Transcript Document

Three Tax Regimes
• C Corp
• S Corp
• Partnership
Check-The-Box
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Corporate entities are C or S.
Partnerships and LLCs under Subchapter K
(partnership) unless all consent to C or S status
One owner LLC disregarded.
Tax consequences of switching can be costly in
some situations.
Entity Candidates
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Sole Proprietorship
C Corporation
General Partnership
Limited Partnership
S Corporation
Limited Liability Company
Limited Liability Partnership
Limited Liability Limited Partnership
Choice of Entity Factors
1.
Future sale potential
9.
2.
Different equity interests
10. Tax deferral
3.
Earnings bailout
11. Real Estate
4.
Conversion ability
12. Passive activity rule
5.
Bracket racquet
6.
Loss utilizations
7.
Control rights
13. AMT (some exemptions
and deductions not available
usually only when income
high enough)
8.
Owner fringe benefits
14. Owner estate planning
Self employment taxes
15. Going public prospects
Big Non-Factor
Owner Limited Liability
Factor # 1
Future Sale Potential
Future Sale Potential
C Corporation Factors
• Double tax potential
• No basis booster for income accumulations
• Tax-free reorganization potential
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1045 rollover potential: In the case of any sale of qualified small
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business stock held by a taxpayer other than a corporation for more than 6 months
and with respect to which such taxpayer elects the application of this section, gain
from such sale shall be recognized only to the extent that the amount realized on
such sale exceeds—
(1) the cost of any qualified small business stock purchased by the taxpayer
during the 60-day period beginning on the date of such sale, reduced by
(2) any portion of such cost previously taken into account under this section.
This section shall not apply to any gain which is treated as ordinary income for
purposes of this title.
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15% capital gains rate at shareholder level
C Corp Double Tax Hit on Asset Sale
C Corp
Assets
Buyer
34% Tax Rate
Cash
Net Proceeds
Summary tax impact on $1,000 gain
Shareholders
Corporate tax @ 34%
15% Tax Rate
Shareholder Tax
15% of $660
Total Taxes
Percent
$340
99
$439
43.9%
C Corp Non-Basis Booster
2000
1800
1600
1400
1200
1000
Stock Basis
800
600
400
200
0
Capital
1st Y r.
Income
2nd Yr.
Income
3rd Yr.
loss
4th yr.
income
Pass-Thru Entity Basis Booster
2000
1800
1600
1400
1200
1000
Stock Basis
800
600
400
200
0
Capital
1st Y r.
Income
2nd Yr.
Income
3rd Yr.
loss
4th yr.
income
Sale Potential of S Corp vs. Sub. K
(partnership)
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S corp can participate in tax-free reorg.
Less ordinary income traps with S corp
Basis boosting a push
C corp convertibility
- S possible with nuisance traps
- Partnership and LLC usually prohibitive
Factor # 5
Bracket Racket
C Corp Bracket Racket
C Corp Rates
Married Rates (2005)
Up to 50k
50K to 75k
15%
25%
Up to 18.150k
18.150k to 73.8k
10%
15%
75k to 100k
34%
73.8k to 148.85k
25%
100k to 335k
335k to 10 mill
39%
34%
10 mill to 15 mill
15 mill to 18.3 mill
Over 18.3 mil
35%
38%
35%
148.85k to 226.8k
226.8k to 405.1k
405..1 to 457.6
Over 457.6k
28%
33%
35%
39.6%
Yellow rates are the
opportunity brackets
C Corp Income Split – 150k
C Corp
C tax on 50k
(15%)
7,500
Owner income
tax on excess(dividend) 15,000
Total Income tax
Pass Thru Entity
22,500
29,212
29,212
Factor # 2
Different Equity Interests
Different Ownership Interests
C Corp Tools: Voting and nonvoting stock, preferred stock,
hybrids, shareholder debt, employment contracts.
S Corp Tools: No preferred or second class of stock. Only
voting differences. Least flexible.
