You may have heard that new federal reporting requirements for owners of business entities went into effect on January 1, 2024. Please allow us to explain what you may be required to do to comply and how we are able to assist you.
What is the Corporate Transparency Act?
The Corporate Transparency Act is intended as an anti-money laundering and financial crime measure. It requires the "beneficial owners" of corporations, LLCs, and other business entities operating in the United States to provide certain basic information about themselves to FinCEN, an agency of the U.S. Department of the Treasury. This information will be kept in a database which will be available to law enforcement and to banks but not to the general public.
Most closely-held business entities in the United States, including most of the business entities our firm forms and works with regularly, are considered "reporting companies" and are covered by the new law. There are certain narrow exceptions, but these do not apply to most of our clients. We strongly advise consulting with us or other knowledgeable professionals before assuming that an exception may apply to you and that you are therefore not required to file.
It is worth noting that publicly-traded entities are not covered by the law, primarily because their ownership is already public information. Thus, you are not required to report just because you own publicly traded stock, or are a trustee or beneficiary of a trust that owns publicly-traded securities. If you are receiving this message, however, you are a business client of our firm whom we believe is likely subject to a filing requirement.
The penalties for failure to comply with the law are substantial. Civil penalties for failure to file, or update, the information can be as high as $10,000, and criminal penalties including prison sentences are also possible.
Who Must Report
Reporting companies must provide information about themselves, as well as about two classes of "beneficial owner" individuals involved with them. First, individuals who either own or control at least 25% of the reporting company's ownership interests must report. Second, individuals who exercise "substantial control" over the reporting company must also report. This second requirement will generally include managers (of manager-managed LLCs), most members of member-managed LLCs (regardless of the percentage owned), directors, officers, and anyone else with substantial influence over the company's operations.
The rules are designed to "look through" entity structures and require the individuals who ultimately control the entities to be disclosed. In the case of trusts which own interests in reporting companies, the trustee must be disclosed, and in many instances current beneficiaries must be disclosed as well.
When to Report
For entities formed before January 1, 2024, an initial report is due by January 1, 2025, meaning that existing companies have one year from the effective date to file.
For entities formed on or after January 1, 2024, an initial report is due within ninety (90) days of formation.
In addition, any change to the information on file must be updated within thirty (30) days of the change. Likewise, any inaccuracy, once known to the reporting company, must be corrected by the company within thirty (30) days of becoming known. Our firm often will not know, and not have any way to know, about a change, so it is very important for beneficial owners of reporting companies to be aware of the requirement to update this information.
What to Report
Reporting companies must report: (1) full legal name; (2) any trade or d/b/a names; (3) complete current business address; (4) state of formation; and (5) IRS-issued employer identification number (EIN).
Beneficial owners must report: (1) full legal name; (2) date of birth; (3) complete residential street address; (4) a unique identifying number from a government-issued photo ID, that is, a passport or state-issued driver's license (and the state of issuance); and (5) an image of such government-issued photo ID.
Where to Report
Reports are filed electronically on the FinCEN website, at the following web address:
https://boiefiling.fincen.gov/
The website is relatively well-designed and navigable. Some of our clients may be comfortable enough with using this website to file their initial reports on their own. If you choose to do this, please simply let us know what reports you have filed for our records.
Our Firm's Involvement
Our firm will be glad to assist you with the required initial filing consistent with the terms of your current engagement with us; however, if you would like our assistance, you must contact us, provide the necessary information, and ask us to handle the filing for you. We cannot handle the initial filings for your company unless we gather certain information from you. Until very recently, we did not gather all of the information needed from each client, and even if we had, we would have no way to know whether it might be outdated.
We have developed a one-page standard form, which beneficial owners can complete via DocuSign, to provide us the necessary information. This form also provides a means for you to upload an image of your photo ID, which must be provided to FinCEN as part of the report.
Once an initial report is filed, we cannot have any obligation to keep the information on file updated unless you provide us the updated information and ask us to make the updated filing.
Registered Agencies
Historically, our firm has served as registered agent for many of our clients' South Carolina business entities. In recent years, because the reporting requirements were so minimal, we have performed this function free of charge in many instances where the entity was not registered in any other state. Regrettably, because of the additional reporting obligations created by the Corporate Transparency Act and related administrative costs, we cannot continue to serve as a South Carolina registered agent without charge.
We will be separately contacting all our clients for whom we are serving as a South Carolina registered agent in the coming days regarding transferring the registered agency. There are companies which can perform this function far more efficiently and cost-effectively than we are able to do. (Clients with entities in other jurisdictions not registered to do business in South Carolina already have third-party registered agents, and are not affected.)
Conclusion
We will be glad to assist you with filing the initial report for your existing company or companies, and to answer any questions you may have regarding these requirements. Please contact us at (843) 202-4472 or via e-mail at info@swwlc.com should you wish to discuss these matters further. Thank you for your continued confidence in us.
Seth W. Whitaker, Ltd. Co. is a personalized trusts and estates and business law firm for individuals, families, professionals, and entrepreneurs, serving clients throughout the Carolinas. This message is not legal advice, and no attorney-client relationship is formed by reading it. We hope you will contact us at (843) 202-4472 or info@swwlc.com if you would like to discuss your specific situation.
Estate and Gift Tax Legislative Update
Since I last wrote a general update to our estate planning clients in late 2020, there had been relatively little real information about what tax law changes Congress might seek to make this year. Most items reported in the press were speculation or were about proposals which stood little chance of passage on their own.
That changed last week, as the House Ways and Means Committee (the House's tax-writing committee) published its initial draft of tax increases designed to pay for the proposed $3.5 trillion spending package also under consideration.
Although still at the committee stage, this bill is the best indication so far of what tax changes might ultimately emerge. For a detailed summary of the bill, I recommend this Forbes article. Key income tax provisions include a top ordinary income tax rate increase to 39.6%, a top capital gains tax rate increase to 25%, changes which eliminate many of the benefits of S corporations over tax partnerships for the self-employed, and more stringent income limits on the 20% passthrough income deduction.
In addition to income tax changes, the bill also contains a number of very important changes to the estate and gift tax law. These include:
a halving of each taxpayer's lifetime exclusion from estate, gift, and generation-skipping transfer taxes from $11.7 million per person for 2021 to approximately $6 million per person (as annually adjusted for inflation) beginning on January 1, 2022
a new rule providing that all grantor trusts (that is, trusts on which the grantor pays the income tax) are includible in the grantor's gross estate, effective for all new grantor trusts or new contributions to grantor trusts, from the date of enactment
a new rule dramatically reducing the availability of valuation discounts for gift tax purposes, from the date of enactment
The changes regarding grantor trusts and valuation discounts are designed to eliminate many of the most popular and effective estate planning strategies of the past two decades. These are the very strategies which we would otherwise recommend to most of our clients affected by the decreasing exclusion amount.
Affected strategies include installment sales to intentionally defective grantor trusts (IDGTs), grantor-retained annuity trusts (GRATs), and qualified personal residence trusts (QPRTs), all of which would be made all but impossible. Irrevocable life insurance trusts (ILITs) and family limited partnerships (FLPs) would also present substantial new challenges.
Furthermore, because the changes regarding these planning strategies would take effect upon enactment of the bill, taxpayers facing potential estate tax increases and their advisors should not wait until year-end to consider new planning. Many strategies we might recommend would have to be put into place before the bill is enacted.
I hasten to add that these proposals must make it through the entire legislative process before they become law. There are certainly interest groups working to prevent their enactment or modify their terms. But, these proposals were the result of internal negotiation among House Democrats for a package which they expect they can pass, and are thus the best indicator to date of what the final law might contain.
We recommend that you confer with your financial advisors and accountants--and with us--if you have any questions or concerns about these proposals. We will stand ready to work with you to decide what, if any, additional planning may be right for you.
You may decide not to act despite these developments. Estate planning is about much more than tax planning--a fact we strive never to forget. As always, we aim to provide you with the information you need to make an informed decision about what is right for you and your family.
Please call us at (843) 202-4472 or email us at info@swwlc.com to contact us or schedule an appointment.
Why Revocable Trusts?
The simplest way to set up an estate plan is simply to sign a will. This can serve well, and there are times when it really is all that a client needs. Often, though, it makes sense to set up a revocable trust, and to put most or all of the grantor’s (that is, the trust creator’s) assets into it.
