e- NEWSLETTER

October/November 2004

Cameron R. Monti
Editor-in-Chief

Taxation Law

IRS Streamlines Procedure for
Late S Corp and Late Corporate Classification Elections
Rev Proc 2004-48, 2004-32 IRB

Timothy M. Hughes

           A new revenue procedure carries a simplified method for requesting relief for a late S corporation election and a late corporate classification election which was intended to be effective on the same date that the S corporation election was intended to be effective.
Background. An eligible entity that wants to be classified as an S corporation must elect to be classified as an association under Reg. § 301.7701-3(c)(1)(i) by filing Form 8832 (Entity Classification Election) and must elect to be an S corporation under Code Sec. 1362(a) by filing Form 2553 (Election by a Small Business Corporation). Often, an entity timely files Form 2553 but fails to file Form 8832. Reg. § 301.7701-3T(c)(1)(v)(C) deems an eligible entity that timely files Form 2553 to also have filed Form 8832. However, in other situations, an eligible entity fails to file a timely Form 2553. Here, Reg. § 301.7701-3T(c)(1)(v)(C) does not apply and the entity would be required to obtain relief in a letter ruling. ( Rev Proc 2004-48, Sec. 3.01 )
Rev Proc 2004-48 provides a simplified method for requesting relief for those situations not covered by Reg. § 301.7701 3T, if the conditions highlighted below are satisfied. The simplified method is in lieu of the letter ruling process ordinarily used to obtain relief for late elections under Code Sec. 1362(b)(5) , Reg. § 301.9100-1 , and Reg. § 301.9100-3 . As a result, user fees don't apply to corrective action under Rev Proc 2004-48 . An entity that doesn't qualify for (or is denied) relief under Rev Proc 2004-48 may request a letter ruling. (Rev Proc 2004-48, Sec. 3.02).
Qualifying for relief. An entity may request relief under Rev Proc 2004-48 it meets all of the following requirements:
o it is an eligible entity as defined in Reg. § 301.7701-3(a) and intended to be classified as a corporation as of the intended effective date of the S corporation status;
o it fails to qualify as a corporation solely because Form 8832 was not timely filed (or was not deemed to have been filed under Reg. § 301.7701-3T(c)(1)(v)(C);
o it fails to qualify as an S corporation on the intended effective date of the S corporation status solely because the S election was not filed timely under Code Sec. 1362(b); and
o it has "reasonable cause" for its failure to file timely the S corporation election and the entity classification election. (Rev Proc 2004-48, Sec. 4.01)
How to request relief. Within 6 months after the due date for the tax return, excluding extensions, for the first year the entity intended to be an S corporation, it must file a properly completed Form 2553 carrying the following at the top of the document: "FILED PURSUANT TO REV. PROC. 2004-48." An attached statement must explain the reason for the failure to file timely the S corporation election and the reason for the failure to file timely the entity classification election. (Rev Proc 2004-48, Sec. 4.02)
IRS will determine whether the requirements for granting additional time to file the elections have been satisfied and will notify the entity of its determination. An entity receiving relief under this revenue procedure is treated as having made an election to be classified as an association taxable as a corporation under Reg. § 301.7701-3(c) as of the effective date of the S corporation election. ( Rev Proc 2004-48, Sec. 4.03 )

Effective date. The new procedure is effective July 20, 2004, but any entity that meets the above requirements as of July 20, 2004 may seek relief under Rev Proc 2004-48 . The new procedure also applies to requests pending with IRS on July 20, 2004.

RIA Research References: For late S elections, see FTC 2d/FIN ¶ D-1571; United States Tax Reporter ¶ 13,624.01; TaxDesk ¶ 612,014; TG ¶ 4748.

