December 2018 Update
Conflicts of Interest
An attorney cannot accept or continue representation of a client without obtaining the client’s informed written consent if
The attorney’s representation is directly adverse to another client in the same or a separate matter (Cal Rules of Prof Cond 1.7(a)); or
There is a significant risk the attorney’s representation of the client will be materially limited by the lawyer’s responsibilities to or relationships with another client, a former client, or a third person, or by the lawyer’s own interests (Cal Rules of Prof Cond 1.7(b)).
To obtain an “informed written consent,” the attorney must first adequately disclose in writing to the client both
The relevant circumstances giving rise to the conflict or potential conflict and the need for such consent; and
The material risks, including any actual and reasonably foreseeable adverse consequences to the client, arising from the giving of consent to the representation (Cal Rules of Prof Cond 1.01(e), (e–1)).
Furthermore, an attorney cannot accept or continue representation of a client without providing written disclosure to the client of the relevant circumstances, even when there is no significant risk that the attorney’s representation of the client will be materially limited by the attorney’s responsibilities to or relationships with another client, a former client, or a third person, or by the attorney’s own interests, when
The attorney has, or knows that another lawyer in the attorney’s firm has, a legal, business, financial, professional, or personal relationship with or responsibility to a party in the same matter (Cal Rules of Prof Cond 1.7(c)(1)); or
The attorney knows or reasonably should know that another party’s lawyer is a spouse, parent, child, or sibling of the attorney, lives with the attorney, is a client of the attorney or another lawyer in the attorney’s firm, or has an intimate personal relationship with the attorney (Cal Rules of Prof Cond 1.7(c)(2)).
In Beachcomber Mgmt. Crystal Cove LLC v Superior Court (2017) 13 CA5th 1105, 1118, the court ruled that an attorney who previously represented both a closely held company and its insiders may continue representing insiders in a derivative lawsuit brought on the company’s behalf against insiders. See §16.4.
Tax Cuts and Jobs Act
On December 22, 2017, legislation commonly referred to as the Tax Cuts and Jobs Act (TCJA) (HR 1) (Pub L 115–97, 131 Stat 2054) was signed into law. The TCJA made significant changes to the taxation of C corporations and of the owners of S corporations, partnerships, and LLCs (so-called pass-through entities), generally effective for tax years beginning on or after January 1, 2018. In general, the TCJA provides reduced tax rates for both C corporations and owners of pass-through entities. However, many of the TCJA tax changes are subject to sunset on December 31, 2025 (or other specified dates). Entity selection based on post-2018 tax benefits must therefore be weighed against the potential expiration of these benefits. In addition, it is unclear whether California will conform its Revenue and Taxation Code to the federal tax changes made by the TCJA. See §3.14.
Under the TCJA, the federal income tax rate on corporations was reduced from a maximum of 35 percent to a fixed rate of 21 percent. See §3.20.
Under the TCJA, the net operating loss (NOL) deduction is limited to 80 percent of a corporation’s taxable income and can be carried forward indefinitely. IRC §172. For partnerships and LLCs, the NOL is not deductible at the entity level but may be deducted against other income by the individual partners or members, subject to certain limitations. See §§3.44, 5.9, 5.54–5.57. See also the at-risk rules (IRC §465) and the passive activity loss rules (IRC §469). The TCJA also provides general limitations on noncorporate taxpayer losses. For tax years 2018 through 2025, individual filers can only deduct $250,000 of business losses against nonbusiness income ($500,000 for joint filers). IRC §461(l). The limitation is indexed to inflation and losses in excess of the thresholds are carried forward under the TCJA NOL rules. See §§3.21, 5.54.
A C corporation may not, as a general rule, use the cash method of accounting. IRC §448(a)(1). However, the TCJA expanded the exceptions to this rule to allow corporate taxpayers with annual average gross receipts that do not exceed $25 million for the three prior taxable-year periods to use the cash method. IRC §448(c). See §3.23.
A partnership is treated as terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership. IRC §708(b)(1). Before enactment of the TCJA, a partnership was considered terminated if 50 percent or more of the interests in a partnership’s capital and profits were sold or exchanged within 12 months. However, the TCJA eliminated these “technical termination” rules. See §3.45.
The American Jobs Creation Act of 2004 (AJCA) (Pub L 108–357, 118 Stat 1589) amended IRC §743(b) to provide another ground for adjusting the basis of an LLC interest—namely, when there is a “substantial built-in loss” immediately following the transfer of the interest. An LLC has a substantial built-in loss with respect to a transfer of an interest if the adjusted basis in the property exceeds the fair market value of the property by more than $250,000. The TCJA modified the definition of substantial built-in loss so that a substantial built-in loss also exists if, on a hypothetical disposition of all LLC assets at fair market value by the LLC immediately after the transfer of the LLC interest, the transferee would be allocated a net loss in excess of $250,000. See IRC §743(d)(1). See §5.79.
