Arbitration and Majority Rules: Resuscitating Stagnant Colorado Condominium Development?

Earlier this month, the Colorado Supreme Court ruled in a 5-2 decision that binding arbitration agreements are valid in condominium construction defects cases and binding on homeowners’ associations that do not receive written consent to remove the arbitration provisions.  The case, Vallegio at Inverness Residential Condo Association vs. Metropolitan Homes Inc., is the most recent in a series of pro-condo-developer developments in Colorado law.  House Bill 1279 also passed this session.  The Bill requires the majority of homeowners, instead of a homeowners’ association board, to decide whether the raise a claim against a condominium developer for construction defects.  Backers of the bill said that it is more fair to homeowners to give them a voice in a dispute that could affect their homes’ resale value.

 

Colorado law has one of the most permissive statutes of limitations on construction defect cases on the books—only two years within the time the claimant or claimant’s predecessor in interest discovers, or should have discovered, the physical manifestations of a defect in the construction improvement that causes an injury.  C.R.S. § 13-80-104. Taken together, it seems as though the current climate in Colorado is shining warmly on encouraging condominium development, which has dropped from 20% of new development in Colorado in 2007 to about 3% today. 

 

This attitude only makes sense because of the increasing number of transplants to Colorado in recent years—almost 101,000 new residents between 2014 and 2015 alone.  Current numbers show the population influx evening out somewhat but it takes one glance at the property market in Denver alone to see what a challenge these newcomers present to a market so hot, the inventory of existing homes for sale is at historic lows.  The demand for affordable housing in Denver continues to go up but supply is down, which drives prices up. 

 

Condominiums and multifamily developments are an obvious solution to the problem.  If we can build up instead of out, residents in Denver will be able to stay in desirable areas without breaking the bank and possibly realize the American Dream of property ownership.  But is the best way to encourage condo development to deregulate and make it more difficult for homeowners to sue their developers?

 

Those in favor of the decision in Vallegio and HB 1279 would argue that these decisions put more power in the hands of homeowners.  The Bill makes it impossible for an HOA board to decide to bring a case without the consent of homeowners.  While the obvious consequence of this rule makes it more difficult to sue developers (majority of 100 unit owners is much more difficult to receive and calculate than a majority of a 10-person HOA board), it also purports to be in the interest of condo owners.  After all, why should they have to worry about changes in their property value based on a lawsuit brought by a sue-friendly HOA?  Then again, a well-settled rule of property law is predicated on sellers disclosing material defects as an exception to the general rule of caveat emptor.  So, if a homeowner wishes to avoid litigation to keep property value up, he or she would still have to disclose known issues with the property at the time of sale.  It is anyone’s guess whether making it more difficult to sue developers for condominium construction defects will be better or worse for homeowners in the long run but hopefully it will serve its purpose of encouraging development of much-needed multifamily housing in highly-populated areas of Colorado.

 

Vallegio seems at first blush to be more protective of developers than warranted but really, the decision simply upholds another well-settled rule of Contracts—that parties can and often do contract around any number of rights in their agreements.  After all, the court did not say that binding arbitration clauses are the norm in construction defects litigation for condos—merely that, since the HOA in the case agreed to a binding arbitration clause, it cannot sidestep the agreement and sue anyway, regardless of the injuries suffered. 

 

As litigation costs rise and the process is a dice roll in terms of favorable decisions, there is a trend in real estate and business law matters toward requiring arbitration in lieu of trial.  Deciding whether to acquiesce to arbitration over court is a decision to make at the start of a deal, not in the middle.  This is the heart of the Colorado Supreme Court decision in Vallegio, and a good rule to remember when embarking on any kind of project.  Because courts in Colorado hold parties to their word and require all parties to have a seat at the table if renegotiation is on the menu.  Regardless of the policy considerations or arguments about protectivism toward questionable real estate construction, the purpose of a contract is to keep deals consistent regardless of the direction in which they go.  And that, at the end of the day, is a strong reassurance for anyone engaged in construction or contract in Colorado. 

 

Sources and Additional Resources: http://www.cpr.org/news/story/why-is-denvers-housing-market-still-on-fire-supply-and-demand; http://www.denverpost.com/2016/07/07/colorado-second-population-growth-2015/; C.R.S. 13-80-104; http://www.denverpost.com/2017/06/05/colorado-supreme-court-construction-defects-battle/.

