1 CHOICE OF ENTITY TAX CONSIDERATIONS Thomas F. Schnellenberger September 20, 2006 1607621.
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Transcript of 1 CHOICE OF ENTITY TAX CONSIDERATIONS Thomas F. Schnellenberger September 20, 2006 1607621.
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CHOICE OF ENTITY TAX CHOICE OF ENTITY TAX CONSIDERATIONSCONSIDERATIONS
Thomas F. SchnellenbergerThomas F. Schnellenberger
September 20, 2006September 20, 2006
1607621
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OVERVIEWOVERVIEW
• Sole ProprietorshipSole Proprietorship• Single Member Limited Liability Company Single Member Limited Liability Company
(“SMLLC”)(“SMLLC”)• General PartnershipGeneral Partnership• Limited PartnershipLimited Partnership• Limited Liability Company (“LLC”)Limited Liability Company (“LLC”)• S CorporationS Corporation• C CorporationC Corporation
Ms. Big Bucks is contemplating how to organize her new business:
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OVERVIEWOVERVIEW
• Ms. Big Bucks uses $10 of personal funds and $50 Ms. Big Bucks uses $10 of personal funds and $50 of funds borrowed from bankof funds borrowed from bank
• Year 1 losses = $50 (Ms. Big Bucks’ share)Year 1 losses = $50 (Ms. Big Bucks’ share)
• Year 2 profits = $100 (Ms. Big Bucks’ share)Year 2 profits = $100 (Ms. Big Bucks’ share)
• Business is sold at the end of year 2 for $1,000Business is sold at the end of year 2 for $1,000
• Ms. Big Bucks is active in the businessMs. Big Bucks is active in the business
Assume the following:
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CHOICE OF ENTITYCHOICE OF ENTITY
SOLE PROPRIETORSHIP SOLE PROPRIETORSHIP
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FORMATIONFORMATION
• Business bank accountBusiness bank account• Federal and state Employer Federal and state Employer
Identification Numbers (“EINs”) and Identification Numbers (“EINs”) and other tax registrationsother tax registrations
• LicensesLicenses• No liability protectionNo liability protection• Self employment (“SE”) taxSelf employment (“SE”) tax
Ms. Big Bucks Bank
$50
Note
CHOICE OF ENTITY SOLE PROPRIETORSHIP
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Employment Tax Employment Tax Components and RatesComponents and Rates
Self-Employed
Employer Employee Individual
OASDI - Imposed on Earnings up to $94,200 (2006):
Employer 6.2% 6.2%
Employee __ 6.2% 6.2%
Total OASDI 6.2% 6.2% 12.4%
Medicare:
Employer (1) 1.45% 1.45%
Employee ___ 1.45% 1.45%
Total Medicare 1.45% 1.45% 2.9%
Total 7.65% (1) 7.65% 15.3% (2)
(1) Deductible by employer in arriving at employer’s taxable income.(2) One-half deductible in arriving at adjusted gross income.
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FIRST YEARFIRST YEAR
Unless otherwise noted, it has been assumed that: (1) at-risk and passive loss rules are satisfied, and (2) Ms. Big Bucks has other sources of SE income against which loss can be offset.
After-tax benefit of $24.72
SOLE PROPRIETORSHIP
Self-employment Tax Income Tax Cash
Income from Operations ($50.00) ($50.00)*
Self-employment Inclusion Percent x 92.35%
Self-employment loss (46.18)
Self-employment Tax Rate x 15.3%
Self-employment Tax benefit (7.06) 3.53
Net Taxable Income (46.47)
Assumed Effective Rate x 38%
Tax Cost < savings > ($7.06) ($17.66) 24.72
Net Cash $ 24.72
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SECOND YEARSECOND YEAR
* After-tax cost of $49.45
SOLE PROPRIETORSHIP
Self-employment Tax Income Tax Cash
Income from Operations $100.00 $100.00
Self-employment Inclusion Percent x 92.35%
Self-employment Income 92.35
Self-employment Rate x 15.3%
Self-employment Tax 14.13 (7.06)*
Net Taxable Income 92.94
Assumed Effective Income Tax Rate x 38%
Tax Cost < savings > $14.13 $35.32 (49.45)
($49.45)
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SALE OF BUSINESSSALE OF BUSINESSSOLE PROPRIETORSHIP
Income Tax Cash
Sales price $1,000.00 $1,000.00
Basis
Personal funds $ 10
Borrowed funds 50
Year 1 loss (50)
Year 2 profit 100 (110.00)
Gain 890.00
Estimated capital gains rate 17%
Income tax $ 151.30 (151.30)
Loan repayment (50.00)