Also under the TCJA, the purchaser of an LLC membership interest must withhold 10 percent of the amount realized on the sale or exchange of an LLC interest that is effectively connected with a U.S. trade or business, unless the seller certifies that it is not a nonresident alien or foreign corporation. See IRC §§864(c), 1446(f). In addition, the sale of a membership interest by a foreign member of an LLC owning U.S. real property interests may trigger a withholding obligation. That withholding obligation is on the purchaser and is equal to 15 percent of the amount of the sale (IRC §1445(e)(5)). That withholding obligation is triggered if the gross assets of the LLC consist of 50 percent of U.S. real property interests, and 90 percent or more of the value of the gross assets consist of U.S. real property interests and cash or cash equivalents. Temp Treas Reg §1.1445–11T(d). See §5.79.
IRC §199A: New 20 Percent Deduction on Qualified Business Income
Among other things, the TCJA introduced new IRC §199A, which provides for a 20 percent deduction on certain qualified business income earned by pass-through entities such as sole proprietorships, partnerships, LLCs, and S corporations. The 20 percent deduction reduces the effective maximum tax rate on eligible pass-through income from 37 percent to 29.6 percent. See §4.32A.
The 20 percent deduction is available to all taxpayers except C corporations. IRC §199A(a). Thus, individuals, trusts, and estates that hold interests in pass-through entities are entitled to the 20 percent deduction on their qualified business income. The deduction also applies to an individual’s qualified business income earned if the individual is a sole proprietorship or the member of a single-member LLC. See §4.32B.
The 20 percent deduction only applies to income from qualified businesses. See IRC §199A(c)(1). The issue of what is a qualified business is discussed in detail in §4.32C. Certain specified service businesses are excluded from the definition of qualified business. In addition, there is an issue whether a particular activity rises to the level of a trade or business. The most common example is rental real estate when the property is either a single-family residential property or a triple net lease property. Case law is not clear whether either activity rises to the level of a trade or business. The enactment of IRC §199A only puts greater stress on this issue. See §4.32C.
Not all income earned by a pass-through entity is entitled to the 20 percent deduction. Generally, the income must be earned by a trade or business within the United States. IRC §199A(c)(3)(A)(i). Also excluded is investment income. IRC §199A(c)(3)(B). Reasonable compensation paid to the taxpayer with respect to the business and any guaranteed payments are also not included in qualified business income. IRC §199A(c)(4). It appears that rental income, royalty income, and other types of passive income are included in qualified business income. See IRC §199A(c)(1). See §4.32D.
Although initially the deduction is 20 percent of the qualifying business income, it is subject to a limitation based on the W-2 wages paid by the business. The W-2 wages limitation is the greater of (a) 50 percent of the W-2 wages paid by the business or (b) 25 percent of the W-2 wages paid by the business plus 2.5 percent of the original cost of depreciable property and acquisition costs for that property that are capitalized in the business. IRC §199A(b)(2)(B). Depreciable property is only included for as long as the asset is subject to depreciation. Once the asset is fully depreciated, it comes out of the 2.5 percent asset base. See §4.32E.
The amount of the deduction is also subject to another limitation. It cannot exceed 20 percent of the taxpayer’s taxable income before the deduction, reduced by net capital gain. IRC §199A(a)(1). For example, a taxpayer who has more itemized and nonbusiness deductions than nonbusiness income will be subject to this limitation. If the taxpayer’s income is only qualified business income, but the taxpayer has deductions for home mortgage interest, state and local taxes, and charitable contributions, 20 percent of taxable income will be less than 20 percent of qualified business income. The effect of this provision is to prevent the deduction from creating a loss for the year. The deduction cannot cause a taxpayer’s taxable income to be negative. See §4.32F.
Despite the exclusion of income from certain service businesses (see IRC §199A(d)(1); §4.32C), certain taxpayers below specified income thresholds can still earn the deduction. Joint taxpayers whose income is $315,000 or less or single taxpayers whose taxable income is $157,500 or less are entitled to the deduction. IRC §199A(b)(3)(A). On a joint return, the benefit is phased out between $315,000 and $415,000 of taxable income; for a single taxpayer, the benefit is phased out between $157,500 and $207,500 of taxable income. IRC §199A(b)(3)(B). See §4.32G.
Updated chap 4 includes several new sections containing examples of the benefit of the IRC §199 deduction, the impact of the deduction on certain taxpayers, and a chart that should facilitate analysis of the operation of the deduction. See §§4.32H–4.32J.
Other Tax Law Developments
In Swart Enters., Inc. v Franchise Tax Bd. (2017) 7 CA5th 497, 500, the court of appeal held that an out-of-state corporation was not doing business in California and was not subject to the $800 minimum franchise tax when the corporation’s only connection to California was its passive ownership of a 0.2 percent membership interest in a manager-managed California LLC. See §3.57.