Business Law

What’s the Difference Between an S-Corp, C-Corp, & LLC??
Cameron R. Monti
 

C-CORPORATION

            One of the most commonly asked questions asked to a business and corporate law attorneys is “What’s the difference between an S-Corporation, C-Corporation, and an LLC?” What clients are really asking is what corporate entity would best suit their needs. A C-Corporation is the traditional and arguably the most well-known corporate entity. What exactly is a C-Corporation though? A C-Corporation allows a company to have an unlimited number of shareholders. This is beneficial to companies which will require many investors, as well as companies who envision offering stock publicly. An inherent benefit of all Corporations is that they shield their shareholders from personal liability arising from business debts and business lawsuits.

            A favorable aspect of the C-Corporation is the simplicity by which its stock can be sold or otherwise transferred. Transfers of C-Corporation stock have very few limitations. Furthermore, if a company anticipates that it will offer stock publicly, the C-Corporation is the only option. S-Corporations and LLCs are not permitted to offer ownership through public offerings. A further consideration is the state filing fee. In Illinois, the fee to form a C-Corporation is less than the fee to form an LLC.

            The primary disadvantage of the C-Corporation is that it is subject to “double taxation.” This means that the company’s profits are initially taxed at the corporate level, and then taxed again at the individual level when distributions are made to the shareholders.

S-CORPORATION

            Since its creation, the S-Corporation has increasingly become the preferred form for many small to medium size business. The S-Corporation is similar in structure to that of a C-Corporation, however, it must meet a few more requirements. In fact, an S-Corporation is initially formed as a C-Corporation by filing the articles of incorporation with the Illinois Secretary of State. The C-Corporation can then become an S-Corporation when an extra step is taken by filing with the Internal Revenue Service.

            The primary benefit of an S-Corporation is that it allows the shareholders to receive profits free of taxation at the corporate level. The profits will only be taxed at the individual level, thereby avoiding the “double tax” that C-Corporation shareholders are subject. (C-Corporations are taxed at the corporate and individual level). However, not all C-Corporations are able to take advantage of the S-Corporation status. A corporation is only eligible for the S-Corporation election if it meets the following list of ownership requirements:
                    • The company must have no more than 75 shareholders (a husband and wife qualify as one shareholder);
                    • All shareholders in the company must be individuals and not other corporations or LLCs (estates, some exempt organizations and certain trusts may  qualify as shareholders);
                    • No shareholders can be non-resident aliens;
                    • There can only be one class of stock in the company (such a limitation disregards differences in voting rights);
                    • The company making the election cannot be a bank or thrift institution, an insurance company, or a domestic international sales corporation (DISC);
                    • Each shareholder must consent to the S-Corporation tax status (as explained in column K of IRS form 2553);
                    • No more than 25% the company’s gross corporate income may be derived from passive income; and
                    • Profits must be distributed according to the ratio of stock ownership.

LIMITED LIABILITY COMPANY

                    Today, many businesses are forming as a Limited Liability Company (LLC) and are finding that an LLC may offer the “best of both worlds” of corporate forms. An LLC allows for pass-through taxation, thereby avoiding the “double tax” of a C-Corporation (as explained above), yet also affords its owners the personal liability protection of a corporation.

                    The popularity of the LLC is primarily based on the Tax Advantage. An LLC operates in most ways as a corporation, yet the distributions to its “members” (shareholders) are not subject to taxation at the corporate level. Instead, the distributions are "passed through" the corporate level and are taxed only at the individual level. Therefore, the LLC avoids “double taxation.”