Net sales proceeds $ 798.70
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NET CASHNET CASHSOLE PROPRIETORSHIP
Original investment ($10.00)
First year tax 24.72
Second year tax (49.45)
Sale proceeds 798.70
Total $763.97
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CHOICE OF ENTITYCHOICE OF ENTITY
SINGLE MEMBER LLC SINGLE MEMBER LLC
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FORMATIONFORMATION
Absent an affirmative election to be treated as a corporation, Big Bucks LLC will be disregarded for income tax purposes; i.e., treated as a sole proprietorship
•Bank account•EINs•Licenses•Liability Protection•SE tax
SINGLE MEMBER LLC
Ms. Big Bucks
$10
100%Ownership
Big BucksLLC
Bank
Note
$50
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NET CASHNET CASHSINGLE MEMBER LLC
Original investment ($10.00)
First year tax 24.72
Second year tax (49.45)
Sale proceeds 798.70
Total $763.97
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CHOICE OF ENTITYCHOICE OF ENTITY
GENERAL PARTNERSHIP GENERAL PARTNERSHIP
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FORMATIONFORMATIONGENERAL PARTNERSHIP
Ms. Big Bucks
50%GeneralPartnershipInterest
50%GeneralPartnershipInterest
Mr. Big Bucks
BigBucks,
GeneralPartnership
$10 $10
Bank$100
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NET CASHNET CASHGENERAL PARTNERSHIP
Original investment ($10.00)
First year tax 24.72
Second year tax (49.45)
Sale proceeds 798.70
Total $763.97
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CHOICE OF ENTITYCHOICE OF ENTITY
LIMITED PARTNERSHIP LIMITED PARTNERSHIP
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FORMATIONFORMATION
• EINs• Bank account• Liability protection for limited partner only• Deductibility of losses subject to basis, at-risk and passive
loss limitations• General partner subject to self-employment tax but limited
partner is generally not
Note
Ms. Big Bucks
50%GeneralPartnershipInterest
50%LimitedPartnershipInterest
Mr. Big Bucks
BigBucks,
L.P.
$10 $10
Bank$100
CHOICE OF ENTITY LIMITED PARTNERSHIP
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FIRST YEARFIRST YEAR
Ms. Big Bucks Mr. Big Bucks
BigBucks,
L.P.
TaxableLoss
<$10> (1)Taxable
Loss<$90>
(1) Basis limitation results in loss limitation to Mr. Big Bucks.
LIMITED PARTNERSHIP
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FIRST YEAR MS. BIG BUCKSFIRST YEAR MS. BIG BUCKSLIMITED PARTNERSHIP
Self-employment Tax Income Tax Cash
Income from Operations ($90.00) ($90.00)
Self-employment Inclusion Percent x 92.35%
Self-employment Loss ($83.12)
Self-employment Tax Rate x 15.3%
Self-employment Tax Benefit ($12.72) (6.36)
Net Taxable Income ($83.64)
Assumed Effective Income Tax Rate x 38%
Tax Cost/(Savings) ($12.72) ($31.78) 44.50
Net Individual Cash $ 44.50
After-tax savings of $44.50
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FIRST YEAR MR. BIG BUCKSFIRST YEAR MR. BIG BUCKSLIMITED PARTNERSHIP
Self-employment Tax Income Tax Cash
Income from Operations $0.00 ($10.00) $0.00
Self-employment Inclusion Percent x 92.35%
Self-employment Income < loss > $0.00
Self-employment Tax Rate x 15.3%
Self-employment Tax Cost < benefit > $0.00 0.00
Net Taxable Income ($10.00)
Passive Loss Limitation 10.00
Net Taxable Income (0.00)
Assumed Effective Rate x 38%
Tax Cost < savings > $0 $ 0 0
Net Individual Cash $ 0
No after-tax savings because of basis limitation
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First YearFirst Year
Note
Ms. Big BucksGP
Mr. Big BucksLP
BigBucks,
L.P.Bank
$100
LIMITED PARTNERSHIP
LP’s basis limitation can be avoided if LP guarantees at least $10 of bank debt
Guarantee
$90 loss $10 loss
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SECOND YEAR MS. BIG BUCKSSECOND YEAR MS. BIG BUCKS
LIMITED PARTNERSHIP
Self-employment Tax Income Tax Cash
Income < loss >from Operations $ 140.00 $ 140.00 <$ 0 >
Self-employment Inclusion Percent x 92.35%
Self-employment Income < loss > $ 129.54
Self-employment Tax Rate x 15.3%
Self-employment Tax Cost < benefit > $ 19.82 < 9.91 >
Net Taxable Income $ 130.09
Assumed Effective Income Tax Rate x 38%
Tax Cost < savings > $ 19.82 $ 49.43 < 69.25 >
