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From the Desk of:
John D. Pivirotto
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Calif. Insurance License #06993078
Financial Concepts
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Burlingame, CA 94010
(650) 348-1880
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JohnPiv@FinancialConcepts.net
Helping Build & Protect Your Future
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Current tax law is subject to interpretation and legislative change. Tax results and the appropriateness of any product for any specific taxpayer may vary depending on the particular set of facts and circumstances. The information contained in this newsletter is not intended as tax, legal, or financial advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek such advice from your professional advisors. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Written and published by Liberty Publishing, Inc. Copyright © 2009 Liberty Publishing, Inc.
Limited Liability Companies Pass the Test
The American business scene has recently seen an increase in the number of limited liability companies (LLCs). An LLC shares characteristics of both a corporation and a partnership. So, why choose this form of business over others? The great attraction of an LLC for many business owners is that they can experience all the advantages of S corporations and general and limited partnerships, without some of the disadvantages. Two major benefits of this form of organization include: 1) limited liability for the debts of the business; and 2) a single level of taxation at the federal level on income generated by the business. These points and others may pique the interest of business owners to inquire further.
Organizational Advantages
Initially, an LLC appears to be an S corporation, due to limited owner liability and the “pass-through” of income. However, an LLC has organizational aspects providing more latitude than available to the typical S corporation. While an S corporation is limited to 75 shareholders and one class of stock, an LLC has no restrictions as to type and number of shareholders or the allowable classes of ownership interests. Moreover, while an S corporation must prorate income, deductions, credits, and losses among all shareholders, an LLC has the flexibility to allocate special items to selected shareholders.
In contrast to a partnership (which usually must have at least one personally liable general partner), an LLC may permit all members to be actively involved in managing the business without exposure to personal liability.
Qualifying Requirements
In order to be treated as a “pass-through” entity, an LLC must have more partnership than corporate characteristics. The Internal Revenue Service (IRS) has applied a four-part test in making this determination. It classifies an entity as a partnership if it lacks at least two of the following four corporate characteristics: limited liability; centralized management; continuity of life, or perpetual existence; and free transferability of interests.
Since an LLC, by nature, holds the corporate characteristics of limited liability, it must give up one other corporate trait in order to pass IRS scrutiny as a bona fide LLC.
Taxation and Other Considerations
For federal income tax purposes, an LLC may be treated in one of three ways: as a corporation; a partnership; or a sole proprietorship. Historically, LLCs have been created to assure partnership taxation. However, in recognition of the fact that LLCs have changed the landscape for classifying taxable entities, the IRS has greatly simplified this process in recent years. For LLCs formed after December 31, 1996, the IRS allows eligible entities not automatically classified as corporations to elect corporate tax status through a simple “check the box” mechanism. Otherwise, they will be taxed as either sole proprietorships or partnerships, depending on the number of owners.
However, while federal tax treatment is clear, state tax treatment remains cloudy. Some states may tax an LLC as a corporation, even though they have an LLC statute. In addition, it remains unclear how states will recognize limited liability on the part of managers of an LLC formed under another state’s LLC statute. Many states permit foreign corporations and limited partnerships to do business in their state, but this is not automatically so for LLCs formed in other states.
The time may be ripe for some partnerships to discuss converting to an LLC. Existing partnerships, unlike S or C corporations, may usually convert without liquidation or tax consequences, although some partners may experience tax consequences if the value of their interest in the entity is changed because of the conversion. $
SIMPLE Route to Small Business Retirement Planning
Small businesses have never had it easy when it comes to employersponsored retirement plans. Nondiscrimination rules have traditionally limited the ability of highly-compensated owners and executives to maximize contributions to such plans.
Established in 1996, a SIMPLE (Savings Incentive Match Plan for Employees) plan makes employer-sponsored retirement plans more appealing for small businesses. The Economic Growth and Tax Relief Reconciliation Act of 2001 makes SIMPLE, and other qualified plans, even more favorable in coming years. Structuring a SIMPLE IRA Although a SIMPLE plan may be structured as either an Individual Retirement Account (IRA), or as part of a 401(k) plan, this discussion will focus on SIMPLE IRAs.