Commercial Leasing; Tenant's, Operating Expenses & The Simple NNN Lease.

     During my day to day, I draft and negotiate my fair share of commercial lease agreements.  They range from office leases, to retail leases and industrial leases but in almost every case, especially with new clients leasing their first space, the conversation begins the same; they say "I am going to send you a simple lease that my Landlord drew up, take a quick look and let me know it all looks good"; and I respond, "Send me the lease and I'll take a look."

     Most real estate lawyers are familiar with this elusive document, the simple lease, so often described by clients eager get their business up and running and turning a profit.  Unfortunately, Landlord leases are typically one sided at best and the clauses invariably tilt to the Landlord's advantage.  

     One example of a lease clause that can be surprisingly expensive for tenants is the clause governing operating expenses.  Most tenants understand the difference between a triple net lease and a gross lease; the former is structured so that in addition to base rent, tenants are responsible for a share of operating expenses (the landlord's real estate taxes, insurance and costs to operate the building in which the premises are located) and the latter is structured so that tenants pay a single rental payment that includes everything.  In the commercial setting, triple net lease forms are very common and tenants often sign these leases without legal review and counseling.  Operating expense provisions seem simple - the tenant pays its share of the operating costs, but, oftentimes the lease language is overly generous with what may be included in the operating costs.  An example of expenses that should be excluded or at least carefully limited are capital expenses.  Furthermore, its ordinary for tenants to ask for a cap on annual operating cost increases so they can budget for the worst case scenario during each lease year.  If there is no cap on operating expenses then they can expand and increase without limit and Landlords have little motivation to keep their costs down when they can be passed through to tenants without question.  Another important concept when it comes to operating expenses is language providing the tenant a right to audit the Landlord's books.  A good audit provision should provide that if the audit reveals overcharges exceeding a certain percentage, the Landlord will be responsible for paying the audit costs. A skilled real estate attorney understands which expense categories are inappropriate to pass through their clients and can help their clients limit ballooning expenses and excess expense pass throughs.

     The key to providing useful legal counsel to tenants in commercial lease negotiations involves picking one's battles.  A typical commercial lease agreement contains upwards of 50 clauses and its possible to negotiate each one, however sending proposed revisions to all or nearly all of the lease clauses is sure to cause delays (which neither side wants) and sometimes, it can blow a deal.  Evaluating which clauses will be most important to a client begins with understanding the nature of their business very well and then focusing on the clauses that relate to their business and those which may cost them additional money above and beyond rental payments.  The expense clauses in triple net leases certainly qualify there!  

     Before signing that next "simple lease" have an attorney take a look and help you try to balance the important terms.  Its very difficult to help a tenant after they've signed the document!

LLC Operations: Shielding Owners from Personal Liability

     This is the last of a series of three posts covering LLC basics.  In two prior posts (March 21st and May 19) we discussed the necessity of a good operating agreement and taxation basics for LLCs.  In addition to pass-through taxation, most LLC owners form LLCs intent on insulating their personal assets from exposure to liabilities incurred by the business.  In a lawsuit against an LLC, a plaintiff's attorney may ask the court to hold LLC members personally responsible for the debts, obligations or liabilities of the LLC; this is referred to as "piercing the corporate veil."  Colorado law concerning this topic, and the grounds for disregarding the liability shield afforded to business owners by LLC is somewhat befuddled.  Many owners are exposed to personal liability for the debts and obligations of their LLCs because they make a common mistake; after creating the LLC and opening for business, they quickly forget all about the entity and operate their companies informally and inconsistently.  Their perception is that registering the entity with the Colorado Secretary of State and paying the annual fees is all they have to do to enjoy the limited liability of operating under the guise of an LLC.  That perception is wrong.  Their LLC is form over substance and as such is susceptible to being viewed as the alter ego if its owners rather than a truly separate entity.

