Illinois State Bar Association May 15, 2018 presentation on the 20% gross income deduction for pass-through entities in the 2017 federal tax code amendments, and on changes appropriate for Illinois limited liability company operating agreements as a result of the 2017 amendments to the Illinois LLC Act

1. LLC and S Corporation Tax Issues
Part I
Illinois State Bar Association
May 15, 2018
Presenter:
William A. Price Attorney at Law
www.growthlaw.com
Tel/Fax 1-800-630-4780
email: wprice@growthlaw.com

2. Tax Questions For LLC and S Corporation Drafters
1. What is the basic tax structure of an LLC or S
corporation?
2. What entity structure will best fit my client and this
deal?
3. How can I change the tax structure of an entity, and
what are the consequences if I do?
4. What are the results of entity dissolution?
5. Did the new LLC Act require any change in my
documents?

3. 1. What is the basic tax
structure of an LLC or S
corporation?

4. Basic Rule: Pass-Through Entities
vs. Business Associations
Business Associations Taxed under IRC
Subchapter C: Double Taxation
Corporate tax at entity level: 21% since
new tax bill
Individual tax when entity distributes
to owners (dividends, salary, etc…)

5. Basic Rule: Pass-Through Entities
vs. Business Associations
Pass-Through Entities
LLC’s, Subchapter S Corporations,
Partnerships
No tax at entity level
Individual tax to owners on net income of
entity, whether or not distributed

6. Single Owner LLC
Entity is Disregarded: No separate
entity tax return
No entity level tax
Individual tax to owner on net income of
entity, reported on Schedule C, Form 1040
Treas.Reg. §301.7701-2(c)(2)

7. Two Or More Owners LLC
Entity is taxed as a Partnership, IRC Subchapter K:
Can elect to be taxed as C Corporation: No entity
level income tax on partnerships
Owners pay individual tax on net entity
income, whether or not distributed
Entity Files Form 1065; Schedule K-1 to owners on
their share of net income

8. Subchapter S Corporation
Entity files election to be taxed under IRC
Subchapter S: No entity level income tax
Owners pay individual tax on net entity
income, whether or not distributed
Entity Files Form 2553 to elect sub S; annual
Form 1120S, shareholders get 1120S Schedule
K-1

9. Net Tax, Business Association
Example: Gross
income $100,
Corporation tax rate
21%,
Individual income
max rate 37%
Income $100
Less
entity
level tax
$79 21%
Less in-
dividual
tax
$50 37%
Total
tax
$50

10. Net Tax, Pass-Through Entity
Example: Gross
income $100,
Individual income
max rate 37%
Income $100
Less in-
dividual
tax
$63 37%
Total
tax
$37

11. Payment Options To Owners That
Change Net Taxable
Income/Other Taxes
C corporation can deduct salaries for owners
(so less taxable net at entity level)
S Corporation dividends have statutory
exception to employment taxes: (Treas. Reg.
Regs. Sec. 1.1368-1(c) specifies S distributions
are reduction in basis or capital gains income.)

12. 2. What entity structure will best
fit my client and this deal?

13. Legal Issues For Choice Of Entity
1. Management Rights
2. S Corporation: Only One Class of Stock, one
share = one vote.
3. LLC: Member Class and other rights set by
Operating Agreement: Capital shares do not
have to equal management authority

14. Legal Issues For Choice Of Entity
1. Agency Authority
2. S Corporation: President has apparent
authority, otherwise per Board resolution
3. LLC: OA defines authority of Members or
Managers: Statement of Authority can be filed
with Secretary of State (IL SoS Form 13.15)

15. Legal Issues For Choice Of Entity
1. Liability
2. S Corporation: shareholders, officers,
directors ordinarily not liable for entity
obligations
3. Cosgrove Distributors, Inc. v. Haff,343 Ill.App.3d 426,
798 N.E.2d 139, 141, 278 Ill.Dec. 292 (3d Dist. 2003);
Main Bank of Chicago v. Baker, 86 Ill.2d 188, 427
N.E.2d 94, 56 Ill.Dec. 14 (1981).

16. Legal Issues For Choice Of Entity
1. Liability
2. LLC:
3. Members and Managers ordinarily not liable for
entity obligations
4. 805 ILCS 180/10-10

17. Legal Issues For Choice Of Entity
1. Liability
2. Veil Piercing
3. For corporations or LLC’s, question is whether
entity adequately capitalized, or if individual tort
or contract liability could attach to owners based
on non-entity duties

18. Legal Issues For Choice Of Entity
1. Liability
2. Professional Services Entities
3. Entities will not protect professionals from
malpractice claims for lawyer/doctor’s own
conduct

19. Examples of Choice Of Entity Analysis
1. Sole Practitioner of Law: S Corporation
• Liability shield limited to business debts, not
professional malpractice (Supreme Court Rule
721).
• Personal property replacement tax of 1.5% of
income if entity used to mean sole proprietor
form best.
• 2017 tax law, however, gives 20% of gross
income deduction to entity, not individuals.

20. Examples of Choice Of Entity Analysis
1. Two non-IL resident buyers of rental real
property: Common Interest Association,
tax-free state owner entities
• No Personal property replacement tax of 1.5% of
income, since no entity (just insurance and
management company contracts).
• 2017 tax law: 20% of income deduction to entities
• Ownership alone is not doing business in IL, so no IL
tax if distribution to non-IL owners from non-IL entity
(805 ILCS 5/13.75 (9).)