                    Unlike sole proprietorships, Corporations and LLCs are separate entities from their owners. Since the two are separate, the personal assets of the owners (such as their personal residences, and personal bank accounts) are generally not reachable by business creditors.
An advantage of an LLC is that the formation and ownership requirements are less stringent. Usually, an S-Corporation can issue only one class of stock, while an LLC may offer a variety of classes. The S-Corporation also limits the number of shareholders to seventy-five or less, and prohibits non-resident aliens from possessing ownership in the company. Further, S-Corporation shareholders cannot be other corporations, LLCs, or partnerships. An LLC has no such limits to ownership.
                    The LLC also offers an advantage in management flexibility. The LLC can be “member-managed,” meaning that it would be managed directly by the shareholders. Or the owners of the LLC can agree to have the business “manager-managed,” meaning that the management can be structured and delegated from the owners to managers. Also, LLC profits (and losses) do not require that they be distributed according to ratio of stock ownership as found with
Simply put, a major disadvantages of an LLC is that is more expensive. For example the filing fee that is required to be filed along with the annual report to the Illinois Secretary of State is more expensive. Specifically, the filing fee for an LLC is $175 more per year than an S-Corporation or C-Corporation (i.e., $250 versus $75) . Also, the initial formation filing fee (i.e., to create the corporate entity) is $500 for an LLC versus $150 for an S-Corporation and C-Corporation. One more way an LLC is more expensive is that an LLC must pay employment tax on the total net income of the LLC including wages paid to an LLC owner, whereas an S-Corporation must only pay employment tax on income of an employee-owner.

                    Although the LLC form is preferable in many ways, a C-Corporation or S-corp may still be the best form in many circumstances. The primary reason that a C-corp or S-corp may still be preferable is the simplicity by which the stock can be sold or otherwise transferred. A sale of an ownership interest in an LLC must meet certain requirements, while a sale of corporate stock virtually has no limitations. As mentioned above, other favorable aspects of the corporation include the public’s familiarity with the form and lower state filing fees. Finally, the “pass through” tax advantage may be less beneficial to businesses that are small enough to take advantage of the 15% and 25% tax rates.

                    If you are thinking about starting a business, or changing your existing corporate form, consider the factors in this article to make an educated decision. If you have any questions or comments, you can address your questions or comments to cmonti@lavellelaw.com.

Estate Planning

Estate Planning for Disabled Beneficiaries
Lauren E. Schaaf

            As people who have children or relatives with special needs and disabilities may know, federal and state government programs exist to provide financial aid in the form of Supplemental Security Income (SSI) and Medicaid. Without this financial assistance, many people with disabilities would not be able to survive. These programs provide cash benefits as well as necessary medical coverage and long-term care services. However, in order to qualify for this assistance, the income and financial resources of an individual with a disability, or their family applying on behalf of their child with a disability, must not exceed a certain amount. Benefit recipients are allowed to retain only a total of $2,000 in assets, with some exceptions. A person with a disability receiving SSI, who accumulates more than $2,000 in cash resources, may lose SSI and, possibly, Medicaid.

            Unfortunately, the available government assistance provides only for the bare necessities of life. It amounts to less than the federal poverty level income, which is not enough for anyone to actually live on. For a person planning for the future of someone with a disability or special needs, this poses a problem. How does one provide for the special comforts of a person with a disability or special needs without disqualifying them for SSI or Medicaid? One alternative is to leave assets to another family member or other person for the care of the disabled individual with the hope the person they leave the money to is trustworthy, and will not suffer a catastrophic financial event such as bankruptcy a lawsuit or divorce.

            Fortunately, there is a second alternative. The government has established rules allowing assets to be held in trust for a recipient of SSI and Medicaid so long as certain requirements are met. Special Needs Trusts (SNTs), preserve government benefit eligibility and leave assets that will meet the supplemental needs of the person with a disability. This money is meant to pay for needs that go beyond food, shelter, and clothing and the medical and long term support and services of Medicaid.  The SNT is drafted so that all moneys are distributed to a third party to pay for goods and services to be used by the person with a disability.

            When planning the financial future of a person with disabilities or special needs one must consider how transfers of funds are made. Nothing can ever be distributed directly to the disabled person. All transfers, whether from insurance policies, wills, trusts or directly from an individual must be made to the trust which will then distribute the funds to a designated third party for the beneficiary’s benefit and according to the terms of the trust.

            The laws governing SNTs are complicated and subject to changes in legislation which could affect a person’s eligibility for the government benefits that they depend on. Therefore, whoever is drafting this document must have an intimate understanding of the current legislation and how it impacts people planning for a person with special needs or a disability in order to preserve eligibility. Setting up a special needs trust requires extensive planning with an attorney specializing in estate planning and SNTs and who can draft a will and necessary trust documents. Do you have a child with special needs or a disability? Are you considering leaving money or other assets to a person with special needs or a disability? Does this person currently receive government aid? If you have any of these questions or questions relating to planning for disabled persons contact Lauren E. Schaaf at Lschaaf@lavellelaw.com.