     In deciding whether to pierce the corporate veil and impose personal liability on LLC owners, Colorado courts apply what is known as the alter ego test.  As the name implies, the initial analysis centers around whether the business entity is truly a separate "entity" or is in fact the alter ego of the owner.  In Colorado this involves an 8 point balancing test.  Factors courts consider include: whether the the LLC is operated as a distinct business entity; whether assets and funds are commingled; whether adequate corporate records are maintained; whether misuse by an insider is likely due to the nature and form of the LLC's ownership and control structure; whether the LLC is marginally capitalized; whether the LLC is a mere shell with no real assets; whether owners disregard legal formalities such as meetings, minutes, approval resolutions and consents in accordance with the LLC's operating agreement and whether corporate funds or assets are used for non business purposes.  No single factor is determinative or holds more weight than another.  That is reflected by the Colorado statute on point, C.R.S. 7-80-107(2) (2016) which states, "the failure of a limited liability company to observe the formalities or requirements related to the management of its business and affairs is not, in itself, a ground for imposing personal liability on members for liabilities of the limited liability company.    

     In Colorado, traditionally, in addition to proving an LLC fails the alter ego test, plaintiff had to establish that the LLC was used to carry out a fraud or overcome an otherwise rightful claim.  However, in recent years, Colorado courts seem to have adopted a looser standard for piercing the corporate veil and done away with this second requirement.  In Martin v. Freeman (Colo. App. 2012), the Colorado Court of Appeals reasoned that "neither wrongful intent or bad faith" are not necessary to satisfy the second part of the piercing test.  The practical effect of this is that by being a party to litigation where the plaintiff seeks to pierce the corporate veil, an LLC is exposed to liability if it fails the alter ego test.  In 2009, in Sheffield Services Company v. Trowbridge (Colo.App. 200), the Colorado Court of Appeals extended personal liability of an LLC to an LLC's managers in addition to the LLC's owners.  It should be noted that the Martin case concerned a single member LLC but logic dictates that it should apply to all manner of LLC's.  The Sheffield case was a clear extension of the applicable law as the relevant statute, cited above, is expressly limited to members.  

     From a practical standpoint, all of this means that in Colorado its easier than ever for the liability shield afforded by LLCs to be disregarded if the LLC's owners treat the entity as a mere alter ego and fail to operate it as a truly separate and independent entity from themselves.  As lawyers, its imperative for us to advise our clients that creating an LLC is merely the beginning and proper operation as truly separate entity is essential to maintain the liability shield that they assume is in place by virtue of operating their business as an LLC.  In addition to creating the LLC and drafting an operating agreement, clients need sound advice on proper procedures, safeguards and formalities in the day to day operation of their business so that they do not unintentionally expose their personal assets to the liabilities and debts of the LLC.

Restaurant Leases; Exclusive Use Clauses

Photo by fazon1/iStock / Getty Images
Photo by fazon1/iStock / Getty Images

     Earlier in my legal career I worked with a large law firm representing a popular and rapidly expanding restaurant chain; those years afforded me a baptism by fire in the negotiation of restaurant leases.  It may be related to those early years fighting for the big chain tenant, or maybe its because I spend so much time enjoying and relaxing in restaurants around Denver, but, I've always enjoyed working on restaurant leases.  In the universe of lease agreements, they are almost always the most interesting.  Since I just finished one up, this seems like a great opportunity to kick off a series of blog posts focusing on restaurant leases and issues tenants need to know about, especially new owners and entrepreneurs without a lot of leasing experiences.

     The issue of exclusivity is often at the center of restaurant lease negotiations.  In shopping centers or other multi-tenant environments,  tenants should try to lock down assurances they will not face harmful competition from other tenants.  The easiest way to do that is to include an exclusive use clause in the lease.  Its best if the broker helping a tenant find a space sets the expectation that exclusivity is a part of the deal by including the concept in the letter of intent (LOI).  In most cases, landlords and tenants agree on a non-binding LOI laying out the basic terms of the deal before proceeding to draft and negotiate the lease document. So, what level of competition is actually "harmful?"  In shopping centers or other retail settings with multiple buildings, tenants should consider whether an exclusive within the building their space is located in is sufficient, or is an exclusive covering the entire retail center appropriate? Further, many retail centers are governed by CC&Rs or Declarations and in such cases, its important to confirm nothing in those documents limits the new tenant's plans for its space or grants another tenant an exclusive use pre-empting the tenant's planned use.  Restaurant tenants should also carefully consider the nature and scope of the exclusive rights they desire; does the tenant want to be the only restaurant in the building/center or, is it acceptable (or even better) for them to allow other restaurants users so long as they have exclusivity based on certain food types (for example, Mexican food) and/or operational type (for example, fast-casual versus a sit down, full service restaurant with table service)?  Does the tenant want to be the only fast casual restaurant in the building serving alcoholic beverages?  A properly drafted exclusivity clause is very specific and leaves no room for argument or interpretation.  With respect to restaurants and bars, different types of operators can often co-exist and feed off of one another (no pun intended!) quite nicely, so it might not necessarily behoove one to be the "only" restaurant in a particular setting.  While thinking about exclusivity clauses for restaurants in multi-tenant settings, one frequently overlooked point is signage on the exterior of the premises; depending on the situation, it may be important for tenants to lock down the exclusive right to display their signage on the exterior of the space. 

