How to choose the best entity

How to Choose the Best Business Entity

by

Alan D. Campbell

Ph.D., CPA, CMA, CFP®

[email protected]

Author of the forthcoming book

Tax Savings Prescriptions

2

Objectives• Explain how to

choose the best business entity:– Sole proprietorship– Partnership– Limited liability

company– S Corporation– C Corporation

3

Sole Proprietorship

4

Characteristics

• Easy to form and operate

• The owner has unlimited liability

• The owner has limited ability to raise capital

5

Formation• The owner may

operate under a fictitious name (a d/b/a)

• The owner may have to file a fictitious name registration with the county or parish

6

Formation

• The individual owner owns the assets

• No owner recognizes any gain or loss on the transfer of personal use assets to the business

7

Income Tax Treatment

• Only one level of income tax

• Income and expenses retain their character

• The net income is taxed at the owner’s marginal tax rate

8


• The owner reports income and expenses on Form 1040, Schedule C

• Losses (except passive losses) are deductible against the owner’s other income

9

More Than One Business• Income and expenses

from each different business are reported on separate Schedules C

• A net loss from one active business may offset net income from other businesses

10

Self-Employment Tax • Reported on Form

1040, Schedule SE

• The net income is multiplied by 92.35%

• The resulting amount is multiplied by the SE tax rate of 15.3%

• Half of the SE tax is deductible for AGI

11

Passive Losses• A passive loss may be

deducted only against passive income for both income tax and self-employment tax purposes

• Unused passive losses are carried forward

12

Employing One’s Children

• Can reduce income taxes and the self-employment tax

• Wages paid to one’s children under age 18 are exempt from employment taxes

13

Employing One’s Spouse

• Salaries are subject to income taxes and employment taxes

• Can be useful in saving self-employment tax on health insurance premiums and income tax and SE tax on medical expense reimbursement plans

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Employing One’s Spouse

• Can make business travel costs for the accompanying spouse deductible

• Can provide the spouse with earnings that can be tax sheltered with pension plans such as a SIMPLE plan

15

Section 179 Deduction

• The Section 179 deduction reduces income tax and the self-employment tax

• Wages count as business income for purpose of the income limitation

16

Net Operating Losses

• May generally be carried back two years and forward for up to 20 years for income tax purposes

• Are not deductible for self-employment tax purposes

17

Transferring the Business

The owner cannot transfer a part of the equity in the business without first changing it to another type of entity

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Sale of the Business

• A sale of a sole proprietorship is treated as a sale of its assets

• Part of any gain will be ordinary income

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Transferring the Business to Reduce Estate Taxes• Bequeath the

business to the surviving spouse

• Sell the business outright and make annual gifts from the proceeds

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Transferring the Business to Reduce Estate Taxes• Sell the business

for a private annuity

• Sell the business for a self-canceling installment note

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Partnership

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Characteristics

• General partners have unlimited liability

• Partnerships have a greater ability to raise capital than do sole proprietorships

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Characteristics• Partnerships have

relatively simple administration and filing requirements compared to corporations

• Partnerships are often much more complex for tax purposes than are other entities

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Formation• Transfers of property to a

partnership in exchange for an interest in the partnership are generally tax deferred

• The receipt of a partnership interest for services is taxable as determined under Section 83

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Tax Year

• The partnership must use the same tax year as used by partners that own more than 50% of the interest in the partnership

• If not possible, use the tax year of all the principal partners

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Tax Year

• If not possible, use the tax year with the least amount of income deferral

• The IRS may approve a different tax year if a business purpose exists

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Tax Year

The partnership may elect a different tax year if the partnership makes the required payment and the deferral period is three months or less

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• Partnerships have a great deal of flexibility in allocating income between or among the partners

• Single level of taxation• Partners, not the

partnership, pay taxes

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Income is taxed to the partners even if the partnership makes no distributions of cash or other assets

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Employment Tax Treatment

For general partners, the distributive share of ordinary income and any guaranteed payments are subject to the self-employment tax

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Reporting Partnership Income

• The partnership must file Form 1065

• Income is reported to each partner on Schedule K-1

• Ordinary income or (loss)

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Reporting Partnership Income

• Separately reported items include portfolio income, capital gain/loss, and the Section 179 deduction

• Net earnings from self-employment

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Losses• Losses flow through to

the partners to the extent of each partner’s– Amount at risk– Adjusted basis in the

partnership interest, which includes the partner’s share of the partnership’s debts

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Losses• Passive losses are

deductible only to the extent of passive income

• Losses from a limited partnership interest are generally passive losses

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Distributions from the Partnership

• Distributions include distributions of cash and other assets

• A net decrease in a partner’s share of the liabilities is treated as a cash distribution

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• Distributions are deemed to occur at the end of the year

• All other items that affect basis are taken into account before distributions

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Distributions of property reduce the basis in the partnership interest by the adjusted basis of the property to the partnership

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• Distributions of cash are a reduction in the basis of the partner’s interest in the partnership

• Distributions of cash in excess of basis result in a recognized gain

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Sale of a Partnership Interest

A sale of a partnership interest is treated as a sale of a capital asset except to the extent of “hot assets”

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Optional Basis Adjustment• The partnership may

elect to adjust a partner’s outside basis when – A partner acquires the

interest of another partner or

– The partnership distributes property to a partner

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Sale of the Assets of the Business

• The partnership can sell the assets of the business

• The gain or loss on each asset must be calculated and characterized

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Termination of a Partnership

A partnership terminates for legal purposes on the death, withdrawal, or bankruptcy of any partner

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Termination of a Partnership

• A partnership terminates for tax purposes – When at least 50% of the

interest in the partnership is transferred in any 12-month period or

– When no business activity is carried on by any partner

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Transferring the Business to Reduce Estate Taxes

• Form a family limited partnership

• Make a lifetime gift of the general partnership interest or sell it

• A corporation or LLC could be formed to be the general partner

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Transferring the Business to Reduce Estate

Taxes• Retain a limited

partnership interest

• The value of the retained interest will receive discounts for – Lack of marketability

and– Lack of control

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Four Types of Entities May Be Taxed as Partnerships

• General partnership

• Limited liability partnership (LLP)

• Limited partnership

• Limited liability company (LLC)

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General Partnership

• All partners have unlimited liability

• Each partner is taxed on the partner’s distributive share of– The partnership’s

ordinary income– The separately stated

items

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Limited Liability Partnership

• Used by professional services firms

• All partners have unlimited liability for the normal business debts of the partnership

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Limited Liability Partnership

Partners are not liable for the professional negligence of another partner unless the other partner is under their direct supervision

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Limited Partnership

• Limited partners have limited liability

• Limited partners cannot take part in management

• Limited partners are often a source of a large amount of capital

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Limited Partnership

• Must have at least one general partner

• The general partner is often a corporation or LLC

• Limited partners pay self-employment tax on guaranteed payments only

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Limited Liability Company (LLC)

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Characteristics

• None of the members is personally liable for the debts of the LLC

• All members have the legal right to participate in management

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Characteristics

• LLCs may have an unlimited number of members

• Any taxpayer can be a member of an LLC (corporations, non-resident aliens, trusts, partnerships)

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State Law

• Little established case law exists to interpret the various state statutes

• Uncertainty exists for LLCs that operate in more than one state as to which state’s law will prevail

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Formation• Transfer of property

to an LLC in exchange for an ownership interest is – Generally governed by

the partnership tax provisions (Subchapter K)

– Generally tax deferred

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• One member LLC is taxed as

– A disregarded entity (sole proprietorship)

– A corporation if the LLC so elects

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• LLC in the USA with two or more members is taxed as

– A partnership– A corporation if the

LLC so elects

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If the LLC elects to be taxed as a corporation, the salaries of the members who work for the LLC will be subject to FICA tax and income tax withholding

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If the LLC elects to be taxed as a corporation, the LLC will be subject to FICA tax and unemployment taxes

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If an LLC owned by one individual is taxed as a disregarded entity, all of the net income will be subject to self-employment tax

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If an LLC is taxed as a partnership, the members who are equivalent to general partners will be subject to self-employment tax on their distributive share and on any guaranteed payments

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Members who are equivalent to limited partners will be subject to self-employment tax only on their guaranteed payments

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LLCs Taxed as Partnerships

• The flexibility of a partnership

• The limited liability of a corporation

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LLCs vs. S Corporations

• LLCs are NOT subject to the taxes on built-in gains and excessive passive income

• LLCs are NOT limited as to the number of members

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Selling the Assets of the Business and Liquidating the LLC• The gain or loss on each

asset must be calculated and characterized

• The treatment of liquidating distributions depends on how the LLC is taxed

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Sale of a Membership in the LLC

• If the LLC is taxed as a partnership, the interest in the LLC is a capital asset

• Capital gain or loss results, except to the extent of the sale of “hot assets”

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A loss on the sale of a membership in an LLC taxed as a partnership or disregarded entity cannot qualify for ordinary loss treatment under Section 1244

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• If the LLC is taxed as a corporation, the sale of the LLC membership should result in capital gain or loss

• Possible limited ordinary loss treatment under Section 1244

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S Corporation

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Eligibility Requirements

• Must be a domestic (USA) corporation

• Must be eligible to elect S status (not an insurance company or non-qualifying bank)

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• Shareholders are only– Individuals – Estates – Tax-exempt organizations,

and – Seven kinds of trusts

• No more than 100 shareholders


• A husband and wife count as one shareholder

• Certain family members may elect to be treated as one shareholder, up to six generations

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• Only one class of stock

• Stock with different voting rights is allowed

• Disproportionate distributions can be deemed to indicate that the corporation has more than one class of stock

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• Generally, nonresident alien shareholders are NOT allowed

• An exception applies if the nonresident alien is married to a U.S. citizen or resident alien and elects to be taxed as a resident alien

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Trusts That Can Own S Corporation Stock

• Grantor trusts• Voting trusts• Testamentary trusts• Qualified Subchapter S trusts• Qualified retirement plan

trusts• Small business trusts• Beneficiary-controlled trusts

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Characteristics

• Limited liability

• Unlimited life

• Centralized management

• Limited transferability of interests without losing the S election

• Subject to more government regulation

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Formation• The transfer of assets in

exchange for the corporation’s stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer

• The transfer of assets for the debt of the corporation is taxable

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Formation• The receipt of stock in

exchange for services is taxable as determined under Section 83

• Service provider may make election under Section 83(b) if stock is restricted

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Making the S Election

• File Form 2553 with the IRS

• All shareholders must consent

• The election must be timely and properly filed

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Deadline for the S Election• The corporation may make

the S election at any time in the year before it is to become effective

• The corporation may make the S election on or before the 15th day of the third month of the tax year of the year it is to be effective

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Deadline for the S Election• A new corporation may

make the S election on or before the 15th day of the third month of its first tax year

• The first tax year begins on the day the corporation has assets, shareholders, or begins business

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Deadline for the S ElectionIf the corporation makes the S election late, the IRS may treat the election as timely if the corporation had reasonable cause

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Deadline for the S Election• The election is faulty if

the corporation failed to qualify or did not obtain shareholder consents

• However, the IRS may honor the election if the corporation corrects the problem within a reasonable time

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Tax Year• An S corporation generally

must use the calendar year

• A fiscal year is allowed if it has a business purpose

• The corporation may also use the same year as used by shareholders who own more than 50% of its stock

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Tax Year

• The S corporation may also elect to use a different tax year

• The maximum deferral of income is three months

• Requires payments to the IRS to compensate for the deferral

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Ownership of C Corporations• A C corporation may

NOT own stock in an S corporation

• However, an S corporation may own stock in a C corporation

• No consolidated return allowed with a C corporation

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QSubs

• An S corporation may have qualified S corporation subsidiaries (QSubs)

• The QSubs are disregarded for tax purposes

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QSub Criteria

• Must qualify as an S corporation

• The S corporation parent must own all of its stock

• The parent elects to treat it as a QSub

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• No corporate income tax except for– Built-in gains– Excessive net passive

income– LIFO recapture tax– Recapture of

investment tax credit

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Penalty Taxes

• An S corporation Is NOT subject to– The accumulated

earnings tax or– The personal

holding company tax

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• The S corporation must file Form 1120S by March 15th

• Income is allocated to the shareholders on Schedule K-1

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• Income is taxed to the shareholders at their marginal tax rates

• Capital gains, tax-exempt income, and other separately stated items retain their character

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• Income is taxed to the shareholders on a per share per day basis

• Therefore, S corporations are not as flexible as partnerships

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Splitting Income• S corporation stock can be

given to family members to split income among the family members

• However, the S corporation must pay reasonable compensation to family members who provide services or capital to the corporation

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Splitting IncomeThe IRS may ignore gifts of stock to family members if the IRS determines that the donor retains the economic benefits and control of the stock

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Dividends Received Deduction

Unlike a C corporation, an S corporation is NOT entitled to the dividends received deduction

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Treatment of Certain Fringe Benefits

• Statutory fringe benefits are included in the gross income of more than 2% shareholders

• The S corporation may deduct the fringe benefits as business expenses

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• Shareholders who work for the corporation are employees

• Salaries are subject to FICA tax and income tax withholding

• The corporation Is subject to FICA tax and unemployment taxes

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Reducing Employment Taxes

The S corporation can reduce employment taxes by paying the lowest amount of a range of reasonable salaries to shareholder-employees

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Treatment of Losses• Losses flow through

to the shareholders to extent of each shareholder’s:

– Basis in stock

– Basis in loans to the S corporation

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Tax Planning for Loss Deductibility

The shareholder can loan money to the S corporation or make a contribution to capital before the end of the year if necessary to deduct the loss currently

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Treatment of Losses• The treatment of losses

is favorable for new businesses that are likely to incur losses

• When the corporation becomes very profitable, the shareholders can revoke the S election

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Treatment of Losses

• Losses subject to

– Amount at risk rules

– Passive activity loss rules

– Hobby loss rules

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Treatment of Losses• Losses of an S

corporation are often more limited than are losses of a partnership

• The basis in a partnership interest includes the partner’s share of the debts of the partnership

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Treatment of Distributions

• Distributions are a tax free recovery of basis to the extent of the shareholder’s basis in the stock

• The basis in debt does NOT absorb distributions

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Treatment of Distributions

Distributions in excess of the basis of a shareholder’s stock result in gain recognition to the shareholder

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Treatment of Distributions of Property

• Distributions of appreciated property result in gain recognition by the corporation

• However, no losses may be recognized

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Treatment of Distributions of Property

• The amount of the distribution of property is its – Fair market value– Minus any debts

assumed or taken subject to by the shareholder

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Former C Corporations• Former C corporations

with accumulated earnings and profits (E&P) keep an accumulated adjustments account (AAA)

• AAA is the total of income and loss from the S period (except tax-exempt income and related expenses)

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Former C Corporations

• Distributions come first from the AAA and reduce the basis in the shareholder’s stock

• Distributions come next from E&P and are taxable

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S Election Remains Until Revoked or Lost

• Voluntary revocation is easy and requires the approval of a majority of the shareholders

• Involuntary revocation occurs when– A new shareholder with over one half of the stock

refuses to consent to the election– The corporation no longer qualifies as a small business

corporation– The corporation does not meet the passive investment

income limitation

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Termination of the S Election for Excessive Passive Income

• Passive income greater than 25% of its gross receipts for three consecutive years and

• C corporation earnings and profits exist for each of the three years

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Preserving the S Election

• Management and shareholders should know the factors that affect S status

• Avoid passive investment income limitation violations

• Restrict transfer of stock to avoid loss of S status

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Inadvertent Terminations

• The IRS may continue to allow the S election if – The termination is

inadvertent and – The corporation takes

the necessary steps to meet the eligibility criteria within a reasonable time

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New Election

• If the S election is terminated, the corporation must – Wait five years to

make a new election or

– Obtain the consent of the IRS

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• You can structure the sale of the business as – A sale of stock or– A sale of assets

followed by a corporate liquidation

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• A sale of the stock should result in capital gain or loss

• Possible limited ordinary loss treatment under Section 1244

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Liquidation

• Liquidation of an S corporation is governed by the provisions of Subchapter C

• No double tax occurs except to the extent of built-in gains

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C Corporation

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Characteristics• Limited liability• Unlimited life• Centralized

management• Free transferability of

interests• Subject to more

government regulation

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Characteristics

• Unlimited number of shareholders allowed

• Often used for a growing business that is reinvesting its profits in the business

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Formation

The transfer of assets to the corporation in exchange for its stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer

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Formation

• The transfer of services to the corporation in exchange for its stock is taxable as determined under Section 83

• The transfer of property in exchange for the corporation’s debt is taxable

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Fringe Benefits

• Many fringe benefits are deductible by the corporation

• They are often tax free or tax deferred to the shareholders-employees

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Passive Activity Loss Rules

• Apply only to

– Personal service corporations

– Closely held corporations

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Net Operating Losses

• Do NOT flow through to the shareholders

• Can generally be carried back two years and then forward for up to 20 years

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Capital Losses

• Are deductible only to the extent of capital gains

• Are carried back three years and then carried forward for up to five years

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Special Deductions

• Organization costs

• Dividends received deduction

• Charitable contributions

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• Sale of stock – No corporate tax– Shareholder

realizes capital gain or capital loss

– Possible limited ordinary loss treatment under Section 1244

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Sale of the Business• Sale of assets

– Corporation recognizes gain or loss on sale of each asset

– Distributions are taxed to the shareholders as capital gain or capital loss

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Double Taxation

• Income is taxed at the corporate level

• Dividends are taxed to shareholders when distributed

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Reducing Double Taxation

• Avoid distributing dividends

• Make cash payments to the shareholders that are deductible by the corporation

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Reducing Double Taxation

• Make cash payments to the shareholder that are a tax free recovery of basis

• Make the S election

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Deductible Cash Payments

• Lease payments

• Reasonable compensation

• Interest

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Cash Payments That Are a Tax Free Recovery of

Basis• Principal payments

on debt

• Stock redemptions treated as a sale

• Liquidating distributions

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Penalty Taxes

• Accumulated earnings tax

• Personal holding company tax

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Double Tax on the Sale of the Assets of the Business

• The corporation recognizes gain or loss on the sale of the assets

• The shareholders recognize capital gain on the distribution of the proceeds

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Conclusion• The best entity for a

your business depends on many factors, including state income tax rules

• You should make the decision with guidance from your attorney and tax professional

Bonus Material

11 Reasons You May

NOT Want to Incorporate

1. Banks Require Cosigners

• Banks will usually require major shareholder(s) to consign any corporate loans

• Thus, there would be no limited liability for bank loans

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2. Piercing the Corporate Veil

• Most corporations keep poor records such as minutes and resolutions

• Many stockholders of small corporations commingle personal and corporate assets

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Shareholders Become Liable

• A plaintiff’s attorney may be able to pierce the corporate veil

• If so, the shareholders could be personally liable for any corporate debt

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3. Defending a Lawsuit Is Expensive

• Even if a corporation keeps good records and does not commingle assets

• The corporation would have to pay to defend a lawsuit, except to the extent that an insurance company will pay

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4. Breach of Fiduciary Duty

• Even if the corporation keeps good records and does not commingle assets

• You can be sued individually for breach of fiduciary duty as a director or officer of the corporation

• You can insure such risk, but it can be expensive

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5. Foreign Corporation Fees

• A corporation is an artificial person that has received a charter from a particular state

• To do business in another state, the corporation must register with that state and pay a fee as a “foreign corporation”

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6. Few Additional Deductions

• Section 162 authorizes deductions for business expenses

• It applies to all types of businesses

• There are few deductions a corporation may claim that are not allowed to other types of business entities

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7. Employment Taxes for Children Under Age 18

• If your children are under age 18 and they work for your sole proprietorship, their wages are not subject to employment taxes

• If your children work for your corporation, their wages are subject to employment taxes

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8. More Government Forms to File

• If you operate as a corporation, you have to file more forms and pay more fees to federal and state governments

• Complying with all the rules takes additional time and money away from your business

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9. Can Lose Stock to Personal Judgments

• A court may not force a creditor to be a partner with someone

• If someone gets a judgment against an LLC member or partner, usually all the creditor gets is a charging order

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Judgment Creditor Can Seize Stock to Satisfy Judgment

• A personal judgment creditor of a shareholder may be able to take the stock to satisfy the judgment

• You can buy personal umbrella liability insurance to hedge against this risk

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10. Payroll Tax Penalties on Your Own Salary

• If your corporation pays you a salary and does not deposit the payroll taxes timely, the corporation could be subject to large penalties

• And you as an individual could be subject to the trust fund recovery penalty

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11. Possible Tax on Transfer of Appreciated Assets

• If you transfer appreciated assets to a corporation that you control and if you do not comply with Section 351

• You could owe income tax just for placing the assets in a corporation

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Conclusion

• Think carefully and get excellent advice before you form a corporation

• Corporations do have some benefits

• But many of the alleged benefits are myths and half truths

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Credits

This presentation was created using PowerPoint® presentation graphics program, a Microsoft® software. PowerPoint® is a Windows®-based and Mac®-based application. All clip art is used with permission from Microsoft®. Microsoft®, Windows®, and PowerPoint® are either registered trademarks or trademarks of Microsoft Corporation in the United States and/or other countries.

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Disclaimers

Alan D. Campbell (d/b/a Campbell Education) is an independent entity and is not affiliated with, nor has he been authorized, sponsored, or otherwise approved by Microsoft Corporation.

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How to choose the best entity

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