Net Individual Cash < $ 69.25 >
After-tax cost of $69.25
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SECOND YEAR MR. BIG BUCKSSECOND YEAR MR. BIG BUCKS
LIMITED PARTNERSHIP
Self-employment Tax Tax Cash
Income < loss >from Operations $ 0 $ 60.00
Passive Loss Carryover < 10.00 >
Net Taxable Income $ 50.00
Assumed Effective Rate x 38%
Tax Cost < savings > $0 $ 19.00 < $19.00 >
Net Individual Cash < $ 19.00 >
• After-tax cost of $19.00 (reduced because of carryover)
• No self-employment tax because of LP status
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SALE OF BUSINESSSALE OF BUSINESSLIMITED PARTNERSHIP
Income Tax Cash
Sales price $ 1,000 $1,000
Basis
Personal funds $ 20
Borrowed funds 100
Year 1 loss < 100 >
Year 2 profit 200
220
Allocable share x 50% < 110 >
Gain $ 890.00
Assumed capital gains rate 17%
Income tax $ 151.30 < 151.30 >
Repay bank (Allocable Share) < 50 >
Net sales proceeds $ 798.70
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NET CASHNET CASHLIMITED PARTNERSHIP
Ms. Big Bucks Mr. Big Bucks
Original Investment < $ 10.00 > < $ 10.00 >
First Year Tax 44.50 -0-
Second Year Tax < 69.25 > < 19.00 >
Sale Proceeds 798.70 798.70
Total
$ 763.95 $ 769.70
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CHOICE OF ENTITYCHOICE OF ENTITY
LIMITEDLIMITED LIABILITY COMPANY (LLC) LIABILITY COMPANY (LLC)
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CHOICE OF ENTITYCHOICE OF ENTITYLimited Liability CompanyLimited Liability Company
Similar to limited partnership, but Similar to limited partnership, but with limited liability for all.with limited liability for all.
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SELF EMPLOYMENT TAXSELF EMPLOYMENT TAX
CHOICE OF ENTITY
Treasury issued Proposed Regulations in 1997 which would exclude limited partners and LLC members from self-employment tax unless individual has any one of the following:
(1) personal liability for debts or claims against the entity by reason of being owner,
(2) authority to contract on behalf of the entity, or
(3) participates in the entity’s business for more than 500 hours during the tax year.
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CHOICE OF ENTITYCHOICE OF ENTITY
S CORPORATIONS CORPORATION
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FORMATIONFORMATION
• Bank accountBank account• EINsEINs• S corporation election requiredS corporation election required• LicensesLicenses• Liability ProtectionLiability Protection
CHOICE OF ENTITY S CORPORATION
Ms. Big Bucks
SCorporation
$50
Note Bank
100%Stock
Cash
$10
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FIRST YEARFIRST YEARS CORPORATION
* Deductibility of loss subject to at-risk, basis limitation and passive loss rates. Assume individual is active in business. Salary????
Income Tax Cash
Income <loss> from Operations < $50* > $0
Basis Limitation 40
Net Taxable Income<loss> < $10 >
Assumed Effective Rate x 38%
Tax Cost <savings> < $3.80 > 3.80
Net Cash $3.80
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FORMATIONFORMATION
CHOICE OF ENTITY S CORPORATION
Ms. Big Bucks
SCorporation
$50
Note
Bank
100%Stock
Cash
$60
Avoiding Basis Limitation
Note: Guarantee by Ms. Big Bucks will not create basis
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SECOND YEARSECOND YEARS CORPORATION
Tax Cash
Income <loss> from Operations $100 $0
Suspended Loss Deductible < 40 >
Net Taxable Income $ 60
Assumed Effective Rate x 38%
Tax Cost <savings> $22.80 < 22.80 >
Net Cash < $22.80 >
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SALE OF BUSINESSSALE OF BUSINESSS CORPORATION
Income Tax Cash
Sales Price $ 1,000 $ 1,000
Basis Personal funds $10
Loaned funds 50
Year 1 loss <50>
Year 2 profit 100 <110>
Gain $ 890
Assumed Capital Gains Rate x 17%
Income Tax $ 151.30 <151.30>
Repay Bank Loan < 50.00>
Net Cash $ 798.70
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NET CASHNET CASHS CORPORATION
Original Investment <$10.00>
First Year Tax 3.80
Second Year Tax <22.80>
Sale 798.70
Total $769.70
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WHY NOT AN S CORP?WHY NOT AN S CORP?