Partnerships and LLCs: Only limitation is “substantial
economic effects” limits of 704. The most flexible
option. (tax allocations will not be honored if they
lack substantial economic effect
Factor # 4
Conversion Flexibility
Conversion Flexibility
From C corp to
- Partnership or LLC: Killer double tax
- S corp: Doable but serious traps
From S corp to
- Partnership or LLC: Painful single tax
- C corp: Piece of cake
From LLC or Partnership to
- C corp: Doable with minor traps
- S corp: Doable if qualify
- LLC or Partnership: Doable
Factor # 6
Loss Utilization
C Corp Losses
Losses
Carry Back
Carry Forward
C Corp
Never Pass Thru
Shareholders
S Corp, Partnership, LLC Losses
Losses
Hurdles:
• Basis limitations (704(d) and
1366(d))
Corp
• At-risk limitations (465)
• Passive activity limitations (469)
Pass Thru
Owners
Material Participation Under 469
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More than 500 hrs in year
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Sole participant in activity
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More than 100 hrs and anyone else
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More than 100 hrs and more than 500 hrs in
significant participation activities
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5 of last 10 yrs meet standard
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Any previous 3 yrs if personal service
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Regular, continuous, substantial based on all
facts and circumstances
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The Application of the I.R.C. § 469 Material Participation Standards
to Members of Limited Liability Companies
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The passive activity loss limitation rules and their material participation requirements are
a vexing problem for investors in trade or business activities that incur losses. In two recent
cases, the Tax Court and Federal Court of Claims have made it easier for individuals who invest
in limited liability companies (“LLCs”) to meet the material participation standard needed to
claim losses from otherwise passive activities.
material participation standard of I.R.C. § 469 and its special rule providing that a limited
partner generally cannot materially participate in his limited partnership.
analyzes two recent court decisions that distinguish the material standards for
LLC members from those that apply to limited partners in a trade or business conducted by the
entity. The article concludes with a discussion of the impact these decisions have upon income
from LLCs being subject to self-employment tax.
• If your company creates a side business, you'll definitely want to
consider structuring it as a limited liability company (LLC) owned
by you. You'd enjoy multiple tax benefits, such as:
• You can deduct your share of losses on your personal tax return.
If you hold a 25 percent interest in an LLC, for example, and the
LLC incurs a $400,000 loss, you can qualify for a $100,000
deduction.
• You won't pay corporate income tax when the business turns a
profit. An LLC, like an S corp or a partnership, isn't subject to the
corporate income tax.
• Your personal assets will enjoy the same liability protection as
they would if you incorporate your company.
• You don't need to meet all the criteria required of S corps. For
example, you can select a foreign co-owner.
• Finally, an LLC can provide shelter from selfemployment taxes. For example, say your selfemployment income is subject to self-employment
(SE) tax. You run up a $100,000 loss from a new
LLC. In some situations, LLC losses reduce SE tax
as well as income tax.
• To receive this benefit you need written authority to
contract on the LLC's behalf.
• But if your new LLC starts showing a profit after a few
years, your share of the profits are subject to SE tax.
At that point, you can elect S corporation status for
this business, assuming it meets the requirements.
Once your business becomes an S corporation, only
your compensation—not corporate profits—is subject
to SE tax.
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3 hurdles
Key point: You must clear three main hurdles, though, if you want to deduct a
loss that's passed through from an LLC.
1. Have an adequate basis. For example, a $100,000 loss is deductible if you
have, say, $150,000 in basis. But if your basis is $20,000, only $20,000 is
deductible.
To get basis in your LLC, you can make cash and property contributions. Your
share of the LLC's debt is also included in your basis.
Suppose you are the sole owner of an LLC that borrows $250,000 from a lender.
This loan increases your basis by $250,000.
2. Prove your amount at-risk. To take a loss deduction, you must also meet the
so-called "at-risk" rules. Those rules are satisfied with a personal guarantee of
some or all the LLCs debt.
Other methods can increase the at-risk amount. You can formally agree to make
future cash contributions to the LLC or you can use unrelated property to secure
the LLC's debt.
3. Choose active loss or passive loss. Finally, you need an "active" rather than a
"passive" LLC loss to deduct it against your ordinary income. If you participate in
the LLC's business at least 500 hours a year, your LLC loss is active.
But you may actually prefer a passive loss, instead, if you want to offset passive
income, such as income from a rental property.
