The elusive nature of documenting the beneficial ownership of a limited liability company (LLC) for tax reporting purposes — and in turn, the indirect ownership of property vested in the LLC — is the subject of newly proposed Internal Revenue Service (IRS) regulations.  State and local government taxing agencies will certainly share this information.

Individuals or other entities may own all the membership in an LLC without disclosing their identities since LLC ownership is off-record and not currently an inquiry made by bankers when an account is opened in the name of the LLC.

Only the identity of the managing member of the LLC is requested by the bank as the person authorized to open the account on behalf of the LLC. For example, an LLC may be owned by a corporate entity or another LLC under an individual’s control, which in turn can be owned by still other entities or held by trustees — effectively insulating an individual owner who wants to remain completely anonymous from the public eye.

Thus, individuals disguised under multiple layers of LLCs, other corporate entities and off-shore trusts are theoretically able to evade taxes and other legal obligations while laundering untaxed money, often illegally acquired.

One method of tax evasion is for these individuals to use LLCs to hide assets in real estate. When a tax reporting individual moves funds from the United States to a foreign depository, the individual is required to notify the IRS about the assets moved off-shore — and the foreign banker accepting those assets needs to identify the beneficial owner(s) of the funds. Thus, the majority of tax evasion by LLC owners occurs within the U.S.

To combat these domestic diversions of taxable income, the U.S. Treasury Department (the Treasury) proposed the following measures:

  • the Customer Due Diligence (CDD) rule, which requires financial institutions such as banks and stock brokerages to verify and document personal information about the controlling owner(s) of an LLC when an account is established;
  • federal beneficial ownership legislation, requiring LLCs to report accurate ownership information about the profit-sharing individual(s) of the LLC — a snitch sheet situation such as a 1099S; and
  • foreign-owned, single-member LLC regulations requiring the LLC to have employer identification numbers (EINs).

California, LLCs and accountability

What do these proposed measures mean for California real estate?

Ultimately, not much.

The federal monitoring of tax information for LLC owners through the above legislation will cut to the root of the issue before the money leeches into real estate transactions via a deposit into escrow at closing.

However, these measures are relevant in other ways. The influx of foreign investors in California real estate means the legislation surrounding foreign-owned LLCs will ensure these investments are legitimate. With heightened legitimacy, ownership also becomes more stable. Although most foreign investors are storing assets legally and for appropriate purposes — such as safeguarding their money from more volatile economic conditions and currencies back home, as is the case with visa investors and many Chinese investors —others may be using them to hide illicitly obtained funds, according to the Treasury. Drug money comes to mind. For these situations, the regulations give the IRS methods of recourse against these nefarious tax-evading LLC owners.

On the other hand, obtaining more specific information about LLC ownership does nothing to close the gaping loopholes in California’s Prop 13 property tax avoidance on transfers of investment properties vested in LLCs — all of which are totally disclosed. Regardless of the IRS disclosures of ownership identities, Prop 13 will still allow individuals (other than homeowners) to sidestep property tax increases. Thus, when a property with an existing LLC vesting is purchased at a price greater than the assessed value while retaining the LLC vesting, the 100% new beneficial owners avoid increased property taxes at the price paid.

So long as no single person or entity acquires more than a 50% share in the LLC which owns real estate, the percentage which when exceeded constitutes a change in ownership triggering reassessment, the property is not reassessed at the price paid. However, the new members have indirectly bought and now control the property no differently than had they taken title as tenants in common (except for personal liability exposure), and incur no property tax increase based on the price they paid. [Ocean Avenue LLC vs. County of Los Angeles (2014) 227 CA4th 344]

Under the proposed ownership identity regulations, it is banks and other financial institutions who are concerned with facing the unfriendly task of collecting, verifying and reporting to IRS the ownership identities from LLCs which are their clients.

For now, the Treasury has not indicated any specific documentation or process to be implemented by bankers to determine individual ownership of an LLC or entity when opening and maintaining an account. Under current conditions, banks might have to attempt to trace ownership through a labyrinth of shell entities in their quest to discover just on whom to pin the responsibility of ownership to keep the account open, as has been recently exposed by the Panama Papers scandal. Without guidelines in place to cover banks’ conduct, dissimilar implementation by bankers will muddle the conduct of LLCs opening a deposit account.

Stay tuned to the first tuesday Journal for any updates to the regulations as they occur and to keep your clients informed.