By Guest Contributor Amanda Han, CPA
One thing that is great is that as practicing CPAs, we get to meet with clients all the time and in these meetings is when we get the most inspirations for our blogs to share with you. There are lots of real life situations that we can share with you guys on things to look out for and mistakes to stay away from. Today we wanted to talk about legal entity mistakes. We are not attorneys so we do not have the credentials to provide you with legal advice. In fact, our legal opinion is probably worth about a dollar, if that. Nonetheless we would still like to share these common errors that we see with you to help you avoid some of these.
Here is the common scenario: client walks in with their tax information and tells me they have formed a few legal entities. Company A was formed to hold rental property on Main Street. Company B was formed to hold property on Harbor Street. Company C was formed for some online business that they were planning on doing. And last but not least Company D was formed to be the holding company of all of these entities. My first question is generally: Great, tell me how the new entities have been working out for you?
Inevitably, there will be the client who turns red and then tell me that they have actually not used any of these entities that were created. Rental properties are still held by their personal names, rent checks still being made to their personal accounts. What about the game plan for that lucrative online business? Well, it was hard to get started so no income have actually been done in the entity just yet.
This means that we, as the tax advisors, have to be the bearer of bad news and give them a reality check. Essentially, what has happened is that the client has incurred a lot of costs (i.e.: legal fees, state fees, etc.) and time to form these legal entities that they are not getting any benefit for. Why would someone go through all the trouble of forming entities for asset protection and tax write offs but then never actually use the entities? We can’t answer that question ourselves….but we can say that this scenario applies to a lot of people that we meet with. So if what we described above sounds eerily like you, don’t feel too bad because you are not alone.
Our guess as to why this happens is that we think maybe some investors have a false sense of security in that they think by simply paying an attorney to form a legal entity that somehow they magically get asset protection. Well….this is definitely not the case. Based on our experience, owning a legal entity alone provides you with no real asset protection. You actually need to be utilizing the entity correctly and in the way that you attorney intended for you to use it before you get any real asset protection.
For real estate transactions, the minimum to be done is to at least transfer your property into the entity. Title should definitely be transferred out of your personal name if you want to protect your personal assets from potential lawsuits.
For active businesses, you will also want to makes sure you set up a company bank account for your entity so that the account can be used to receive income and pay expenses with. This way you can show that the entity is distinct and separate from you. Another great benefit of having an entity bank account is that it makes things a heck of a lot easier for you at tax time. If you have ever paid your business expenses from your personal bank accounts, you know what we are referring to when we talk about the pain and time needed for you to break out the business expenses from your personal bank account at tax time. This is something that can easily be avoided if you have an entity bank account to pay for all your business related expenses.
Furthermore, having separate bank accounts can help you tremendously for audit protection purposes. IRS generally puts more weight to something being a business expense if it is paid out of a legitimate operating legal entity rather than out of your personal bank account.
Now what about that entity you formed last year for your planned online business? Well, I would definitely ask yourself the question: Do I plan on generating income this year? If the answer is yes, then start using that entity for all your online income and expenses. If the answer is no, then now is a good time to visit with your CPA to strategize on what the best thing is to do with that entity. For example, are there other ways we can use this entity to save taxes or minimize liability exposure? Or is it simply better to just dissolve the entity and minimize costs of an entity that is no longer needed.
Another common myth that I see is that people often think that because a legal entity was not used, there are no taxes to be filed. That is definitely incorrect. Yes, it is possible that in certain instances, you would not be required to file a tax return if no business was done in the entity. However, most of the time tax returns are required even for entities with no activities. Whether a tax return needs to be filed for an entity or not will depend on the state you live in, the state the entity is formed in, as well as who the owners are. The IRS imposes hefty penalties for entities that don’t file the required tax returns and so do a lot of the states. So if you have formed an entity but had no activities within them, be sure to let your CPA know about these entities so they can help you strategize accordingly.
Amanda Han, CPA