three tax regimes c corp s corp partnership. check-the-box corporate entities are c or s....

Three Tax Regimes

• C Corp

• S Corp

• Partnership

Check-The-Box

• 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

• 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

2. Different equity interests

3. Earnings bailout

4. Conversion ability

5. Bracket racquet

6. Loss utilizations

7. Control rights

8. Owner fringe benefits

9. Self employment taxes

10. Tax deferral

11. Real Estate

12. Passive activity rule

13. AMT (some exemptions and deductions not available usually only when income high enough)

14. Owner estate planning

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• 1045 rollover potential: In the case of any sale of qualified small

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.

• 15% capital gains rate at shareholder level

C Corp Double Tax Hit on Asset Sale

C Corp34% Tax Rate

Buyer

Assets

Cash

Shareholders15% Tax Rate

Net Proceeds

Summary tax impact on $1,000 gain

Corporate tax @ 34% $340

Shareholder Tax 15% of $660 99

Total Taxes $439

Percent 43.9%

C Corp Non-Basis Booster

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Capital 1st Yr.Income

2nd Yr.Income

3rd Yr.loss

4th yr.income

Stock Basis

Pass-Thru Entity Basis Booster

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Capital 1st Yr.Income

2nd Yr.Income

3rd Yr.loss

4th yr.income

Stock Basis

Sale Potential of S Corp vs. Sub. K (partnership)

• 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 15% Up to 18.150k 10%

50K to 75k 25% 18.150k to 73.8k 15%

75k to 100k 34% 73.8k to 148.85k 25% 100k to 335k 39% 148.85k to 226.8k 28%

335k to 10 mill 34% 226.8k to 405.1k 33%

405..1 to 457.6 35%

10 mill to 15 mill 35% Over 457.6k 39.6%

15 mill to 18.3 mill 38%Over 18.3 mil 35% Yellow rates are the

opportunity brackets

C Corp Income Split – 150k

C Corp Pass Thru Entity

C tax on 50k (15%) 7,500

Owner income tax on excess(dividend) 15,000 29,212

Total Income tax 22,500 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

C Corp

Shareholders

Carry Back Carry Forward

Never Pass Thru

S Corp, Partnership, LLC Losses

Losses

Corp

Owners

Pass Thru

Hurdles:

• Basis limitations (704(d) and 1366(d))

• At-risk limitations (465)

• Passive activity limitations (469)

Material Participation Under 469

• More than 500 hrs in year

• Sole participant in activity

• More than 100 hrs and anyone else

• More than 100 hrs and more than 500 hrs in significant participation activities

• 5 of last 10 yrs meet standard

• Any previous 3 yrs if personal service

• Regular, continuous, substantial based on all facts and circumstances

• The Application of the I.R.C. § 469 Material Participation Standards

to Members of Limited Liability Companies

• 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 self-employment taxes. For example, say your self-employment 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.

• 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

• 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.

Preference C Corporation S Corporation Partnership/LLC

Tax-free Conversion X X

Fringe Benefits X X

Tax-free Reorganization X X

Shelter income X X

Alternative Minimum Tax X

Maximum Control X X

Ease of Going public X

Offset Gains/losses X X

Self-employment tax (LP exception)

X

Limited Liability X X X (LP, LLCs, corp. GP)

Earnings Bailout w/ min. tax issues

X X

BUSINESS PLANNING STRATEGIES AND PREFERENCES

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 self-employment taxes on any income they receive from the business. You represent Roger.

Recommendation:

Problem 1: Roger Specialized Shop

Driving factors for Roger:

• Maximum control (Board control) - no hassles from minority owners

• Income bailout to minority owners - no double income taxes or self-employment taxes

• Protected compensation contract and bonus program

• Limited liability - machines, employees and contracts

• Passive income to minority owners

Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com

Recommendation: S Corp

Problem 2: Roger’s Machine ShopRevised 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 start-up losses during the first three years, and 5) a primary incentive for the investors is the big tax write-offs in the early years. What form of business entity do you recommend?