Generally, small businesses with 100 or fewer employees who earned at least $5,000 from their employers during the preceding year—and who do not currently maintain another qualified plan—can set up a SIMPLE IRA. The plan must ordinarily be open to all nonexcludable employees who received at least $5,000 in compensation during any two preceding years with that business, and who are reasonably expected to receive at least $5,000 in compensation during the current year. The employer may elect to exclude employees covered by a collective bargaining agreement (if retirement benefits were the subject of good faith bargaining) and nonresident aliens with no income from sources within the United States. However, self-employed individuals may participate.
Details on Contributions
SIMPLE IRAs allow employees that enter into qualified salary reduction arrangements to make elective contributions of up to $8,000 per year for 2003 ($9,000 for workers age 50 and older). Employers are also required to make matching or nonelective contributions. Employer contributions generally must satisfy one of two contribution formulas.
Under the matching contribution formula, employers must match employee contributions on a dollar-for-dollar basis up to 3% of employee compensation for the year. However, a special rule permits the employer to elect a lower percentage (not less than 1%) for any year for all employees eligible to participate in the plan for such year, provided employees are notified of this election a reasonable time before the 60-day period for electing into the plan. Additionally, the employer cannot use the lower percentage if it would result in the percentage being lower than 3% in more than two out of five years ending with the current year.
Under an alternative formula, the employer makes nonelective (i.e., non-matching) contributions of 2% of compensation for all eligible employees with at least $5,000 in compensation from the employer for the year up to a maximum of $4,000 (based on a $200,000 compensation limit for 2003). In this case, the employer’s contribution is independent of the employee’s contribution. However, regardless of the formula used, all contributions— whether made by employers or employees—to SIMPLE IRAs are immediately vested and nonforfeitable.
An added benefit of a SIMPLE IRA is that, unlike other qualified plans, SIMPLE IRAs are not subject to topheavy rules. While SIMPLE IRAs are not subject to traditional nondiscrimination rules, specialized statutory nondiscrimination rules apply. This feature provides flexibility to highly-compensated employees whose contributions under the typical qualified plan would be limited by lower-paid employee contributions.
Weighing the Benefits
SIMPLE IRAs eliminate some of the more onerous regulations and reporting requirements that generally apply to other qualified retirement plans. However, employers will need to evaluate if pension simplification is worth limiting annual deferrals to $8,000, or $9,000, compared to higher limits for more popular qualified plans such as the 401(k) ($12,000 for 2003). $
Rabbi and Secular Trusts can Reward Top Executives
Companies wishing to retain valued executives often create retirement incentives to keep those personnel in the fold. Since there are limits on amounts that can be contributed to qualified retirement plans on an annual basis, many businesses look beyond them to nonqualified plans.
Nonqualified plans are usually offered to top executives. They allow companies to reward high-level employees with replacement income at retirement that is based on their overall compensation package. When trust arrangements are used to create nonqualified plans, companies often turn to rabbi trusts or secular trusts. These trusts protect nonqualified benefits from various risk factors, such as a change in the control of the company or simply a future change of heart on the part of management.
In a rabbi trust, the company deposits funds that are tax deferred. No taxes are due until the funds are paid out. However, in order to avoid immediate taxation, the nonqualified benefits protected by the trust are subject to the claims of corporate creditors in the event of insolvency. Employers may not take a tax deduction for contributions made to a rabbi trust, and income on trust assets is taxed to the employer.
Meanwhile, benefits placed in a secular trust are not subject to the claims of creditors. Therefore, funds deposited in a secular trust effectively become the property of the executive at the time they are deposited. As a result, taxes are due as soon as the participant becomes vested. Because of immediate taxation, future payouts of principal will be tax free. To help minimize the tax burden, employers often provide a bonus to cover the tax owed, or set up a distribution schedule from the trust to help cover taxes.
Companies also sometimes use hybrid rabbi/ secular trusts. This occurs when a rabbi trust contains language within the agreement calling for conversion to a secular trust—if specific business conditions arise that increase the risk of business insolvency. This arrangement protects the funds from outside creditors, but it also means participants could be faced with an accelerated tax liability. $
Strategies for Entrepreneurial Success
Whether you’re planning to start a new business, trying to grow a fledgling business, or working to keep an older enterprise competitive, your business plan is your roadmap toward success. And, since running a business is a little like embarking on a journey without a final destination, it may be necessary to consult, or even reconfigure, your map from time to time.
Some of the assumptions in a business plan are based on “hard” data (e.g., cost quotes for materials, supplies, and various services), while others are based on “soft” data or projections of what you reasonably expect to happen in the future (e.g., sales one year from now). In between the “hard” and the “soft” lies the key to a happy bottom line—pricing your product or service to ensure profitability.
Pricing Strategy
A well-conceived pricing strategy is based on a combination of factors that consider cost, demand, and competition. Having the hard data on cost is essential, but cost alone is insufficient for establishing profitability. A clear picture of profitability can emerge only by relating cost with demand at various price levels, and understanding how the competitive environment works to set some limits.
However, estimating demand requires more sophistication than simply striving to have the lowest price in the marketplace. It requires evaluating the relationship between price and value, and realizing the price that customers are willing to pay is often related to characteristics they perceive as important such as quality, accessibility, and product guarantees. Consequently, the key to proper pricing is having your customers perceive good value for their money.
Knowing how your product or service compares to others in the market, and understanding the demand for such a product or service, will help determine its realistic price level. And, although formal market research can be helpful, a business can gather valuable market information by talking with customers and recording their responses. Sometimes this informal database can provide the impetus for revising a particular strategy or changing a course altogether.
Finding Your Road to Success
While proper pricing is the mechanism that can turn an exciting idea for a business into a profitable ongoing enterprise, there is no “best way” or “single formula” for establishing the price of a particular product or service. That is, it is possible to create a pricing strategy that is primarily cost-based, demand- based, or competition-based or, more likely, a combination of all three factors. The nature of the industry in which the business operates and the specific product or service the business provides are significant factors influencing the creation of a viable pricing strategy.
Irrespective of how your company’s roadmap is drawn, it might be best to view it as a work in progress. Changes in the business climate or rapid change within the business may require a reexamination of various assumptions that went into an earlier pricing model. The critical point is to have your pricing strategy keep you wellpositioned for staying ahead of the competition on your road to success.
Copyright 2009 Liberty Publish- ing, Inc., Beverly, MA. The opinions and recommendations expressed herein are solely those of Liberty Publishing, Inc., and in no way represent advice, opin ions, or recommendations of the Financial Planning Association, its affiliates or members. CFPTM and CERTIFIED FINANCIAL PLANNERTM
are federally registered service marks of the Cer- tified Financial PlannerBoard of Standards (CFP Board). This summary does not constitute legal and/or tax advice and should only be relied upon when coordinated with a qualified legal and/or tax advisor. Febuary, 2009.
are federally registered service marks of the Cer- tified Financial PlannerBoard of Standards (CFP Board). This summary does not constitute legal and/or tax advice and should only be relied upon when coordinated with a qualified legal and/or tax advisor. Febuary, 2009.
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*Disclosure – Securities and Advisory services offered through representatives of Lincoln Financial Securities Corporation, member FINRA & SIPC. This is not an offer to sell securities, which may be done only after proper delivery of a prospectus and client suitability is reviewed and determined. Information relating to securities is intended for use by individuals residing in California, Oregon and Colorado only. Advisory Services are offered to residents of the state of California only. Lincoln Financial Securities Corporation is not affiliated with Financial Concepts. Financial Concepts offer insurance & financial services to residents in California and Oregon. Variable & Group insurance products offered through LFS Marketing and Insurance Sales Corporation; fixed insurance products offered through Financial Concepts Insurance & Financial Services.
John Pivirotto’s California Insurance License #: 0699308
Financial Concepts’ California Insurance License #: 0786047
