that can easily be converted to cash.  Bob does, however, have a high net worth, thanks to interests in some LLCs.

            Can John access those LLC assets to collect on the judgment? Generally not. The best (and sometimes only) option available under most LLC statutes is a charging order on Bob’s interests in the LLCs. While there are a range of charging order statutes in LLC Acts around the country, generally speaking, a charging order makes the creditor only a little better off than it was without the order. It’s leverage.

            Some charging order statutes give creditors more leverage than others. Those states allow creditors to foreclose on an LLC interest. If a creditor can foreclose on the interest, the creditor has all rights to the interest. Section 503(b) of the Uniform Limited Liability Company Act (the 2013 version) (the “Uniform Act”) provides for foreclosure rights where the creditor shows that distributions under a charging order will not pay the judgment debt within a reasonable time.

            In addition, under Section 503(f) of the Uniform Act, the foreclosing creditor can effectively cause the LLC to be liquidated, if the debtor is the sole member of the LLC.

            The drafters of the Uniform Act support their approach on two bases. First, in the absence of a foreclosure right, the debtor could use the LLC simply as an asset protection device. LLCs were not intended to be asset protection devices per se. Second, where the debtor is the sole member of the LLC, allowing the creditor to cause a liquidation does not violate the pick-your-partner principal. That principle comes from a long-standing partnership legal principle known as delectus personae. Under that principle, partners are allowed to choose those with whom they partner. Since there are no other partners in a single-member LLC, the policy for the charging order as an exclusive remedy does not exist.

            Other statutes, such as Delaware and Maine, provide that the charging order is the exclusive remedy for judgment creditors. Under those statutes, there is no foreclosure right.

            While a creditor may not foreclose on an LLC interest of a Delaware or Maine limited liability company, the creditor may sometimes access a single-member LLC’s assets. Courts have the power to order such a result if the LLC is the alter ego of the single-member. In other words, before a court may order that a creditor can access the assets of an LLC wholly-owned by the judgment debtor only if the creditor makes a veil piercing case.

            Sky Cable, LLC v. DIRECT TV Inc., 886 F.3d 375 (4^th Cir. 2018) does a great job applying Delaware law on this issue. Judge Keenan, writing for the Fourth Circuit Court of Appeals, held that creditors of Randy Coley, the sole member of several LLCs, could satisfy their judgment against Mr. Coley with assets of those LLCs. The trial court found that Mr. Coley commingled cash of the LLCs with his personal funds, paid personal obligations (including the mortgage debt on his residence) with LLC cash, and also commingled assets among the LLCs. In short, he treated the LLCs like they were personal accounts. Further, the trial court found that Mr. Coley defrauded the creditor. Under the circumstances, piercing the LLC veil seems perfectly consistent with Delaware law and business entity policy.

            While the Uniform Act makes a good case for Section 503(f), the Delaware approach makes the best sense. The drafters of the Uniform Act support the Section 503(f) by considering the interests of the member(s) as against the interests of the creditor(s). That’s too narrow a view. There are other people who could be effected by a foreclosure. The LLC also may have employees, other creditors, vendors, or other third parties whose businesses could be adversely affected by allowing the LLC to be liquidated. By requiring the creditor to make an equitable case – a veil piercing case – for liquidating the LLC, the law allows a court to consider those interests as well.

            However you view the policy on this issue, as a business manager, the differences described above present you with a choice. Your choice could have a material impact on your business, on your investors, on your employees, on other third parties. It could also have a material affect on you and your liability as a manager. You owe those people (the investors in particular) a duty. Think about that. Choose wisely.

WARNING: This post is more cathartic than instructive. It’s my rant on this lousy Bill before Congress that will likely become law. It’s not intended to be political. It addresses wrongs committed by both Republicans and Democrats. It so happens that the latest wrongs are all attributable to Republicans. The latest wrongs, though, are particularly offensive. They are packaged and sold as tax reform. They are not tax reform. Real tax reform requires an intensive policy-driven process. The Tax Cuts and Jos Act (it may well  become known as the Jobs Cuts and Tax Act) stinks of politics. It has no soul. It will hopefully soon be replaced with a new tax code based on real tax reform.

Section 199A (the 20% pass-through business income deduction) exemplifies the wrong that bothers me. So, my rant about the Tax Cuts and Jobs Act picks on that provision.

Section 199A

If any member of Congress or the Executive Branch attempts to claim that the Tax Cuts and Jobs Act simplifies the Internal Revenue Code, ask that member to explain in 30 seconds or less the details of new Section 199A.

Section 199A epitomizes so many politically-driven provisions of the Code. It excludes certain income from gross income. The exclusion is not based on any broadly-shared policy goal. It’s directed to certain taxpayers. Those taxpayers tend to be higher-income. They also tend to be very well-represented by lobbyists. It costs a lot of money. Without complicated exclusions, it would cost too much money. So, Congress must narrow the exclusion to reduce its cost. Section 199A limits the exclusion in several ways:

• The income does not include investment income: interest, dividends, commodities trading, notional principal contract income, foreign currency gains, any annuity payments;
  • Without going into details, Section 199A provides exceptions to these qualified business income exceptions. Creating exceptions to exceptions is another feature of provisions like Section 199A.
• The income must be effectively connected with a US trade or business;
• The deduction is capped at 20% of qualified business income.
• Despite the popular name for the provision (a 20% pass-through deduction), the deduction is really the sum of
  • The greater of 2 amounts (subject to the 20% cap):
    • 50% of “adjusted wages” paid by the trade or business, or
    • 25% of the “adjusted wages” paid by the trade or business, plus 2.5% of the “unadjusted basis” of the business capital assets, plus
  • 20% of the sum of:
    • qualified REIT dividends, plus
    • qualified publicly-traded partnership income.

As you might expect for a provision like Section 199A, the terms like “adjusted wages” and “unadjusted basis” are determined with reference to existing Code concepts. Those concepts, though, are tweaked just for Section 199A. Isn’t that grand?

But wait, there’s more! While the House version of the Act excluded professional service income from Section 199A benefits, the Conference version includes it, subject to more limits. Those limits are based on the income of the taxpayer. The Section 199A benefit phases out for taxpayers who are married and file jointly at $315,000 taxable income. The benefit phases out for other taxpayers at $157,500 of taxable income. The benefit is completely phased out for married-filing-jointly taxpayers at $415,000 taxable income and for other taxpayers at $207,500.

As noted above, the Section 199A deduction is not a simple 20% of easily-calculated income. It’s based on a formula that takes adjusted wages paid and unadjusted bases of capital items. The phase-out just complicates that formula. No biggie! Could it get more complicated? Why yes!!

Only certain professional service income is subject to the phase out. Apparently, the engineers and architects had better lobbyists than the ABA. Or maybe Congress decided to penalize the ABA for determining that 2 of the Administration’s nominees for Appeals Courts were not competent. In any case, the engineers and architects are not subject to this professional service rule.

So, what will professional service partnerships do? Well, they might divide their businesses between the pure consulting/counseling element and other elements that are more based on capital and product sales.

The Act provides the Treasury Department (Internal Revenue Service) with authority to issue regulations to implement this provision and to provide anti-abuse provisions. Whenever you see an Act that grants IRS regulatory authority to draft anti-abuse provisions, it usually means that Congress knows it just created a provision that is vulnerable to (maybe even invites) abuse.

Based on the IRS budget allocation and the regulatory comment period, we should expect final regulations about the time that another Congress repeals this provision in a real tax reform act.

 

H.R. 1 of the 115^th Congress – the “Tax Cuts and Jobs Act” – repeals the Historic Rehabilitation Tax Credit (the “HTC”). That credit is found in section 47 of the current Internal Revenue Code. The effective date of the repeal is the date the Act becomes law. The Republican Leadership wants the Act to become effective on January 1, 2018. So, generally speaking, assuming the Republicans’ dreams come true, any rehabilitation expenditures for a building that is not substantially rehabilitated by December 31, 2017 will not generate HTCs.

The Senate version of the Tax Cuts and Jobs Act (as voted out of the Senate Finance Committee on November 16) does not repeal the HTC. It does, however, change the timing of the credit. Now, the 20% credit is earned in the year the rehabilitated historic building is placed in service. The Senate Bill provides that the credit is earned ratably over the five year period beginning when the historic rehabilitated building is placed in service. Here’s how the credit would work under the Senate bill:

Example

X Corp (a C corporation) acquires Building (an historic structure) on January 1, 2018. During the 24 months beginning January 1, 2018, X Corp incurs $5,000x dollars in qualified rehabilitation expenditures substantially rehabilitating (more on that later) Building. On December 31, 2019, X Corp places Building in service. Assuming X Corp has complied with all requirements for the HTC, then

Current Law

Under current law (assuming the Tax Cuts and Jobs Act is not enacted) X Corp would be entitled to a $1,000x HTC for 2019.