Recommendation:

Question 2: Roger Revised Plan Driving factors for Roger:

• Losses passed through to investors

• Beat basis and at-risk hurdles for investors

• Maximum control - no hassles from minority owners

• Income bailout to minority owners when turn profitable - no double income taxes or self-employment taxes, preferably passive income

• Protected compensation contract and bonus program

• Limited liability - machines, employees and contracts


3-21

Recommendation: LLC or Limited Partnership with Roger-owned S Corp general partner

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 Module 4: Choice of Entity ChallengeChallenge

Part 3: Entity conversionsPart 3: Entity conversions

From Partnership to Corp: Option 1


Corp

Stock (2)

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 transfers to corp)

• Owners not original issuees – 1244 impact and potential S election impact in year 1

Owners

Partnership

Assets & liabilities (1)

Stock inLiquidation (3)



Corp

Stock (3)

Tax Impacts:

• No gain or loss to Partnership or Corp


• No gain or loss to owners unless money in excess of basis is distributed

• Owners’ basis in assets equal basis in partnership interests, which carries over to Corp and determines Owners’ basis in stock

• Owners original issuees of stock

Owners

Partnership

Assets & Liabilities(2) Assets and

liabilities in liquidation (1)



Corp

Stock (3)

Tax Impacts:

• No gain or loss to Partnership or Owners


• 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 Corp’s basis in assets

• Owners original issuees of stock

Owners

Partnership

Partnership Interests(2)

Assets and liabilities in liquidation (1)

Check The Box

• No need to form corp or transfer assets and liabilities

• Entity remains the same – only tax status changes

• Reduces paperwork and third party hassles

• Tax consequences same as option 1- Partnership contribution followed by Partnership liquidation

• No corporate “trappings” benefits

• No S status payroll tax benefits

• No tax-preferred employee benefits to owner/employees



Piece of Cake

• No entity change nor need to transfer assets and liabilities

• Entity remains the same – only tax status changes

• Revoke S election (takes majority) or cease to qualify as S

• 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

• Mid-year effective date creates short S year and short C year – allocation options

• No election back into S status for 5 yrs

• Bailout S earnings that have already been taxed to shareholders – 1371(e) one year bailout period


From S status to C status

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.


C Corp

Three Golfer Owners

Two LimitedPartnerships

One ToilerOwner

Two Golfer Owners

Common & Preferred

Common & Preferred

Big Loans Common

&Preferred

Common &Preferred

Challenge: Convert to Pass Thru Entity


Convert to LLC or Partnership?

• Prohibitively tax expensive-treated as a distribution of assets that results in double tax.

• Full recognition of all asset gains at corporate level

• Full recognition of capital gains at shareholder level

• S corp only viable optionCopyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com

Problem 1: Colson Inc. Election Mechanics to Convert to S Corp.

• Election effective on first day of following year • Retroactive election not possible because had

ineligible shareholder on 1st day of current year

• Must be eligible for S at time of election – no disqualified shareholders or 2nd class of stock

• S tax year calendar year unless sustain business purpose proof burden for fiscal year

• All shareholders must consent (Form 2553) – community and joint interest owners



S Eligibility Problems

• Limited partnerships not eligible S shareholders

• Preferred stock not permitted with S status

• Shareholder loans could trigger one class of stock requirement

• Any stock options held by toiler owner or other owners could violate one class of stock requirement



Getting rid of ineligible shareholders:

• Partnership shareholders: Redeem stock or have stock distributed to eligible partners

• Corporate Shareholder: Redeem stock; merge or reorganize to eliminate corporate shareholder; have corporate shareholder distribute or sell stock to eligible S shareholders

• Non-qualified trusts and estates: Redeem stock or distribute to qualified S shareholders

C to S Conversion: Getting Eligible


Getting rid of second class of stock issues:

• Preferred stock: Redeem or E Reorg (“Reclassification”)

• Risky debt: Reform to fit within safe harbor of 1361(c)(5)(B)

• 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.

C to S Conversion: Getting Eligible

three tax regimes c corp s corp partnership. check-the-box corporate entities are c or s....

Documents

entity c tax

c corp pass

asset sale c corp

c corp income split

c corp double tax hit

sale potential of s

prohibitive slide

s corp basis