****** A note from Jeff Nabers ******
I asked attorney Dan Marsh to shed a bit of light on entity maintenance and its importance. With a general purpose LLC, failing to properly maintain the entity can result in “piercing the veil” which means subjecting creditors to assets of the LLC owner(s). With a special purpose IRA LLC, “piercing the veil” could mean a prohibited transaction resulting in hefty taxes, penalties, and interest.
Entity maintenance is important and it shouldn’t take too much time or money… yet it could save you a lot of time and money in the long run. I suggested Dan keep this post brief, but instead he did what attorneys are supposed to do: he was thorough. Rather than ask him to dumb it down and shorten it, here’s the article in its entirety…
LLC’s and corporations (whatever type) are separate entities, separate and apart from you as an individual. An LLC and corporation provide its members with so-called limited liability. This means that the LLC’s members or shareholders in a corporation (entities or entity) have no personal liability for any of the entities debts, liabilities or other obligations. When boundaries of the entity are not respected, a liability claim would likely have the claim attach to the owner of the entity personally (called “piercing the corporate [or LLC] veil”). When using an IRA or a qualified plan to fund an entity that will in turn be used to make investments, special consideration should be given to the formalities of maintaining the entity.
WHY INVEST THROUGH AN ENTITY IN AN IRA OR QUALIFIED PLAN
There many reasons to use an entity. Sometimes good deals must be funded quickly. When the funds are held in the entity’s name at a local bank, they can be accessed more quickly. Also, it may be difficult to explain to some people how the investment will be held. If they do not understand it, they may pull out the deal under the misunderstanding of how qualified plans can operate. In addition, a check from an entity is easier for many to understand. Further, using an entity to make the investment keeps the investing parties and their assets confidential. Lastly, when retirement funds are invested in an entity, there is more control over the investments and can enable lower administration fees (i.e., no transaction fees that are charged by some custodians).
TYPICAL DEFECTS THAT MAY ALLOW PIERCING OF THE CORPORATE VEIL
Typical defects supporting the piercing of a corporate veil include the following:
1) a failure to follow sufficient corporate formalities beyond the filing of the articles of incorporation;
2) severe undercapitalization;
3) the entity was used as a device to achieve fraud;
4) a pervasive failure to document transactions between the owners as individuals and the entity; and
5) a general failure to keep financial records of the entity separate from those of the individual shareholders or members [LLC].
A theory supporting the concept of “piercing the corporate veil “is that the entity is a creation of technical statutory requirements, and if the requirements are not met, the entity does not “legally” exist. If the entity does not exist, then the “would be” beneficiaries of the entity are looked at to fulfill the obligations in behalf of the entity.
WHY MAINTAIN FORMALITIES
The members in an LLC or the directors, officers, and shareholders in a close corporations are usually few in number and usually the same people. They normally want to comply with legal formalities in the most informal and expeditious manner possible. Thus, most business decisions are reached in informal conferences—not in called and noticed meetings. The statutory divisions of responsibility among shareholders, directors, and officers or members and managers have little practical meaning to business owners. The few people who own and operate the closely held business view formal meetings and procedures as being designed for publicly held companies, not small closely held ones. Owners do not expect to pay for unnecessary legal documents, and many question whether they really need to document meetings and actions of shareholders, members, directors, managers, etc.
Generally, in order to maintain the liability protection that the entity structures offer, the entity owners must operate the entities carefully and with proper recognition as to their separate status. When an IRA or a qualified plan is involved in these entities, there is an additional reason to maintain formalities; to help judges and government agency personnel understand the distinction between the entity and you and the plan assets.
As Jeff Nabers indicated in his June 9, 2008 blogspot entitled, “What’s so special about the IRA LLC?” the IRS auditors need to see formalities are respected to insure the special benefits that are enjoyed are not being abused. This is consistent with how the tax code operates whenever a tax benefit is conferred; in exchange for the tax benefit (tax deferral in this case) there is an obligation to maintain proper documentation to support requirements for the benefit have been met. The IRS requirement for accurate record keeping supports good business practices and should not be a burden for responsible business people.