     Another important consideration for restaurant tenants negotiating exclusive use clauses is the practical effectiveness of these clauses.  Often tenants focus on obtaining the exclusivity language they need but neglect addressing how they'll actually enforce that language if the landlord disregards it, or if another tenant disregards it and assigns or sublets their space to a competing business.  In addition to the exclusivity clause, its a good idea for tenants to try to push for language discouraging landlords from ignoring the exclusivity restrictions and also requiring them to take action in the instance of renegade tenants.  There are several ways to do that, including expressly providing that a tenant may pursue equitable remedies such as an injunction or even granting the wronged tenant a substantial rental reduction or abatement during the period their exclusive use protection is compromised.  If unaddressed, a tenant may be left with no recourse except for an expensive lawsuit against a landlord who may have deep pockets.  A tenant's ability to obtain adequate exclusivity protection is often proportionate to their bargaining power with respect to the landlord (is the tenant a highly desirable addition to the center?) and other tenants, and is also related to how the desired protective language relates to the overall negotiation of the lease.

    Next time this series of posts will address building out restaurant lease spaces and common issues surrounding landlord and tenant construction obligations.  Until then, contract safely and remember, everything is negotiable.

 

Real Estate 101 - Helping Residential Buyers and Sellers

     Most residential real estate transactions are handled by real estate brokers.  Traditionally, sellers execute a listing contract with a seller's broker who, in return for a commission of around 6% of the sales price, markets the seller's property on a multiple listing service (MLS).  Brokers representing buyers then show their clients properties of interest.  When a sale closes the brokers split the commission. One common exception to the standard process described above is when a "transaction broker" represents both parties. Today, to stay competitive, many brokerage firms are starting to offer flat fees for facilitating transactions.  Most straight-forward residential deals don't necessitate an attorney being involved on either side.  My opinion is that in most instances, competent brokers are more than capable of facilitating real estate transfers using the form contracts produced by the Colorado Real Estate Commission (CREC) for that purpose.  Also, brokers have access to resources such as the MLS, their own property databases and word of mouth intel on properties coming to market that real estate attorney can't provide.  The best brokers also bring marketing expertise and property staging expertise to their clients.   Therefore, until recently, my involvement in residential deals has typically been limited to helping buyers and sellers and their brokers in transfers involving high value, luxury class properties that involve significant changes to the CREC contracts, or in sales that have become contentious or involve some problem or extraordinary circumstance.  So far this year has been different noticeably different.

When parties use a broker, the higher the sales price, the larger the commission due from the seller

     While the bulk of my law practice remains focused on commercial real estate deals, finance and leasing, lately more buyers and sellers are asking me to get involved with their straight forward residential deals on the front end.  While I'm happy to help; I've also been curious why the volume of this work has increased so noticeably.  I perceive several reasons for this increase in residential deal work.  obviously, since leaving big firm life in January, I'm closer to the ground (both literally and figuratively) with office space in a building dominated by younger, dynamic entrepreneurs and tech oriented tenants so, I find myself talking to a variety of people and fielding questions about real estate throughout the days rather than talking to the same old people every day, and some of these conversations lead to residential work as these folks are looking for homes in a tight market.    Its no secret its a seller's market around Denver these days, with quality properties going under contract very quickly (often 24 hours or less) and commonly escalating into bidding wars.  Ready buyers abound and the higher the sales price, the larger the commission due from the seller at closing; consider that 6% of $400,000.00 is $24,000.00.  With buyers easier to find than ever and the supply of available properties at an all time low, I see sellers foregoing the MLS and coming together with buyers on their own through alternative means such as Zillow or most often, through word of mouth.  These sellers and buyers need someone to draft the contracts, deeds and other paperwork necessary to transfer the property and to coordinate closings with a title company - that is where I come in.  

these days I find myself drafting residential sales contracts between landlords selling condos or townhomes to tenants; and in seller-carryback deals.