By adjusting your work schedule, you can wind up with a passive or an active
loss, whichever provides the most tax shelter.
Control
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Voting rights
Veto power
Classes of interests
Buy-sell agreements
Restrictions on transferability
Fringe Benefits
• Medical, health, life, disability,
dependent or family care
• Easier to offer in C-corporation
because employee benefits deductible
by corporation; not available in Pship or
LLCs
• Can include as part of compensation
package.
• Use pre-tax dollars.
BUSINESS PLANNING STRATEGIES AND PREFERENCES
Preference
C Corporation
Tax-free Conversion
S Corporation
Partnership
/LLC
X
X
Fringe Benefits
X
X
Tax-free Reorganization
X
X
Shelter income
X
X
Alternative Minimum Tax
X
Maximum Control
X
Ease of Going public
X
Offset Gains/losses
X
X
Self-employment tax (LP
exception)
Limited Liability
Earnings Bailout w/ min.
tax issues
X
X
X
X
X (LP, LLCs, corp.
GP)
X
X
Problem 1: Roger’s Machine Shop
Roger plans on opening a specialized machine shop. He will put up 55
percent of the capital, receive 55 percent of the equity interests in the
business, work full time as CEO of the business, and draw a salary and
a bonus based on performance. Three other individuals have
committed to fund the balance of the needed capital in equal shares,
and they will each receive 15 percent of the equity of the business. The
business will have minimal debt and is expected to be profitable by
year two. Roger wants a structure that assures, to the maximum extent
possible, freedom from minority owner hassles and contractual
negotiations and dealings with minority owners. He wants total control.
He wants to insure that his investors do not have to pay selfemployment taxes on any income they receive from the business. You
represent Roger.
Recommendation:
Problem 1: Roger Specialized Shop
Driving factors for Roger:
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Maximum control (Board control) - no hassles from
minority owners
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Income bailout to minority owners - no double
income taxes or self-employment taxes
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Protected compensation contract and bonus program
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Limited liability - machines, employees and contracts
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Passive income to minority owners
Recommendation: S Corp
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Problem 2: Roger’s Machine Shop
Revised Plan
Same facts, except assume that Roger 1) puts up
only 10 % of the equity capital, 2) the owners put up
90% of the equity, 3) the business will incur debt
financing equal to nearly four times the total equity
capital, 4) the business will generate substantial startup losses during the first three years, and 5) a
primary incentive for the investors is the big tax writeoffs in the early years. What form of business entity
do you recommend?
Recommendation:
3-21
Question 2: Roger Revised Plan
Driving factors for Roger:
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Losses passed through to investors
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Beat basis and at-risk hurdles for investors
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Maximum control - no hassles from minority owners
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Income bailout to minority owners when turn
profitable - no double income taxes or selfemployment taxes, preferably passive income
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Protected compensation contract and bonus program
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Limited liability - machines, employees and contracts
Recommendation: LLC or Limited Partnership with Rogerowned S Corp general partner
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Key Lessons
1) Figure out the parties’ unique goals that will
narrow the options to 1-2.
2) Go through the requirements of each to see if
narrow to preferred option.