Corporate Law

When Does the “Silent Partner”
Become the “Liable Partner” of a Business?
Kerry M. Lavelle

            The District Court recently reversed the Bankruptcy Court and held that the proverbial “silent partner” in a corporation who did not actually exercise control over the daily operations of the corporation is liable for the IRC § 672 Trust Fund Recovery Penalty for the corporation’s failure to remit employment taxes to the federal government.

            In U.S. v. Marino, Dan Myers sought to organize a mortgage broker company. Because of his financial problems he asked his “significant other” Ellen Marino to become the president, sole shareholder, and license holder for the corporation. Marino did not receive a salary, but at the request of her boyfriend, opened and closed corporate bank accounts and signed corporate checks. She also approved of making a signature stamp which Myers used as he desired. Myers ran the day-to-day affairs of the corporation while, Marino, despite her titles, had little contact with the business. Marino was aware that the corporation was having financial problems because she lent it money and signed a guarantee on a loan for the corporation. At first, the Bankruptcy Court ruled that Marino was not the responsible officer for the taxes because her position was in title only, and found that she did not have control over the financial affairs, disbursement of corporate funds or knew of the accruing tax liability.

            The District Court disagreed and said that the facts amply demonstrated that Marino acted in reckless disregard of the obvious risks. The District Court stated that the Bankruptcy Court erred by giving too much weight to the fact that Marino did not “actually exercise control” over the daily operations and decisions of the corporation.  The District Court ruled that Marino not exercising her control over the corporate decisions, does not avoid liability. The Court ruled that because Marino had the authority to pay the taxes and at least had the ability to control the corporate finances, she had the effective power to pay.
With respect to willfulness, the Court stated that the “willfulness” requirement is satisfied when a responsible person either has the knowledge of payments to other creditors after she learns of the failure to remit that withheld taxes knowingly, or the responsible person acted with reckless disregard of a known or obvious risk that the trust funds may not be remitted to the government.

            In the Marino case, the Court ruled that she knew or should have know that the corporation was having financial difficulty (by lending it money and guaranteeing a loan) and that she had constructive knowledge of the tax liability. All clients should be aware that when individuals are often asked by friends or family members to serve in some capacity in a business venture with a friend or relative, they must be aware. This case identifies the potential liability that can arise when one undertakes a service in title only, as a favor. If you are in this situation, or know someone who is, and want to discuss the case, e-mail me at klavelle@lavellelaw.com.

Litigation
 

Default Judgment
Matthew J. Sheahin

            The most efficient way to obtain a judgment against a Defendant is by means of a Motion for Default Judgment. Unfortunately, such a motion relies upon a factor completely out of your control: the Defendant’s failure to respond to your lawsuit. In most cases, a party that is served with your lawsuit will either file an appearance themselves (known as pro se) or will retain an attorney to represent their interests. However, in some case, a Defendant who received proper notice of your lawsuit, for whatever reason, will not respond as required by law. In these cases, a Plaintiff may obtain judgment without the necessity of trial or lengthy litigation, by filing a motion for default judgment.

            735 ILCS 5/2-1301 is the Illinois statute which addresses default judgments. Section (d) of the statute states:
 

                        “Judgment by default may be entered for want of an appearance, or for failure to plead, but the court may in either case , require proof of the allegations of the pleading upon which relief is sought.” '

            In Illinois, once a Defendant has been properly served with your lawsuit, that Defendant has 30 days to file an appearance (essentially a form notice to the Court that the Defendant is formally entering the case) and a responsive pleading, which is a document filed with the Court which identifies the Defendant’s position with respect to the allegations contained in Plaintiff’s Complaint. If a Defendant fails to file an appearance and responsive pleading (they must file both to comply with the statute) the Plaintiff should move for default judgment against the Defendant.