     One fact that many people outside the real estate world don't realize is that brokers don't actually draft contracts.  While they offer many services a lawyer can't (see above), when it comes to drafting they simply fill in the blanks on CREC form contracts.  They are actually forbidden by law to make changes to these forms other than filling in the blanks and their forms are locked.  I use the same CREC form contracts as the brokers but, as a licensed attorney I have access to alterable MS Word versions.  That makes these deals  fun for me since I can make some changes to these contracts that benefit my clients!   Since I can draft contracts and coordinate a straightforward residential closing for in between 4 to 8 hours of total attorney time, regardless of the purchase price, the sellers I work with are usually very happy that my legal fees are substantially less than the brokerage commission would have been!  Buyers can also benefit from that fact and sometimes use it to bargain for a price reduction.  The two most common situations where I find myself drafting residential contracts for sellers and buyers these days are: when a landlord wants to sell their condo or town-home to their tenant; and when a seller is providing the financing for the buyer and taking back a note and deed of trust at closing.  I'm always happy to help sellers and buyers close residential property sales.

End of the Wild West In Denver's Short Term Rental Market?

Cheeseman Park Winter Morning:  Copyright David C. Uhlig 2016

Tonight city council votes on two ordinances legalizing (and regulating) strs in primary residences.

     Did you know that operating a private home as an Air BNB, VRBO or as a similar short-term rental property, is currently illegal in the City of Denver? Denver’s zoning code specifies the types of uses that are allowed as accessory to residential use and in almost all cases, short term rentals of 30 days or less (“STRs”) aren’t listed.  The city’s position is that currently, these short term rentals are not allowed under most residential zone districts but the city also does not enforce the prohibition.  According to an April 7, 2016 letter to the city from the Denver Short Term Rental Alliance, to date the city has only received six (6) complaints about STRs.     One exception is that in mixed use commercial zone districts, an STR may be allowed as a “lodging accommodation” if the owner obtains a zoning permit and complies with relevant parking and building ordinances.   

     Tonight the Denver City Council is scheduled to vote on two bills: one would revise Denver’s zoning code (CB16-0261) to permit short term rentals in an owner’s primary residence; and the other, a companion bill (CB16-0262) would enact a licensing and regulatory framework for short term rentals in primary residences.  As drafted, the zoning code amendment is expressly conditional upon passage of the companion bill.  As drafted, the proposed zoning code amendment legalizes STRs in primary residences.  By preventing owners from using investment properties and vacation homes as STRs, Denver’s zoning ordinance limits owners to a single STR.  The intent to prevent investors and businesses from operating STR portfolios or STR investment properties in residential neighborhoods underlies the proposed ordinances which expressly forbid STRs operated by entities such as corporations or LLCs, joint ventures or associations.  While owners may be absent during the short term occupancy, as drafted the proposed zoning amendment expressly requires that owners live in the residence.  The companion bill would delegate authority to the Denver Department of Excise and Licensing to license and regulate STRs.  In addition to numerous other requirements, under the proposed licensing ordinance STR owners will be required to apply for a license, register with Denver Excise and Licensing and obtain a lodging tax identification number.  Lodging taxes on STRs would be the same as for a hotel room (10.75%).  Additionally, if the bills are passed, STR owners will be required to maintain fire, hazard and liability insurance at levels set by Denver Excise and Licensing, maintain a minimum level of life safety systems in a residence used as an STR, and include the STR license number in all advertisements.  The fee for the STR license will be $25.00 per year and fines for advertising without a license and/or operating without a license will be up to $999.00 per incident.

some groups think the primary residence requirement is anti small business.

     In the two-year run up to the vote, council members and staff received varying input from numerous parties running the gamut from individual homeowners and neighborhood associations to property investors and short term rental industry groups.  Much of the feedback received by the city characterizes the primary residence requirement as anti-small business and complains about the increased regulation of private property, increased taxes and favoritism toward the hotel industry.  The Denver Short Term Rental Alliance’s letter states that the primary residency requirement will effectively lock VRBO (Vacation Rentals by Owner) out of Denver and the city will be deprived of a significant tax revenue stream.  Proponents of the primary residence requirement feel it is appropriate in that it limits STRs to small businesses that generate supplementary income for homeowners and cite concerns about investors buying up entire blocks or apartment buildings and operating them as STRs in otherwise primarily residential neighborhoods.  In general, they  feel such operations would pose a risk to public health and safety and detract from the quality and vibe of Denver neighborhoods; the obvious concern being strange cars and stranger people steadily coming and going.