21. 3. How can I change the tax structure of
an entity, and what are the consequences
if I do?

22. Tax Effects of Conversion Or Merger
Organizations taxed as partnerships can convert to
or merge with each other without any gain under
IRC Section 721
Owners must be identical before and after
conversion/merger.
No deemed sale under IRC §708(b)(1)(B) for
exchange of interest for something of same value.

23. Tax Effects of Conversion Or Merger
Exceptions to taxable liquidation gain to
shareholders:
a. If gain is less than shareholder's basis, then
there is a capital loss under IRC Section 331(a).
b. Tax-exempt shareholding entities do not owe
income tax on liquidation gains, IRC Sections
512(b)(5), 514(a).
c. Subsidiaries merged into parent entity, no gain,
IRC Section 337(a).

24. Alternatives To Taxable Corporation
Conversion To Or Merger With LLC
2. Corporate Freeze:
Old entity contributes assets to new LLC in
exchange for profits share at “frozen” (time of
conversion) value in exchange for new entity
ownership.
Shareholders make additional contributions
to new LLC (or take on new entity liability)
and get all new entity capital gains.

25. 4. What are the results of entity
dissolution?

26. Dissolution and Other Business
Ownership Termination Events
1. Dissolution
For LLC's, see 805 ILCS 180/35-1 ff.
Dissolution means the entity terminates:
members receive their proportionate share of
gain or loss, per their capital account balance
as of dissolution. (IRC Section 731)

27. Dissolution and Other Business
Ownership Termination Events
2. Dissociation
For LLC's, see 805 ILCS 180/35-55
Dissociation means the member no longer
has management rights or liabilities, but still
gets distributions per their membership
share, with gain or loss per their capital
account balance as of time of distributions.
(IRC Section 731)

28. Dissolution and Other Business
Ownership Termination Events
3. Corporation dissolution
See 805 ILCS 5/12.30
Shareholders get a distribution of the entity's
assets according to their interests (e.g.
preferred or common share order of
distribution, percentage of company, etc...)
IRC Section 331 treats distributions over
share basis as capital gains.

29. 5. What Changes In LLC Operating
Agreements Are Needed As A Result
of the 2017 Amendments To That Act?

30. New LLC Act Effective July 1, 2017
P.A. 99-0637
Product of 6 year drafting project by the
Institute of Illinois Business Law
www.iibl.org

31. New LLC Act Effective July 1, 2017
P.A. 99-0637
Product of 6 year drafting project by the
Institute of Illinois Business Law
www.iibl.org

32. Oral Operating Agreements
Allowed by new Act, not
encouraged
Permits default provisions of Act
to help manage disputes

33. Member Management
Act allows management by
Members or by Managers
Member management is default
rule: can be changed by Articles
of Organization or Operating
Agreement

34. Member Anonymity
Act requires official filings to list
all Members or Managers with
management authority
Non-manager Members do not
have to be listed: same rule as for
shareholders of corporations

35. Member And Manager Rights
Former Act definition of actions
Manager can take deleted:
Amendment of Operating
Agreement to define Manager
and member authority is
recommended

36. Organization Records
Transferees and dissociated Members
can get access to organization's books
and records, if their purpose is “proper”
Amendment to OA: make sure trade
secrets and NDA/other agreements with
third parties items not “proper” reasons

37. Agency Authority of Members and
Managers
Neither Members nor Managers now
have agency authority by default
Amendment to OA: Define Member
or Manager or other officer authority
File Statement of Authority, IL SoS
Form 13.15, to notify public

38. Duty of Loyalty
Act now allows OA or Articles to
restrict or eliminate Duty of Loyalty of
members/managers
Example: joint owners want freedom
to pursue similar deals to LLC
Change must be clear/unambiguous

39. Duty of Care
Act now allows OA or Articles to
modify Duty of Care of
members/managers
Limit: no intentional misconduct or
knowing violation of law allowed
Duties of good faith and fair dealing
still apply

40. Wrongful Distributions
Act now defines when Member may
be liable (to LLC or other Members)
for receipt of wrongful distribution
OA Amendment recommended:
define what distributions are allowed

41. Buy-Out Rights
Act changed: dissociating Member no
longer has default right to fair value
buyout of Member's interest
OA Amendment recommended:
define buy/sell rights and dissociated
Member rights

42. Outside Creditors
Act defines charging order as only
remedy for Member's creditors
(distributions, not
management/dissolution)
OA Amendment possible: additional
rights for creditors of whole LLC

43. Opression of Minority Members
Act now allows alternative remedies,
not just dissolution, for fraudulent or
oppressive conduct
OA Amendment possible: define
information/oppression rights and
remedies, including non-court
remedies like arbitration

44. Entity Conversion and
Redomestication
Act now allows conversion to any type of
domestic entity (partnership, LLC,
corporation), and change of entity domicile
(domestication) in other state
Amendment possible: redomesticate
in zero tax state

45. Remainder of Q and A Slide topics:
James Nepple

46. Thank You For Your Attention
Any Questions?
After the program, you can contact:
James Nepple William A. Price Attorney at Law
www.nepplelaw.com www.growthlaw.com
866.355.6841 Toll Free Tel/Fax 1-800-630-4780
email: wprice@growthlaw.com