CONSEQUENCES FOR FAILURE TO FOLLOW FORMALITIES
Failure to follow formalities can lead to assertions by the IRS that an abusive transaction may be involved. When an IRS agent makes such accusation, the agent does not have to prove anything initially; it is up to owners or directors to show that the accusation is false or cannot be supported. How could anyone defend against that accusation without proper record keeping and documentation that the entity and the plan assets are separate from the plan owners?
For example, in the case of qualified plans having a significant investment in a Corporation operated by the plan owner, failure to follow formalities could result in the characterization by the government that the Corporation is no longer an operating company and is holding plan assets within the meaning of 29 C.F.R. § 2510.3-101(c). Under § 408(e)(2)(A), the IRS may take the position in appropriate cases that transactions that have already taken place gives rise to one or more prohibited transactions between a plan and a disqualified person described in § 4975(e)(2). The provision of services by the entity to the plan owners or any business the plan owners may be associated with (which is a disqualified person with respect to the entity under § 4975(0(2)) would constitute a prohibited transaction under § 975(0(1)(C). Also, the Department of Labor has advised the IRS that, if a transaction between a disqualified person and the qualified plan would be a prohibited transaction, then a transaction between that disqualified person and the entity owned by the qualified plan would be a prohibited transaction if the qualified plan may, by itself, require the entity to enter into the transaction.
The penalty sanctions for engaging in a prohibited transaction are:
1) § 4975 (a) a 15% excise tax on the amount of the prohibited transaction paid by the disqualified person who participates in the prohibited transaction, and
2) § 4975 (b) a l00% excise tax on the amount of the prohibited transaction if the transaction is not corrected in the taxable period in which it occurs, also paid by the disqualified person who participates.
3) Additional penalties can be assessed for failure to file excise tax returns and pay excise taxes timely.
4) If the prohibited transaction is deemed to be a distribution from the IRA, the account owner can be taxed on the distribution and subject to penalties for early distribution if under age 59 1/2.
A review of Internal Revenue Notice 2004-8 indicates what the IRS suggests might happen when an abusive transaction is found. Any purported tax benefits claimed can be challenged on a number of grounds. If the accusation cannot be disproved with proper records and documentation and the accusation otherwise cannot be defended
against, there is ample authority for the IRS to allocate gross income, deductions, credits or allowances among persons owned or controlled directly or indirectly by the same interests, if such allocation is necessary to prevent evasion of taxes or to clearly reflect income. (See IRC §482). In addition to any other tax consequences that may be present, amounts treated as contributions may be subject to the excise tax described in §4973. This is a 6% excise tax on excess contributions and is due annually each year that the
excess contributions remain in the account.
SUGGESTIONS ON FORMALITIES TO FOLLOW
The following formalities when utilized may significantly reduce the chance that the limited liability shield can be “pierced.”
1) For LLC’s, have an operating agreement that is meaningful. Boilerplate or “standard” operating agreements are not appropriate and will get close scrutiny from government officials when an audit or an investigation is underway. The more care that is taken in drafting meaningful documents to support the entity structure, the more confidence the government may have in your assertions. The operating agreement should be tailored to fit the needs of its members and to ensure that their needs and expectations meet the form of the characteristics prescribed by the IRS. There are many issues to consider in an LLC Operating agreement; the duration of the relationship and the circumstances and terms of termination; the division of investment, distributions, gain, and loss; exercise of control, including management positions and voting mechanisms; and so forth, depending on the particular project or enterprise. Once the important substantive choices have been made, then a recommendation on a standard form of organization can be made. The entity will only be beneficial if the organizers adhere to the state and federal limitations on structure.
2) Open a separate bank account,
3) Purchase assets with entity funds.
4) Title assets in the name of the entity name
5) Maintain insurance in the entity name
6) All legal documents such as leases and contracts are in the entity name.
7) Do not pay personal expenses from the entity funds
8) Stay current with all State or Jurisdictional reports and filing. It is important to keep your entity in good standing legally.
Meeting Formalities and Record Keeping
Meeting formalities and record keeping is very important. Hold annual meetings and receive the financial reports for the year, authorize actions, such as the sale or purchase of property, and any other business that might require approval. If no meeting occurred, do not draft minutes of a fictitious meeting. All this action can do is lead to a claim that you created false records of actions. If you now seek to document an action that was taken previously without a meeting, ratify the earlier action either in a present meeting or in a current written action by consent. If an actual meeting occurred, draft the documentation to indicate;
1) who was present and who was absent and who arrived late and who left early, etc. If your minutes describe who attended, and no objections to improper notice were made at the meeting, attendance constitutes a waiver of those defects.
