Perhaps you operate your small business as a sole proprietorship and want to form a limited liability company (LLC) to protect your assets. Or maybe you are launching a new business and want to know your options for setting it up. Here are the basics of operating as an LLC and why it might be appropriate for your business.
An LLC is somewhat of a hybrid entity because it can be structured to resemble a corporation for owner liability purposes and a partnership for federal tax purposes. This duality may provide the owners with the best of both worlds.
Personal asset protection
Like the shareholders of a corporation, the owners of an LLC (called “members” rather than shareholders or partners) generally aren’t liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors. This protection is far greater than that afforded by partnerships. In a partnership, the general partners are personally liable for the debts of the business. Even limited partners, if they actively participate in managing the business, can have personal liability.
The owners of an LLC can elect under the “check-the-box” rules to have the entity treated as a partnership for federal tax purposes. This can provide a number of important benefits to the owners. For example, partnership earnings aren’t subject to an entity-level tax. Instead, they “flow through” to the owners, in proportion to the owners’ respective interests in profits, and are reported on the owners’ individual returns and are taxed only once.
To the extent the income passed through to you is qualified business income, you’ll be eligible to take the Code Section 199A pass-through deduction, subject to various limitations. In addition, since you’re actively managing the business, you can deduct on your individual tax return your ratable shares of any losses the business generates. This, in effect, allows you to shelter other income that you and your spouse may have.
An LLC that’s taxable as a partnership can provide special allocations of tax benefits to specific partners. This can be an important reason for using an LLC over an S corporation (a form of business that provides tax treatment that’s similar to a partnership). Another reason for using an LLC over an S corporation is that LLCs aren’t subject to the restrictions the federal tax code imposes on S corporations regarding the number of owners and the types of ownership interests that may be issued.
Review your situation
In summary, an LLC can give you corporate-like protection from creditors while providing the benefits of taxation as a partnership. For these reasons, you should consider operating your business as an LLC. Contact us to discuss in more detail how an LLC might benefit you and the other owners.
© 2021 Covenant CPA
The world’s largest meat production company was recently sidelined by a ransomware attack. The hack forced the company to temporarily shutter plants in the United States, Canada and Australia, affecting the U.S. meat supply and even hurting commodity prices.
If it seems like cybercriminals often target manufacturing (including food processing) and distribution companies, that’s because they do. According to software company Varonis, manufacturers account for nearly a quarter of all ransomware attacks — more than any other industry. To prevent your company from becoming another statistic, learn about security breaches and protect your network.
A high price
It’s only natural that manufacturers fear data breaches — and unfortunately hackers often can use that fear to cripple organizations through ransomware. This type of malware is installed on a computer or network without the user’s consent. Hackers subsequently demand that the company pay a ransom to regain control of its data.
Cyberattacks can harm a manufacturer or distributor by causing safety issues, negative publicity, lost productivity, and compromised personal and corporate data. IBM reports that the average cost of a company data breach was approximately $4 million in 2020.
Role of employees
Employees are a manufacturer’s first line of defense against hackers. But your workers can also be a liability if they aren’t vigilant and knowledgeable about cyberthreats. It’s critical to provide training about the latest scams and encourage employees to report suspicious emails immediately to your IT department.
Many hackers look for easy targets, so even the simplest security measure will deter some cyberbreaches. For example, you can use relatively inexpensive encryption software and phishing filters to make it harder for hackers to get inside your network. Probably the most important simple step you can take is to update security software as soon as updates and patches become available.
On the safe side
To minimize losses if a breach occurs or a ransom demand is made, think about purchasing cyber insurance to cover direct losses and the associated costs of responding to breaches. Your traditional business liability policy probably doesn’t include such coverage.
Also consider assembling a breach response team. The team should be responsible for making a response plan, identifying potential weaknesses in your network and conducting breach response drills. Include cybersecurity, financial, legal and public relations experts on your response team. They’ll be essential in the event a criminal demands ransom and your company must weigh the difficult decision about whether to pay it.
More to lose
No company can afford a cyberattack, but manufacturers that rely on automation, robotics and network connections may have more to lose than businesses in other industries. Contact us for help protecting your assets from fraud.
© 2021 Covenant CPA
One benefit of the current federal gift and estate tax exemption amount ($11.7 million in 2021) is that it allows most people to focus their estate planning efforts on asset protection and other wealth preservation strategies, rather than tax minimization. (Although, be aware that President Biden has indicated that he’d like to roll back the exemption to $3.5 million for estate taxes. He proposes to exempt $1 million for the gift tax and impose a top estate tax rate of 45%. Of course, any proposals would have to be passed in Congress.)
If you’re currently more concerned about personal liability, you might consider an asset protection trust to shield your hard-earned wealth against frivolous creditors’ claims and lawsuits. Foreign asset protection trusts offer the greatest protection, although they can be complex and expensive. Another option is to establish a domestic asset protection trust (DAPT).
DAPT vs. hybrid DAPT
The benefit of a standard DAPT is that it offers creditor protection even if you’re a beneficiary of the trust. But there’s also some risk involved: Although many experts believe they’ll hold up in court, DAPTs haven’t been the subject of a great deal of litigation, so there’s some uncertainty over their ability to repel creditors’ claims.
A “hybrid” DAPT offers the best of both worlds. Initially, you’re not named as a beneficiary of the trust, which virtually eliminates the risk described above. But if you need access to the funds in the future, the trustee or trust protector can add you as a beneficiary, converting the trust into a DAPT.
Before you consider a hybrid DAPT, determine whether you need such a trust at all. The most effective asset protection strategy is to place assets beyond the grasp of creditors by transferring them to your spouse, children or other family members, either outright or in a trust, without retaining any control. If the transfer isn’t designed to defraud known creditors, your creditors won’t be able to reach the assets. And even though you’ve given up control, you’ll have indirect access to the assets through your spouse or children (provided your relationship with them remains strong).
If, however, you want to retain access to the assets later in life, without relying on your spouse or children, a DAPT may be the answer.
Setting up a hybrid DAPT
A hybrid DAPT is initially created as a third-party trust — that is, it benefits your spouse and children or other family members, but not you. Because you’re not named as a beneficiary, the trust isn’t a self-settled trust, so it avoids the uncertainty associated with regular DAPTs.
There’s little doubt that a properly structured third-party trust avoids creditors’ claims. If, however, you need access to the trust assets in the future, the trustee or trust protector has the authority to add additional beneficiaries, including you. If that happens, the hybrid account is converted into a regular DAPT subject to the previously discussed risks.
If you have additional questions regarding a DAPT, a hybrid DAPT or other asset protection strategies, please don’t hesitate to contact us.
© 2021 Covenant CPA
The COVID-19 pandemic has often made the due diligence process for business acquisitions more complex and time-consuming. But if you’re buying a company, it’s critical to dedicate your full attention to this part of the M&A process — not only to confirm that the selling business is as valuable as you believe it to be, but to protect against fraud. Plan early to engage a fraud expert to review financial statements and other documents for signs that you could be dealing with a dishonest seller.
Subtle warning signs
When reviewing a seller’s financial statements, forensic experts look for subtle warning signs of fraud. These include excess inventory, a large number of write-offs, an unusually high number of voided discounts for returns, insufficient documentation of sales and increased purchases from new vendors. Another suspicious sign is increased accounts payable and receivable combined with dropping or stagnant revenues and income.
Fishy revenue, cash flow and expense numbers and unreasonable-seeming growth projections warrant further investigation to determine whether financial statements represent fraud or they’re evidence of unintentional errors or mismanagement. The latter is common in smaller companies that don’t have their statements audited by outside experts or that may not have adequate internal financial expertise.
To determine whether unusual income numbers indicate systematic manipulation, experts often consider whether owners or executives had the opportunity to commit fraud. A lack of solid internal controls makes financial statement fraud more likely. Regulatory disapproval, customer complaints and suspicious supplier relationships can also raise red flags. If warranted, a forensic expert may perform background checks on your target company’s principals.
It’s important to note that some accounting practices adopted to present a business in the best light may be perfectly legal. However, if your expert finds evidence of intentional fraud — particularly at the executive level — you’ll probably want to rescind your acquisition offer. In less serious cases, you may simply need to make purchase price adjustments or even change the deal’s structure.
An indemnification clause written into the purchase agreement can protect you if a seller lies about matters that affect your acquisition, such as fraud. But negotiating these clauses can be tricky since sellers tend to push for a narrow definition of “fraud” and for limits on liability. The fact remains that if a seller has committed fraud, it’s better to uncover it before the M&A transaction goes through.
Contact us with your questions about M&A fraud and for help evaluating your potential business acquisition.
© 2021 Covenant CPA
Many businesses were unprepared when the novel coronavirus (COVID-19) pandemic required them to close their physical offices and shift to remote operations. Your company, for example, may have had to scramble to set up a virtual private network (VPN) or move files to the cloud. And while adapting to working from home, employees may have let your usual security procedures slide.
From a cybercrime perspective, working from home generally isn’t as safe as working in the office. So you need to look for ways to protect your disbursed workforce and prevent criminals from gaining access to your digital assets.
Here are five ideas:
- Invest in education. Require remote employees to participate in security-related training that covers “old-school” phishing scams as well as new COVID-19 variations. As schemes emerge (check the Federal Trade Commission’s website at ftc.gov for the latest), notify employees and remind them what to do if they think they’ve fallen victim to a scam.
- Enable automatic updates. To keep the operating systems of employee computers safely patched, remind workers to enable automatic software updates. Also, double-check that every employee-assigned device is fortified with current malware and antivirus software.
- Revisit access privileges. To maintain productivity, most employees need access to the same systems at home as they had in the office. However, consider reviewing which workers have access to certain files, network controls and cloud accounts — and whether they really need access now. Remember that when employees work from home, their partners, children and visitors may have easy access to their computers. To protect your company, ensure systems generate user audit trails that can be followed in the event of a breach.
- Protect WiFi connections. While working from home, employees use their personal WiFi connections to access your company’s IT environment. Unfortunately, many people use the default WiFi password or a simple password that hackers can easily break. To foil fraud perpetrators, employees should change it to a complex combination of letters and other characters. If possible, require them to use a VPN with two-factor authentication.
- Secure your videoconferences. Most videoconferencing services employ multiple layers of security. But some platforms offer greater protection than others. Before choosing one, perform a simple Google search to read user reviews and security bug reports. Once you’ve selected a service, communicate security protocols before allowing employees to use it for company business.
Finally, provide employees with access to a technical support desk so they can report problems — and get solutions — as quickly as possible. Working from home may be new for a lot of Americans, but fraud is a familiar foe for most. If can be defeated with appropriate knowledge and tools.
© 2020 Covenant CPA