            Most courts make proof of the allegations a requirement before they will enter a default judgment. Therefore, a Plaintiff should attach as an exhibit to the Motion for Default Judgment an affidavit signed by a person with knowledge, either the Plaintiff himself or a qualified agent of the Plaintiff, outlining the liability and damages in the case. Although this affidavit is unopposed due to Defendant’s failure to appear, it must still comply with Supreme Court Rule 191(a) and be cased upon personal knowledge and contain only facts not speculation. If the Court is satisfied by the Motion and supporting evidence, including an affidavit, it will enter judgment against the Defendant.

            A plaintiff should be wary even after obtaining a default judgment, because a Defendant can still come to Court within thirty (30) days after the Plaintiff obtained judgment and move to vacate under Illinois law. Basically, the courts would rather decide a case on the merits, so they allow Defendants plenty of chances to participate in the lawsuit. However, if the Defendant sits on its hands and does nothing, the Plaintiff can obtain judgment and all the rights of collection that come with that. If you have any questions concerning this article, please feel free to e-mail Matt Sheahin at msheahin@lavellelaw.com.

Corporate Law

Protecting Minority Shareholders
Theodore M. McGinn

            From time to time you may be confronted with an opportunity to invest in a closely held business. When considering such investment opportunity, it is crucial that you insure that your interests are protected. Primarily, the most important considerations facing one with an investment opportunity are who will be making the decisions for the business and how will profits, if any, be distributed or allocated. To best insure that your rights are protected, it is essential that you enter into a shareholder agreement.

            A shareholder agreement is a document that addresses certain contingencies that a business will undoubtedly encounter sometime during the course of its life. In order to protect your investment and/or your rights, you should require the shareholder agreement to contain language which obligates or entitles you to a certain officer positions and director positions with the company. Furthermore, you should make sure the shareholder agreement specifys as to how certain decisions affecting the company will be voted upon and/or decided. You may wish to require a certain type of voting requirement such as two-thirds approval and/or sometime unanimity.

 
            If the business is to be successful, the business will generate profits. How are those profits going to be used? Some owners may wish to retain the profits and invest it in the business. Other owners may wish to have a return on their investment and have a distribution to the shareholders. If such issue is not decided and set forth in a shareholder agreement, the matter will be decided by shareholder vote. If you are acquiring a minority interest, you may be outvoted.

            Absent to shareholder agreement, a minority shareholder still has certain protections by operation of law. Shareholders in a closely held company owe one another a fiduciary duty to act in the best interests of the corporation as well as to exercise good faith towards one another. In addition, every shareholder has a right to review the books and records of a corporation. It is possible that the majority owner of a corporation may attempt to freeze out a minority shareholder and prevent a minority shareholder from enjoying a financial benefit. One way this is accomplished is by disguising dividends in the form of salary and/or wages. Instead of having profits, the corporation will inflate salaries to majority shareholders or their family members and eliminate any profit. If thee is no profit, then the corporation naturally will not declare a dividend. In such a scenario, such majority shareholders may be considered to have breached their fiduciary duties owed to minority shareholders and maybe liable to compensate such minority shareholder for damages. The best way to prevent this is to review the books and records of the company from time to time.

 
            When contemplating entering into an investment in a closely held company or if currently investor in a closely held company, there are certain steps an individual can take to protect their interest. One common way is to have the shareholder agreement entered into to protect their interest. Absence of shareholder agreement, there are many options under law that can be used to protect your rights.  If you would like to discuss this topic, please contact Ted McGinn at tmcginn@lavellelaw.com.

For past e-newsletter articles of interest, please visit the Lavelle Legal Services, Ltd. website at:         http://www.lavellelaw.com/newsletters/newsletter.htm.

 

This newsletter is a publication of Lavelle Legal Services, Ltd. We attempt to highlight and discuss areas of general legal interest that may lead to planning opportunities. Nothing contained in this Newsletter should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein.