In This Issue

• Use Single Member LLCs to Limit Business Liability Risks
• Ohio Income Tax on Trusts

Use Single Member LLCs to Limit Business Liability Risks

By Charles J. Kegler

Many business owners are justifiably concerned that a mistake in one aspect of their business could not only damage their entire business but also put their own personal assets at risk. To minimize the liability concerns, business owners can establish Limited Liability Companies (LLCs) and spread the risk of potential liability to separate LLCs owned by the parent business.

1. A $50 Million Example Illustrating the Potential Risk

   Consider the business owner who thought implementing an LLC strategy would be too complicated. The owner was the sole shareholder of an Ohio Subchapter S corporation, which operated construction and manufacturing facilities in Ohio and four adjoining states, including Kentucky. The Kentucky facility generated approximately 15 percent of the company's total business.

   In April of 2002, the Kentucky facility produced a product with a defect. In more than 20 years of business, the company had never previously experienced this problem. Within a 24 hour period, but before the client became aware of the defect, the defective product was incorporated into a substantial number of products produced by the company's customers. Within 48 hours of receiving notice of the defect, the client was threatened with damage claims exceeding $50 million for a product that generated less than $80,000 of annual revenue to the company. The client's insurance carrier offered to immediately tender the entire amount of the insurance coverage —a total of $6 million —leaving a potential deficit of $44 million. A bad product run during one 8 hour shift not only threatened the existence of a company which had operated successfully for more than 20 years, but also threatened financial ruin for the company's sole shareholder.

2. How the LLC Strategy Would Have Limited the Potential Liability Exposure

   Beginning in 1994, Ohio joined a number of other states in authorizing limited liability companies by enacting Chapter 1705 of the Ohio Revised Code. Pursuant to §1705.48 of the Ohio Revised Code, neither owners of an LLC nor any of its managers or members will be personally liable to satisfy any obligation of the LLC. In the example described above, if the Ohio S corporation had established a separate LLC to own and operate its Kentucky manufacturing business, any liabilities of the Kentucky business would be limited to the Kentucky LLC's business assets including the $50 million claim resulting from the Kentucky product defect. In short, neither the Ohio S corporation nor the assets of its other businesses would have been responsible for any claims relating to the Kentucky product defect.

3. Steps to Implement the LLC Strategy

   Implementing an LLC strategy for ownership of separate divisions and business assets is neither complicated nor expensive, particularly in comparison to the benefits. The steps required include executing formation documents, transferring assets, conducting business, simplifying income tax and securing the authority to do business in other states.

1. Executing Formation Documents. In our example, the Ohio S corporation would establish a separate Ohio LLC for each separate business operation. Under Ohio law, this would require filing Articles of Organization for each limited liability company with the Ohio Secretary of State. The Articles of Organization would include the name of the limited liability company which must include the words "limited liability company" without abbreviation, or include one of the following abbreviations: "LLC," "L.L.C.," "Limited," "Ltd.," or Ltd". The Articles of Organization must also include an original appointment of a statutory agent who must be an individual resident of Ohio, an Ohio corporation, or a foreign corporation holding an Ohio license as a foreign corporation. The organizational documents may also include a written declaration identifying the purposes and powers of the LLC, vesting management and control of the company in the member-owner of the LLC, and setting forth procedures for appointment of directors and officers of the LLC.

2. Transferring Assets to the LLC. In order for the strategy to be effective, the Ohio S corporation would then transfer assets of each separate business or location to the separate LLC, which has been formed to hold and operate that business and its assets. For real estate, the company will need to deed any real estate to the LLC. For other assets, a bill of sale or other transfer documents are required. In the event any property of the business is subject to a mortgage or lien, the transfer may require consent of the lender or lien holder in order to avoid violating the mortgage or lien rights.

3. Conducting Business in the Name of the LLC. After formation of the LLC and transfer of assets to the LLC, the business held by the LLC should be operated in the name of the LLC. Employees who actually perform services for the division should become employees of the LLC, although many companies use the parent owner as the common paymaster for all employees of the organization.

4. Simplified Income Tax Treatment. Prior to January 1, 1997, §7701 of the Internal Revenue Code imposed somewhat complicated rules on how LLCs should be characterized for income tax purposes. Depending on the characteristics of the LLC, the LLC could be treated for federal income tax purposes as a corporation, a partnership, or a sole proprietorship.

   On December 18, 1996 the Treasury Department simplified life when it issued final so-called "check-the-box" regulations designed to simplify classification of a business entity as either an association, which would be taxable as a corporation, or a partnership. Under those regulations, an LLC having only one owner could elect to be taxed as a corporation, or could elect to be disregarded for tax purposes. If a single member LLC fails to make an election or chooses not to elect a classification, it is automatically classified under the "default rules" of the check-the-box regulations as an entity that will be disregarded for income tax purposes. In short, even though the entity will be treated as existing for state law purposes thereby providing liability protection for its owners, for federal income tax purposes the LLC and its assets will be treated as if they were owned by the sole owner of the LLC —the Ohio S corporation. This treatment substantially simplifies income tax filing requirements.

5. Securing Authority to do Business in Other States. All 50 states, as well as the District of Columbia have enacted state laws authorizing the formation of LLCs and recognizing the existence of LLCs formed in other states. Thus, in the Kentucky business example described above, if the Ohio S corporation had formed an LLC to own and operate its Kentucky manufacturing business, the Ohio S corporation parent could have (and should have) taken the appropriate action to secure the consent of the state of Kentucky to do business in Kentucky.

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Ohio Income Tax on Trusts

By Erika L. Haupt

In an effort to decrease Ohio's budget deficit, Governor Taft signed Amended Substitute Senate Bill 261, effective June 5, 2002, which imposes an income tax on trusts that "reside" in Ohio or generate income from Ohio sources. The new tax applies for 2002, 2003 and 2004 tax years.

Only trusts that reside in Ohio are subject to the new tax ¹. In order to be a resident of Ohio, a trust must meet one of the following requirements:

1. Assets were transferred to the trust under the will of a decedent who was domiciled in Ohio at the time of his or her death; or

2. Assets were transferred to the trust by a person who was domiciled in Ohio and the trust is not irrevocable; or

3. Assets were transferred to the trust by a person who was domiciled in Ohio when the trust became irrevocable BUT only if for some portion of the current taxable year at least 1 beneficiary of the trust is a resident of Ohio.

In determining residency, the domicile of the trustee, the domicile of the grantor or settlor at the time the trust was created, and the domicile of the transferor of trust assets at the time of transfer are all irrelevant. The determining factor is where the transferor of assets to the trust was domiciled at the time the trust became irrevocable.

Trust income tax is imposed on "modified taxable income," which is comprised, in general terms, of the following:

1. Modified Business Income

   Business income is income arising from the regular course of a trade or business to the extent such income is derived in Ohio. It includes gain or loss from a partial or complete liquidation of a business. Modified business income is business income reduced by the qualifying amount (see 2, below). Because most trusts do not carry on a trade or business, few, if any, will be subject to tax on modified business income.

2. Qualifying Amount

   A trust's qualifying amount is the capital gain or loss attributed to a sale, exchange or other disposition of equity or ownership in, or debt obligations of, a qualifying investee to the extent included in the trust's Ohio taxable income, but only if the location of the physical assets of the qualifying investee is available to the trustee. The key limitation in this definition is the availability to the trustee of information relating to the physical assets of the qualifying investee. For example, it would be next to impossible for a trustee to find out from General Electric which of its assets are located in the State of Ohio. If that information is not available to the trustee, the capital gain or loss would be treated as modified business income (unlikely) or modified nonbusiness income (catchall category).

3. Modified Nonbusiness Income

   Modified nonbusiness income is a trust's taxable income, other than modified business income and the qualifying amount, to the extent such income is produced by assets held by a trust or a portion of a trust that is a resident of Ohio for the taxable year. Modified nonbusiness income would include interest and dividends to the extent not distributed to beneficiaries.

   To determine if your trust is subject to the new income tax, you should ask and answer the following questions:

1. Is my trust a revocable trust (e.g., an A-B trust, a contingent trust for children or a living trust) or is it considered a "grantor trust" for income tax purposes (e.g., a GRAT, a QPRT, an intentionally defective grantor trust)? If yes, there is no filing requirement. If no, then…

2. Is my trust irrevocable? If no and assets were transferred to the trust by a person domiciled in Ohio, there is a filing requirement. If no and assets were transferred by a person not domiciled in Ohio, there is no filing requirement. If your trust is irrevocable, then…

3. Was my trust created by the will of a decedent? If yes and the decedent was domiciled in Ohio, there is a filing requirement. If yes and the decedent was domiciled outside of Ohio, there is no filing requirement. If the trust was not created by the will of a decedent, then…

4. Were assets transferred to my trust under the pourover provision in a will? If yes and the decedent was domiciled in Ohio, there is a filing requirement. If yes and the decedent was domiciled outside of Ohio, there is no filing requirement. If assets were not transferred under the pourover provision in a will, then…

5. Were assets transferred to my trust by a person who was domiciled in Ohio when the trust was irrevocable? In other words, if the trust was irrevocable at the time assets were transferred to it, was the person making the contribution to the trust domiciled in Ohio? If no, there is no filing requirement. If yes, then…

6. Are any potential current beneficiaries of the trust residents of Ohio? If yes, there is a filing requirement. If no, there is no filing requirement.

The new trust income tax law is dense and confusing. Although we believe that the majority of Ohio trusts will not be subject to income tax, you should consult with your attorney, tax advisor or accountant to determine if your trust is required to file an Ohio income tax return for this year, next year and 2004.

¹ Nonresident trusts may also be subject to Ohio income tax if certain income is generated from Ohio sources.

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