Why take these extra steps? While every situation is different, there are two main reasons which apply to most people:
Probate avoidance; privacy and efficiency. The probate process for a deceased person’s estate is an essential government function, which aims to make sure that estates are handled fairly and that beneficiaries receive what they are supposed to receive. That does not mean, though, that you need to use it! In general, probate is only required for assets titled in the decedent’s own name and which do not pass to the heirs in some other manner (such as a beneficiary designation on a bank or brokerage account, which also avoids probate). By setting up a revocable trust and putting certain of your assets into it, you retain full control of them during your lifetime, but upon your death, there is no need to probate them. Instead, they go to your beneficiaries according to the terms of the trust.
The two main advantages of keeping assets out of probate are privacy and efficiency. The estate records of your county Probate Court (in South Carolina) or Clerk of Court (in North Carolina) are public, which means that there will be a public record made of what assets your heirs receive through probate and their value. Sadly, in the age of the internet, it is not difficult for parties with an interest in gathering personal information to obtain and use these records for their own purposes; and that’s in addition to any specific people from whom you might prefer to withhold information about your family’s property holdings.
A revocable trust also lets your beneficiaries receive their inheritance more quickly and with less paperwork and hassle than probate. After an estate is opened, your executor (North Carolina) or personal representative (South Carolina) must generally wait several months—three months in NC, and eight months in SC—to allow creditors time to make claims against the estate before assets can be distributed. The assets must also be formally inventoried, and accountings must be prepared and filed with the court. While there is certainly recordkeeping associated with trusts, the burden on your loved ones will generally be substantially less in the months following your demise if their inheritances are handled with a trust.
In some states, probate also carries heavy fees. Probate fees in North and South Carolina are small (in the tenths of a percent of the estate value), but in other states, fees may also be a concern.
Handling of incapacity. The traditional means of planning for the chance that a person may no longer be able to handle his or her own property is to grant power of attorney to a relative or other trusted person. Banks, brokerages, insurance companies, and other financial institutions are often the primary parties with whom you will want to use such a power. They can be wary of accepting powers of attorney, however, especially if they date back several years. Despite recent changes in the law designed to encourage third parties to accept powers of attorney, I still frequently hear of difficulties with them.
Often, these problems can be remedied ahead of time by putting assets into a revocable trust which includes a clear process for allowing the successor trustee to take over should the grantor become incapacitated. Institutions are generally more comfortable accepting the authority of a successor trustee under such circumstances.
Funded revocable trusts are often, but not always, at the center of a well-crafted estate plan. Please contact us if you have questions about whether a revocable trust makes sense for you and your family.
Seth W. Whitaker, Ltd. Co. is a personalized trusts and estates and business law firm for individuals, families, professionals, and entrepreneurs, with offices in Charleston and Raleigh and serving clients throughout the Carolinas. This article is not legal advice, and no attorney-client relationship is formed by reading it. We hope you will contact us at (843) 202-4472 or info@whitakerltdco.com if you would like to discuss your specific situation.
Of LLC Operating Agreements
An operating agreement is the basic document for a limited liability company, or LLC. The agreement should spell out how owners, called members, deal with each other and make decisions for the company; how new members may be brought into the company; how profits and losses are allocated and distributed among the members; and what happens when a member wants out, or when the company winds down. These matters may sound simple, but they are often fraught with perils.
I would like to describe some of the most common pitfalls I see in reviewing operating agreements in my practice. There are certainly others, but these are the problems that come up most often.
Big income tax bills for “sweat equity.” A client, who has worked hard over the past five years, is offered a 10% stake in his company, which is an LLC taxed as a partnership. He doesn’t have to pay anything in; the boss just wants to give a 10% interest to him so he can share in the company’s success. The draft operating agreement says that he gets 10% of everything; capital, profits, losses, voting. Sounds great, right?
Not so fast. As far as the IRS is concerned, he’s not being given anything. Because he is getting an interest in a business in return for performing services for it, the value of the interest in the company he is getting is considered income. Unless the agreement is drafted carefully, he could end up with “income” in the year he receives the interest equal to 10% of the value of the company! If it’s a $1 million company, he’s suddenly facing taxes on $100,000 in income he had not planned on and for which he didn’t receive any cash with which to pay the taxes. There are ways to address this problem, but they require careful drafting and an understanding of the tax laws governing receipt of interests in a company in return for services.