Module 4: Choice of Entity
Challenge
Part 3: Entity conversions
From Partnership to Corp: Option 1
Corp
Assets &
liabilities (1)
Stock (2) Partnership
Owners
Stock in
Liquidation
(3)
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Tax Impacts:
• No gain or loss
recognized
• Partnership’s asset
basis transfers to C
corp
• Partnership
terminated
• Owner’s stock basis
equals basis in
partnership interest
(adjusted for debt
From Partnership to Corp: Option 2
Corp
Tax Impacts:
• No gain or loss to
Partnership or Corp
Assets
Stock
Partnership
&
(3)
Liabilit
ies Owners
Assets and
(2)
liabilities in
liquidation (1)
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
• Partnership
terminated
• No gain or loss to
owners unless money
in excess of basis is
distributed
• Owners’ basis in
assets equal basis in
partnership interests,
From Partnership to Corp: Option 3
Corp
Assets and
liabilities in
liquidation (1)
Partners
Stock
hip
(3)
Interests
(2)
Owners
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Partnership
Tax Impacts:
• No gain or loss to
Partnership or Owners
• Partnership terminated
• No gain or loss to Corp
unless money in excess
of basis is distributed
• Owners’ basis in stock
equals basis in
partnership interests,
which carries over to
Corp and determines
From Partnership to Corp: Option 4
Check The Box
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No need to form corp or transfer assets and liabilities
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Entity remains the same – only tax status changes
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Reduces paperwork and third party hassles
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Tax consequences same as option 1- Partnership
contribution followed by Partnership liquidation
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No corporate “trappings” benefits
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No S status payroll tax benefits
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No tax-preferred employee benefits to
owner/employees
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
From S status to C status
Piece of Cake
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No entity change nor need to transfer assets and liabilities
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Entity remains the same – only tax status changes
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Revoke S election (takes majority) or cease to qualify as S
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Specify effective date to ease accounting and tax hassles. Default
date is first day of next taxable year unless revocation before 15th
day of 3rd month of current year
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Mid-year effective date creates short S year and short C year –
allocation options
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No election back into S status for 5 yrs
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Bailout S earnings that have already been taxed to shareholders –
1371(e) one year bailout period
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Problem 1: Colson
Colson Inc. is a successful C corporation. It has eight shareholders,
six of whom are individuals and two of whom are family limited
partnerships. None of the shareholders are related. Only one of
the shareholders works for the company. In recent years, the
company has paid substantially all of its income to its
shareholders as dividends and anticipates that it will continue to
do so in the future. The shareholders are frustrated with the
double tax burden. Many of them would like to explore the
possibility of converting to a pass thru entity, such as an S
corporation or a limited liability company.
The company has issued both common and preferred stock to its
shareholders. Three of the shareholders have made substantial
loans to the company. The tax basis of the company's balance
sheet assets is substantially less than the fair market value of
the assets. Plus, as a result of the company's significant
profitability, the unrealized goodwill and going concern value is
huge.
Problem 1: Colson Inc.
Common &
Preferred
C Corp
Common &
Big
Loans Preferred
Three Golfer
Owners
Two Golfer
Owners
Common &
Preferred
Common
&
One
Toiler
Preferred
Owner
Two Limited
Partnerships
Challenge: Convert to Pass Thru Entity
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Problem 1: Colson Inc.
Convert to LLC or Partnership?
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Prohibitively tax expensive-treated as a
distribution of assets that results in double
tax.
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Full recognition of all asset gains at
corporate level
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Full recognition of capital gains at
shareholder level
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S corp only viable option
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
Problem 1: Colson Inc.
Election Mechanics to Convert to S Corp.
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Election effective on first day of following year
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Retroactive election not possible because had
ineligible shareholder on 1st day of current year
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Must be eligible for S at time of election – no
disqualified shareholders or 2nd class of stock
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S tax year calendar year unless sustain business
purpose proof burden for fiscal year
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All shareholders must consent (Form 2553)
community and joint interest owners
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
–
Problem 1: Colson Inc.
S Eligibility Problems
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Limited partnerships not eligible S
shareholders
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Preferred stock not permitted with S
status
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Shareholder loans could trigger one
class of stock requirement
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Any stock options held by toiler owner
or other owners could violate one class
of stock requirement
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
C to S Conversion: Getting Eligible
Getting rid of ineligible shareholders:
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Partnership shareholders: Redeem stock or have stock
distributed to eligible partners
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Corporate Shareholder: Redeem stock; merge or reorganize
to eliminate corporate shareholder; have corporate
shareholder distribute or sell stock to eligible S shareholders
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Non-qualified trusts and estates: Redeem stock or distribute
to qualified S shareholders
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com
C to S Conversion: Getting Eligible
Getting rid of second class of stock issues:
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Preferred stock: Redeem or E Reorg (“Reclassification”)
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Risky debt: Reform to fit within safe harbor of 1361(c)(5)(B)
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Options and warrants “in the money”: Buy back or have
them exercised.
•
Options and warrants “not in money”: Make sure strike price
is at least 90% of FMV. May present too tough of a
valuation issue. Best course may be to buy back or trigger
exercise.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com