2) whether notice was given (attach copies of the notice and any written waivers),
3) the location of the meeting,
4) whether any objections were raised at the meeting about the propriety of the meeting. When documenting an actual meeting, carefully consider whether and to what extent those minutes will be approved. Many state statutes do not contain any specific requirements about approval of minutes or other documents describing owner or manager actions. You may want the operating agreement or corporate bylaws to describe in general terms the process for minutes and their approval, but only if you are willing to live with those procedures. If feasible, you may want all of the decision makers to approve in writing minutes of actual meetings. This will avoid arguments later about whether the minutes were accurate. This also allows you to argue that a signer who later complains about an action has waived the right to complain.
If you are not documenting an actual meeting, you will be documenting corporate
action to be approved by written consent. When the action involves an LLC, the documentation can be under whatever procedures created in the LLC’s operating agreement. For the LLC, this can be a Consent Resolution. Your document will not describe any discussion (because there was no meeting) but may include reasons or acknowledgments with which all of the signers agree.
The documentation should include a clear statement of the action or decision that was made. Do not write every word said in the meeting when documenting discussions at meetings or reasons for actions. Instead, draft the document with the appropriate purpose in mind. If you are documenting the retention of cash in a corporation to meet reasonable needs of the business, draft your minutes as if you were the IRS agent reading the minutes during an audit. If you are documenting an action to construct a fancy new corporate office building, draft the document as if it were being read by a disgruntled minority shareholder who claims that the new office is a personal extravagance that is not in the best interests of the other shareholders.
Consider whether notes and earlier drafts of minutes and other documentation should be destroyed. In most cases, destruction may be advisable. Those drafts would otherwise be discoverable in litigation and can be used to question, if not impeach, the accuracy of the final written product. You should advise the drafters of the minutes that they may be called on to testify in any dispute regarding any description in meeting or action documentation.
If the action approves or adopts specific documents such as bylaws, loan agreements, operating agreements, or other contracts, the documentation should either attach a copy of, or clearly refer to, the documents. The record keeper should retain a clearly identified copy of all approved documents with the record of the meeting or action.
If you wish to conduct meeting using phone conferencing or other electronic devices, your operating agreement or corporate bylaws should provide for such meetings. If there is not a provision in those documents for a meeting held electronically, some state statutes do not recognize a meeting even took place.
COMPARE LLC REQUIREMENTS WITH CORPORATE REQUIREMENTS
Documenting each of the above factors might lead to the conclusion that veil piercing should be no different in the LLC context from the corporate context, with one significant exception. Most state statues provide detailed specific guidance on many corporate formalities, such as notices of meetings, voting procedures, waivers of notices, rights of certain entities to vote interests, rules to follow in conducting meetings, meeting adjournments, etc. However, state statues provide almost no guidance to LLC’s whatsoever on these matters. No annual meeting requirement exists, for example, in many state statutes.
When comparing the two statutes, you may conclude that no meetings, minutes, or actions by consent are needed at all in an LLC. This course of action is not advised.
Most, if not all, state LLC statutes do not state that documentation of LLC formalities is not needed; the LLC statute is merely silent on the subject. You should document appropriate actions periodically, or at least annually.
It is important to stress that ALL the characteristics of the entity must be maintained: separate checking account, meetings, proper legal contracts, operating agreement, etc. Keep good records. Be sure the bank statement is balanced, the accounts are up to date; hire a bookkeeper if necessary, and be certain that you do not advance or commingle any personal funds on behalf of the entity. Make sure checks are made out the entity and not to you. Stay current with all state or jurisdictional reports and filing. Pay all fees from the entity and not personally. Never pay an entity expense with personal funds and then request the entity to reimburse you. This is a loan (prohibited) to the LLC, followed by a repayment to a disqualified person. Remember that all IRA account owners are disqualified persons all of the time. To obtain the benefits of speed, convenience, privacy, and control over investments and lower fees, entity formalities should be observed.