Phantom income. This issue is similar to the first one, but can happen at any time, not just when a member joins the company. Under the partnership income tax laws, which are the most common way for LLCs to be taxed, the company itself does not pay any income taxes. Rather, it passes through all of its income, losses, deductions, credits, and the like to the members on a Schedule K-1, and the members include all these on their own tax returns.
Just because a company has income on paper to pass through, though, does not mean that it has distributed any cash to its members. This phenomenon is called “phantom income;” the members owe taxes on income the company made, but did not get any cash to use to pay the taxes. A well-drafted operating agreement will, in cases where phantom income could be a significant problem, include a provision to ensure that the members receive at least some percentage of the profits each year, so that they are not caught short at tax time.
Incomplete buy-sell arrangements. An operating agreement needs to have a clear scheme for what to do when a member (owner) leaves the company, whether voluntarily or because of bankruptcy, death, disability, or some other reason. These are often called “buy-sell provisions.” If these provisions are not clear, disagreements about how to implement them can easily lead to lawsuits and the related delays, lawyers’ fees, and costs.
Common issues with buy-sell arrangements include: Can a member transfer his interest to a family member by will without consent of the other members? Put it in a trust or family partnership? Will the company or the other members have a right of first offer or of first refusal to buy the interest of a member who wants to sell? Is there a clear and fair process for how that will be done? If a member dies or becomes disabled, is there a clear and fair process for liquidating the member’s interest to provide cash for her and her family? How will the price be determined? Can the members use life or disability insurance to fund such purchases? All these issues call for review and drafting by a competent lawyer.
Hidden ways for members to be pushed out of the company. A client, excited that her boss wants to make her a part-owner of the company, may come to me with a draft operating agreement prepared by their business-partner-to-be’s lawyer, asking me to review it to be sure she is “protected.” I will ask her questions about what she wants protection from, but I know she means certain basic things. One of those is protection from being forced out of the company.
Many operating agreements allow a majority of the members to vote to require the members to put in additional capital. This sounds convenient, but what happens if one member doesn’t have any more capital to contribute? Often, the agreement will have penalties for not contributing, including dilution of interests, forced loans, suspension of distribution of profits, or even forced buyout of the defaulting member’s interests.
An LLC owned 50-50 by two friends may seem like a great, straightforward business that does not need legal help, but often that simply isn’t the case. Even a brief consultation with a lawyer, just to go over some issues which the owners may never have thought of, is worthwhile. It will usually turn out to be money well spent, which can save many times the amount in taxes and expenses later on.
Seth W. Whitaker, Ltd. Co. is a personalized trusts and estates and business law firm for individuals, families, professionals, and entrepreneurs, with offices in Charleston and Raleigh and serving clients throughout the Carolinas. This article is not legal advice, and no attorney-client relationship is formed by reading it. We hope you will contact us at (843) 202-4472 or info@whitakerltdco.com if you would like to discuss your specific situation.
Grantor Trust Basics
Grantor trusts--an introduction
“Grantor trust” is a shorthand term of art for a trust that is not a separate taxpayer for federal income tax purposes. The taxation of grantor trusts is governed by Sections 671-679 of the Internal Revenue Code. While other trusts are treated as separate taxable entities which must file their own income tax returns on Form 1041 and pay income tax according to a special rate schedule, a “grantor trust” is one for which the settlor (or another person) is treated as the “owner” and reports income, deductions, and credits against tax on his or her own income tax return. This treatment has potential implications for the rate of income tax paid on the assets in the trust. Grantor trusts also interact with the transfer tax system in interesting ways that give rise to estate planning opportunities.
The tax code and grantor trusts
Sections 671-679 of the Internal Revenue Code are commonly called the “grantor trust rules.” Section 671 establishes the basic principle that where the grantor trust rules apply, the owner of the trust for federal income tax purposes reports its income, deductions, and credits on his or her own income tax return. Section 672 contains important definitions. Sections 673-677 describe types of trusts for which the settlor is treated as the owner. Section 678 describes trusts for which a party other than the settlor is treated as the owner because of certain powers over the trust assets. Section 679 deals with foreign trusts and is beyond the scope of this introduction.