     A seemingly simple issue on its face, legalizing STRs in Denver has broader implications.  If the council votes in favor of these bills tonight, individual owners renting out a room or garage apartment on a short term basis, as a means of earning supplementary income will be permitted to continue doing so and now, legally, although now subject to applications, annual reporting and taxation.  Owners operating investment properties as true STR businesses, or desiring to do so, have been kicked out of the pool in the interest of protecting neighbors who own or who are traditional renters. The STR game in Denver may be more exclusive and predictable by the end of the day; and also more expensive to play.  One cannot help thinking that many STR owners will miss the days of the wild west.  

Taxation of LLCs: More to Check Than A Box (Post 2 of 3 on LLC Basics)

Arapahoe Basin Spring 2016.  Copyright, David C. Uhlig 2016.

     This is the second in a series of three posts concerning LLC basics; the first covered operating agreements, this one covers taxation and a future post will cover liability protection and piercing the corporate veil.

Depending on the entity, the irs taxes income and losses differently.

     Working with entrepreneurs in real estate and other realms is a lot of fun because it affords many opportunities to listen to the plans and ideas of creative and intelligent people and and assist them with making those plans a reality.  Almost daily, people call or sit down across from me and want to talk about creating an LLC.  The plans for the entity and experience of the clients vary. Sometimes, they are financially savvy and/or they’ve talked extensively with tax advisors in advance and have a solid understanding of LLCs, why that entity will work best for their purposes and exactly how it needs to be structured to reap the maximum benefit for them and their co-venturers.   Other times they haven’t thought about entity formation much beyond knowing they need one and they’ve heard that LLCs are a great choice from a tax perspective. To me, the first scenario is always preferable because while I can describe the different ways that various entities, including LLCs, will be taxed, I don’t purport to advise clients on the consequences the taxation regimes will have on the various members, partners or shareholders. When it comes to planning the structure of an entity, all but the most sophisticated clients are best served by working with a team of advisors which includes, at a minimum, an attorney, a business CPA and a financial advisor.  Depending on the entity chosen, income generated or losses incurred are treated differently for tax purposes. Let’s take a close look at how the IRS treats LLCs and some of the basic structuring options that are available to owners that choose to operate as an LLC.

     The IRS treats single member LLCs as disregarded entities.  The entity does not file a return. From a tax perspective, it’s as if the LLC doesn’t exist. As with a sole proprietorship, the member simply attaches a Schedule C reporting the profits or losses of the business to their individual tax return.  Unless the LLC elects to be taxed as a corporation, LLC income is passed through to the member and is taxed as his or her individual income. Unlike single member LLCs, corporations are treated as separate entities by the IRS.  As such, C corporation income is taxed at the corporate tax rate and when part of that income is paid to shareholders as wages or salaries, it is taxed again at the individual tax rates (unless the corporation is an S corporation); this is the infamous “double tax” synonymous with doing business as a C corporation.   So, if a single member LLC is taxed like sole proprietorship, which doesn’t require any formalities, why form and operate under an LLC?  Unlike with a sole proprietorship, the members of a properly organized and operated LLC are insulated from the debts and liabilities of the LLC.  For that reason alone, in most cases creating and operating as an LLC is worthwhile; certainly if there is any possibility of exposure to third party liability.

single member llcs are disregarded entities; multi member llcs are tax reporting entities but not tax paying entities.

     Unlike single member LLCs, the IRS recognizes multi member LLCs as reporting entities, like a partnership. They file a separate return, but the multi member LLC’s income or losses are passed through to the members rather than taxed to the LLC itself.  In common parlance; pass through entities such as partnerships, multi member LLCs and S Corps are tax reporting but not tax paying entities.  The pass through is accomplished by attaching Schedule K-1s to the LLC’s tax return describing each member’s pro-rata share of the LLC’s income. 