 Senate Version of Tax Cuts and Jobs Act

Under the Senate Bill, X Corp would be entitled to a $200x HTC for each of the five tax years beginning 2019 (i.e., 2019, 2020, 2021, 2022, and 2023).

Obviously, the current law HTC is worth more than the HTC under the Senate Bill. As a consequence, if the Senate Bill is enacted, it will be more difficult to finance historic rehabilitation than it is under current law. However, the Senate Bill is much better for historic rehabilitation than the House Bill which repeals the credit altogether.

Transition Rule

Even if some version of the Tax Cuts and Jobs Act repeals or modifies the HTC, some existing projects will earn HTCs under current law, though the projects are placed in service after the Act is enacted.  Each version of the Act contains a “transition rule” for existing historic rehabilitation projects. The point of most transition rules is to take account of the fact Congress is changing the rules of the game with very little notice. Without the transition rule, people who made capital commitments in reliance on current law would be harmed.

But, Congress has to set a limit to the harm they’ll address. Otherwise, the exception would swallow the rule. So, Congress drafts the exception with a clear fence around the relief from harm generated by its harmful conduct.

The following is the transition rule for the HTC repeal. Be forewarned. This transition rule will not make any sense to you if you read it quickly. And even if you read it carefully several times, you’ll notice that it does not provide clear guidance to taxpayers about the exception it was drafted to create. In other words, the transition rule needs to be clarified to be understood.

Here’s the text of the transition rule:

In the case of qualified rehabilitation expenditures (within the meaning of section 47 of the Internal Revenue Code of 1986 as in effect before its repeal) with respect to any building –

(A)  Owned or leased (as permitted by section 47 of the Internal Revenue Code of 1986 as in effect before its repeal) by the taxpayer at all times after December 31, 2017, and

(B)   With respect to which the 24-month period selected by the taxpayer under section 47(c)(1)(C) of such Code begins not later than the end of the 180-day period beginning on the date of the enactment of this Act

the amendments made by this section (3403 of the House Bill) shall apply to such expenditures paid or incurred after the taxable year in which the 24-month period referred to in subparagraph (B) ends.

The Rule – In English

The House Bill repeals the Historic Rehabilitation Tax Credit (the “HTC”) effective 12.31.2017. However, a taxpayer can claim the HTC for qualified rehabilitation expenditures (“QREs”) incurred after 12.31.2017 if the taxpayer satisfies two tests:

(1) the building ownership test, and

(2) the substantially rehabilitated test.

1. Building Ownership Test

QREs incurred after 12.31.2017 may produce HTCs only if the taxpayer who incurred the QREs/claims the HTCs owned or leased the building at all times after 12.31.2017.

2. Substantial Rehabilitation Test

First, a little background on substantial rehabilitation.

            What is Substantial Rehabilitation?

HTCs are only available if the rehabilitated building was “substantially rehabilitated”. A building is substantially rehabilitated if the amount of QREs incurred in any 24-month period selected by a taxpayer is equal to or greater than the adjusted tax basis of the building at the start of that 24-month period.

            Example: A owns Building. On July 1, 2015, A’s adjusted tax basis in Building is $500,000. During the 24-month period beginning July 1, 2015, A incurs $750,000 of QREs in rehabilitating Building. A selects that 24-month period as the test period for “substantial rehabilitation”. That 24-month period ends June 30, 2017.

(i)                 Because A incurred QREs that were greater than A’s basis in Building at the beginning of the test period, Building is “substantially rehabilitated”, and

(ii)               Because Building is substantially rehabilitated, A may take HTCs for all QREs incurred through the end of 2017 – the year in which the 24-month period ends.

The Test – Substantial Rehabilitation

The transition rule says that QREs incurred on Building after December 31, 2017 will generate HTCs only if the substantial rehabilitation test period begins within 180 days after the Act is effective. That means, if the Act is effective as of January 1, 2018, the substantial rehabilitation test period should begin before June 30, 2018.

The Result

If a taxpayer satisfies both tests, then all QREs incurred by the end of the year in which the substantial rehabilitation test period ends will generate HTCs for the taxpayer.

            Example

A acquires Building on December 31, 2017, the date the Act is effective. On June 1, 2018, A’s adjusted tax basis in Building is $500,000. During the 24-month period beginning June 1, 2018, A incurs $750,000 of QREs in rehabilitating Building. A selects that 24-month period as the test period for “substantial rehabilitation”. That 24-month period ends May 31, 2020.

(i)                 Because A incurred QREs that were greater than A’s basis in Building at the beginning of the test period, Building is “substantially rehabilitated”, and

(ii)               Because Building is substantially rehabilitated, A may take HTCs for all QREs incurred through the end of 2020 – the year in which the 24-month period ends.

The Transition Rule Applied to Partnerships

In the examples above, we assume that A owns Building and is the taxpayer. What if a tax partnership (a limited partnership or an LLC) owns Building? Since many (maybe most) historic rehabilitation projects that generate HTCs are conducted through partnerships, most projects will benefit greatly from a transition rule that addresses tax partnerships.

 

H.R. 1 of the 115th Congress (the “House Bill”) has elements of H.R. 1 of the 113th Congress (the “Camp Proposal”).  However, there are big differences between the two bills. In contrast to the House Bill, the Camp Proposal was a real tax reform proposal. It truly simplified the tax code. It repealed many special provisions that reduced taxable income. In technical terms, it expanded the tax base.

The Camp Proposal was also a net revenue raiser. The Congressional Budget Office projected that the Camp Proposal would generate 3 billion dollars over the 10 year term ending 2023. The House Proposal, by contrast, is estimated (by those who are presenting the proposal in the most favorable light) to reduce tax revenue over the next 10 years by $1.5 TRILLION. Others forecast the true cost at as much as $3,000,000,000,000. That mesmerizing number is $3 trillion.

The Camp Proposal is designed to achieve tax policy goals. I’d approach those goals differently. Despite disagreeing with the methods of achieving those policy goals, I admire the Camp Proposal. It’s a respectable legislative effort to expand the tax base and reduce income tax rates. It simplified the Code without increasing the federal government budget deficit.

The House Bill, in contrast, appears to be driven by a predominant desire to cut taxes. The House Bill contains some of the simplifying elements of the Camp Proposal, but, those seem to be driven more by politics than policy. Other elements of the House Bill introduce mind-numbing complexity (like the special rate for pass-though “business” income). It achieves a tax cut at the expense of complicating the Code. In short, the House Bill lacks the coherent tax policy features of the Camp Proposal.

Noteworthy Features

According to the folks in DC who know best, the House Bill as drafted will not be enacted. However, elements of it may survive. And those items that survive may be effective as of January 1, 2018. That provides little time to plan for these changes. So, it makes sense to assume that certain elements of the House Bill will become law. The following presents my initial thoughts on changes to section 1031 and how they will affect 1031 transactions. In other posts, I’ll consider some of the other items.

1031 Exchanges

The House Bill repeals 1031 exchanges for personal property. Only real property exchanges can qualify for 1031.

Many (and I suspect most) 1031 exchanges are deferred exchanges. Most deferred exchanges are forward deferred exchanges. In a forward deferred exchange, the taxpayer sells relinquished property before acquiring replacement property.

At closing of the relinquished property, a qualified intermediary takes proceeds of sale to hold for certain periods while the taxpayer identifies and acquires replacement property. Presently, the QI typically takes all of the proceeds of sale. If any of the proceeds are paid to the taxpayer, the taxpayer is treated as receiving boot. Boot is taxable to the taxpayer up to the amount of the taxpayer’s gain. The taxpayer also receives boot to the extent that it has a net reduction in liabilities in the exchange.

If only real property qualifies for 1031 exchange treatment, the taxpayer selling a building will recognize gain on the sale of any personal property sold as part of the building’s sale.

If some of the gain from the sale of a building cannot be deferred and is immediately taxable, it would make sense to allow the taxpayer to take proceeds from the sale of those assets and give the balance to the QI. Sounds easy when you say it fast. It’s not easy, though. Avoiding boot on the real estate assets of building sale with a mix of real and personal property will require some thought – and some guidance from IRS:

• Will IRS treat any cash taken at closing as relating to boot from the real estate sale?
• What if the real and personal property are security for a loan (as is almost always the case)? Will any debt discharge in the exchange be treated as boot? Or will boot be limited to the amount traced to the real property? How will that traced amount be determined?

A lot of real estate investors aggressively characterize building assets as personal property. These investors’ positions are often supported by “cost-segregation” reports. These reports are sold by accounting firms and others who look at all of the building’s assets to determine which can be characterized as personal property. They sell the reports to investors promising to significantly reduce annual income and therefore boost after-tax NOI.

In light of changes to section 1031, cost segregation may be a net loser for real estate investors. Investors should calculate the net present value of the additional depreciation deductions cost segregation offers in light of (i) the fact that the depreciation is recaptured at ordinary rates, and (ii) the fact that none of the gain recognized on the sale of personal property will be eligible for gain deferral.