Perhaps the most important estate planning concept to grasp about grantor trusts is that the grantor trust rules and the estate and gift tax inclusion rules do not always give the same results. These inconsistencies create tax planning opportunities with grantor trusts.
Also relevant to understanding the uses of grantor trusts is Internal Revenue Code § 1014, which generally provides a step-up in basis for assets in a decedent’s estate as of his or her date of death. By carefully using advanced estate planning methods, a client can potentially save lifetime income taxes but also obtain a basis step-up at the client’s death.
A two-minute history of the grantor trust rules
A bit of history is helpful to understanding where the grantor trust rules come from and why they can produce tax savings. When the rules were first enacted in 1954 (based on earlier regulations), it made sense for taxpayers to move income-producing assets into a trust, which would be taxed at a lower marginal rate. The grantor trust rules were thus usually a net revenue generator for the IRS, and it sought to push income out of the trust to the deemed “owner” when possible. Conversely, a common tax planning goal was to avoid grantor trust status so that a trust’s assets could be taxed at a lower marginal rate.
The Tax Reform Act of 1986 fundamentally changed these incentives in two ways: (1) it flattened the progressivity of the individual income tax brackets, and (2) it compressed the trust income tax brackets such that a trust reaches the highest marginal tax rate at a far lower income level than does an individual. Any income tax savings which might be achieved by conveying assets to a nongrantor trust are now almost always more than offset by the planning and administration expenses of the trust. Conversely, clients who are not in the highest marginal tax bracket will often save overall income tax if trust assets are taxed to them as the owner.
When the income tax avoidance incentives of nongrantor trusts were removed, tax planners focused their efforts on avoiding transfer taxes using trusts, and found that grantor trust status is often a good thing from an estate and gift tax perspective. Because grantor trust status traditionally was not desirable, these trusts became known, among other names, as “intentionally defective grantor trusts” or IDGTs. Despite the name, when used properly today there is nothing “defective” about these trusts.
How to use grantor trusts in estate planning
Creative estate planners have devised many innovative strategies using intentional grantor trusts for their clients. The most common of these can be put into three main categories:
Transfer tax leveraging for income taxes paid. Suppose a client with a potentially taxable estate sets up a grantor trust, contributions to which are treated as completed gifts and not includible in his gross estate. Importantly, each dollar contributed to the trust potentially incurs gift tax (or at least uses up the client’s unified credit). The trust’s assets grow income tax-free once paid in, from the perspective of the trust itself, so long as the client is paying the income tax. Because the client can make the income tax payments the trust would otherwise make without making a taxable gift to the trust to pay them, the overall effect is to save the client the gift tax consequences of a gift to the trust in the amount of the trust’s income tax liability each year. This allows the client to transfer more net wealth to beneficiaries free of gift tax.
Tax-free sale. For income tax purposes, a transaction between an owner and his or her grantor trust is disregarded. By selling, instead of gifting, assets to a grantor trust (in return for cash, securities, or, as is commonly done, a promissory note), an asset can be transferred to the grantor trust free of both income and gift taxes at the time of the transfer, even if a significant capital gains tax liability would have resulted from a sale to some other party. The asset’s value for transfer tax purposes is thus “frozen” as of the date of the sale. This is a popular method of removing the future appreciation of an asset from a client’s taxable estate in a way that is gift-tax free.
Asset exchange to maximize basis step-up. One of several ways of intentionally creating a grantor trust is to give the settlor the power to reacquire trust assets by substituting assets of equivalent value. This power can also be of great practical use in the right circumstances. By exchanging high-basis assets which would be includible in a client’s taxable estate for low-basis assets held in a grantor trust when the client is near death, the client can take full advantage of the step-up in basis which occurs at the client’s death under § 1014.
If you are interested in learning more about the potential benefits of grantor trusts or other estate planning devices, please call us at (843) 202-4472, or e-mail us at seth@whitakerltdco.com.
Seth W. Whitaker, Ltd. Co. is a personalized trusts and estates and business law firm for individuals, families, professionals, and entrepreneurs, located in Charleston, South Carolina and serving clients throughout the Carolinas. This article is not legal advice, and no attorney-client relationship is formed by reading it. Please contact us if you would like to discuss your specific situation.