• Only natural persons and certain trusts can be shareholdersOnly natural persons and certain trusts can be shareholders• Maximum 100 shareholders (family members may be treated Maximum 100 shareholders (family members may be treated
as one shareholder)as one shareholder)• Only one class of stock permitted (except can have differing Only one class of stock permitted (except can have differing
voting rights)voting rights)• No special allocationsNo special allocations• No tax basis for liabilities even if guaranteeNo tax basis for liabilities even if guarantee• A distribution of appreciated assets from an S corporation is a A distribution of appreciated assets from an S corporation is a
taxable event; such a distribution from a partnership or LLC taxable event; such a distribution from a partnership or LLC generally is tax-freegenerally is tax-free
• Salary/payroll taxesSalary/payroll taxes
CHOICE OF ENTITY S CORPORATION vs. PARTNERSHIP
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CHOICE OF ENTITYCHOICE OF ENTITY
C CORPORATIONC CORPORATION
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FORMATIONFORMATION
• Bank accountBank account• EINsEINs• LicensesLicenses• Liability ProtectionLiability Protection
CHOICE OF ENTITY C CORPORATION
Ms. Big Bucks
CCorporation
$50 Cash
Note Bank
100%Stock
Cash
$10
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FIRST YEARFIRST YEARCHOICE OF ENTITY C CORPORATION
Income <loss> from Operations < $ 50 >
Net Operating Loss Carryover < $ 50 >
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SECOND YEARSECOND YEARCHOICE OF ENTITY C CORPORATION
Income <loss> from Operations $ 100
Net Operating Loss Carryover Used < 50 >
Net Taxable Income $ 50
Assumed Effective Rate x 18%
Net Cash Cost to Corporation $ 9
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SALE OF ASSETSSALE OF ASSETSC CORPORATION
Corporate Corporate Individual Individual
Income Tax Cash Income Tax Cash
Sales Price $1,000 $1,000
Basis
Original Investment $10
Bank Loan 50
Net Cash Investment 41 < 101 >from Operations
Net Gain 899
Assumed Corporate Rate x 40%
Corporate Tax $ 359.60 < 359.60 >
Repay Bank Loan < 50.00 >
Net Cash to Distribute $ 590.40 $ 590.40 $ 590.40
Individual Basis < 10.00 >
Net Gain 580.40
Assumed Capital Gains Rate x 17%
Tax 98.67 (98.67)
Net Cash $491.73
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SALE OF STOCKSALE OF STOCKC CORPORATION
Income Tax Cash
Sales Price $ 950* $ 950
Basis 10
Net Gain $ 940
Assumed Capital Gains Rate x 17%
Tax $ 159.80 < 159.80 >
Net Cash $ 790.20
*Assume stock sold for $1,000 less $50 bank loan.
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NET CASHNET CASHC CORPORATION
Sale Sale
of of
Assets Stock
Original Investment < $10 > < $10 >
First Year - 0 - - 0 -
Second Year - 0 - - 0 -
Sale $ 491.73 $ 790.20
Net Cash $ 481.73 $ 780.20
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COMPARISON OF NET CASHCOMPARISON OF NET CASHCHOICE OF ENTITY
Sole Proprietorship/General Partner $763.97
Limited Partner 769.70
S Corporation 769.70
C Corporation – Sale of Assets 481.73
C Corporation – Sale of Stock 780.20
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C CORPORATIONC CORPORATIONDOUBLE TAX ON DIVIDENDSDOUBLE TAX ON DIVIDENDS
CHOICE OF ENTITY
Tax Cash
Corporate Profit $100 $100
Assumed Effective Corporate Tax Rate x 40%
Income Tax $ 40 < 40 >
Cash Available for Distribution $ 60 $ 60
Assumed Effective Individual Tax Rate x 17%
Income Tax $10.20 <10.20>
Net Cash $49.80
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EMPLOYEE FRINGE BENEFITSEMPLOYEE FRINGE BENEFITS
CHOICE OF ENTITY
• Group term life insurance• Disability insurance• §125/cafeteria plans• Educational expenses• Employee-paid parking• Health and accident plans• Meals and lodging furnished for the convenience of the
employer
Sole proprietors, partners (including LLC members) and more than 2% shareholders in an S corporation are not eligible for the following tax free benefits:
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EMPLOYEE FRINGE BENEFITSEMPLOYEE FRINGE BENEFITS
CHOICE OF ENTITY
• 2000 60%
• 2001/2002 70%
• 2003 100%
• 2004 100%
• 2005 100%
• 2006 100%
To ameliorate adverse tax consequences to self-employed, a percent of health/medical insurance costs and actual costs are deductible in arriving at Adjusted Gross Income:
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Choice of EntityChoice of EntityMulti-State OperationsMulti-State Operations
• Each owner must file in multiple jurisdictions
• Entities may be treated differently from state to state
• Non-residents may be subject to withholding on income
Operations in more than one state complicate flow through entity (partnership (for tax) or S corporation) operation because:
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Choice of EntityChoice of EntityObservationsObservations
Sole Proprietorship – simplest, but no liability protection.Single Member LLC – liability protection.General Partnership – no liability protection.Limited Partnership – liability protection and no self-employment
tax for L.P.s.LLC – liability protection for all and flexible, but self-employment tax question.S Corporation – liability protection for all, but not as flexible. Can
manage FICA (self-employment tax).C Corporation – liability protection for all, but double taxation not
attractive.