An LLC may elect out of the partnership audit and adjustment rules only if all of its members qualify as “eligible partners” under Treas Reg §301.6221(b)–1(b)(3)(i). This category includes individuals, C corporations, S corporations, estates of deceased partners, and certain foreign entities. The following, however, are not “eligible partners” under Treas Reg §301.6221(b)–1(b)(3)(ii): partnerships; trusts; certain foreign entities; “disregarded entities” (as defined in Treas Reg §301.7701–2(c)(2)(i)); estates of individuals other than deceased partners; and nominees or others that hold interests in an entity on behalf of another person. Under Treas Reg §301.7701–2(c)(2)(i), a “disregarded entity” includes any business entity (other than a corporation) that has a single owner. Thus, any LLC with even one single-member LLC as a member will not be eligible to elect out of the centralized partnership audit regime. See §5.16A.
California Secretary of State
Through the California Secretary of State’s BizFile service, http://www.sos.ca.gov/business-programs/bizfile/, it is now possible to file LLC formation documents and statements of information online, using a laptop, tablet, or smartphone. See §7.23A for additional information. All of the Secretary of State LLC forms are posted online, at http://www.sos.ca.gov/business-programs/business-entities/forms/#llc, and are modified from time to time. Before completing an LLC form, it is a good idea to check the Secretary of State’s website to ensure that the current form is used. The website also sets forth the current filing fees and other relevant information. See §§7.1, 7.23A.
As discussed in §§7.35 and 13.3–13.3E, it is also possible to prepare and file the required biennial Statement of Information (Limited Liability Company) (Form LLC-12) entirely online. In addition, the public can view online (and download or print) PDFs of the two most recent Statements of Information of record and PDFs of articles of organization (and amendments) for most LLCs. See §7.23A.
Rights of Transferees
A transferee who holds only a transferable interest will have no right to vote, to participate in management, or to conduct activities of the LLC, except as permitted under Corp C §17705.04 with respect to a deceased member’s personal representative or other legal representative. Corp C §17705.02(a)(3). But see SP Inv. Fund I LLC v Cattell (2017) 18 CA5th 898, in which the court held that a limited partner could contract to transfer the right to direct the voting of his limited partnership interest even though the transferee had not been approved as a new limited partner. See §12.8.
Reverse Veil Piercing
For a case allowing potential alter ego liability with respect to an LLC for the obligations of a member (“reverse veil piercing”), see Curci Invs., LLC v Baldwin (2017) 14 CA5th 214. In Curci, the court noted that a creditor does not have the same options against a member of an LLC as it has against a shareholder of a corporation. “[I]f the debtor is a member of an LLC, the creditor may only obtain a charging order against distributions made to the member.… The debtor remains a member of the LLC with all the same rights to manage and control the LLC, including … the right to decide when distributions to members are made, if ever.” 14 CA5th at 223. The court therefore ruled that reverse veil piercing might be available. In contrast, reverse veil piercing was not allowed in Phillips, Spallas & Angstadt, LLP v Fotouhi (2011) 197 CA4th 1132 or in Postal Instant Press, Inc. v Kaswa Corp. (2008) 162 CA4th 1510, but neither Phillips nor Postal Instant Press involved LLCs. See §§12.9, 13.2.
Effect of Certificate of Cancellation
Prior to 2016, Corp C §17707.06(a) provided that an LLC that has been dissolved continues to exist not only to wind up its affairs, but also to prosecute and defend actions against it concerning its obligations and the disposition and conveyance of its property and other assets. However, under Corp C §17707.08(c), once a certificate of cancellation was filed, the LLC was required to be cancelled and its powers, rights, and privileges ceased. Effective January 1, 2016, Corp C §17707.06(a) was amended by substituting the phrase “has filed a certificate of cancellation” for the phrase “is dissolved,” so that now, an LLC that has been cancelled expressly continues to exist for the purpose of “winding up its affairs, prosecuting and defending actions by or against it in order to collect and discharge obligations, disposing of and conveying its property, and collecting and dividing its assets.” See §16.53.
Retroactivity of RULLCA Amendment
The retroactivity of the amendment to Corp C §17707.06(a) was discussed in DD Hair Lounge, LLC v State Farm Gen. Ins. Co. (2018) 20 CA5th 1238, in which the court declined to give the amendment retroactive effect so as to allow the plaintiff to maintain its lawsuit. The plaintiff was an LLC whose articles were cancelled after the January 1, 2014, RULLCA effective date but before the effective date of the amendment to §17707.06(a), but the plaintiff had hidden its certificate of cancellation in an attempt to maintain its suit. See §§1.9, 16.53.