     One thing to bear in mind when evaluating choice of entity and whether an LLC is the best entity form for a business is that the most substantial tax savings realized by LLC members is often not on income taxes.  Individual and corporate tax rates are not widely disparate until income amounts are very high; that isn’t a problem commonly suffered by early stage companies.  More substantial tax savings can be realized by LLC members if the business expects long term capital gains or if it incurs losses.  The individual tax rate on long term capital gains is 15% for all but top earners.  Conversely, corporate long term capital gains are taxed at the corporate income tax rates: 15% on the first $50,000, 25% on the next $25,000, 34% on the next $25,000 and then 39% on the next $235,000.

     At the risk of stating the obvious, many startup companies and early stage businesses experience losses in their early years.  If an individual is a member of an LLC with losses and that person has other alternative sources of income, it may be possible to offset the LLC’s losses against that other income and/or completely eliminate income taxes otherwise due.  Each business and its principals have a unique equation so, it’s important to closely scrutinize choice of entity.  That being said, the advantages with respect to treatment of losses and of long term capital gains present a strong case for many early phase businesses to utilize an LLC instead of a corporation.

     At this point, you may be wondering ‘why not elect corporate taxation and file an S election so the business can utilize the corporate structure, benefit from a liability shield and obtain pass through treatment for income tax purposes?’  Additionally, S Corporations have an employment tax advantage. Wages and salaries paid to S. Corporation shareholders are subject to employment taxes, paid through withholdings, but not other S. Corporation income reported on a shareholder’s K-1.  The S. Corp can hold back income for reserves or capital acquisitions and avoid employment taxes on that corporate income when it’s distributed as dividends or when shareholders sell their stock.  Despite other tax advantages, LLC’s aren’t ideal when it comes to employment taxes.  All LLC income is treated as wages to the Members and as such it subject to employment taxes.  In 2016 the rate is 15.3% on net income up to $118,500.00 and 2.9% of the rest.   

s corporations are subject to several restrictions that dont apply to llcs.

     Still with me?  In summary, subject to exceptions based on circumstances and plans, an LLC is often better than a C corporation for early phase businesses but LLC’s do not enjoy, at least not readily, certain tax advantages enjoyed by S corporations, such as employment tax savings. S corporations also enjoy tax free reorganization benefits that are especially attractive in certain acquisition contexts.  If you are thoroughly caffeinated, you may now be wondering why one would consider an LLC when it’s possible to obtain pass through taxation and employment tax advantages by incorporating as an S corporation.  The short answer is, it’s not that simple!  S corporations have several disadvantages, mostly in the form of restrictions, that LLCs do not suffer from.  To name a few big ones: S corporations may only have a single class of stock; unlike LLCs, S corporations can’t use special allocations to assign disproportionate losses (or gains) to certain shareholders that may want those losses; and likewise, S corporations must distribute their income pro-rata, according to share ownership.  This last restriction, when combined with the first, makes preferred returns very difficult.  In short, S corporations afford many of the same benefits as LLCs, as well as some notable extras such the employment tax advantages, but they are much less flexible than LLCs from a structural standpoint. At some point, I’ll do a post examining the relative advantages and disadvantages of S corporations, but, sticking to the theme, LLC basics, there is a final twist:  LLCs, even single member LLCs, may elect corporate taxation, then file an S Election and thereby enjoy the employment tax benefits of the S. corporation structure! 

     When an LLC makes an S election it agrees to play by the S corporation rules.  That can be a non-starter for many businesses; it’s a decision that should be carefully evaluated.  An LLC that elects corporate taxation may not change back for 5 years and then must wait 5 years before it may again elect corporate taxation (i.e., a company cannot pick and choose based on how any given year is going).  Further, changing back to an LLC is treated as a liquidation which can be a taxable event.

     This blog only scratches the surface, the waters become deeper and murkier fast.  There are many nuances that are not addressed here in the interest of sticking to the theme.  Ideally, when working with clients on choice of entity matters, its best for attorneys who are not tax specialists (such as myself), to work with a team comprised of a business CPA and/or a financial planner, at a minimum.  While most business attorneys should understand and be able to explain the basic tax methodologies applicable to different business entity forms, a CPA or tax specialist should consider and advise clients on all the nuances and how they impact a particular client’s overall financial picture.  Thanks again for taking the time to read the Summit 6 Legal blog.