How to Slam Dunk Your Entity SelectionTax & Legal Considerations

01 Tax Savings..........................................................................................................................6

02 Industry..............................................................................................................................7

03 Liability Protection...........................................................................................................9

04 Number and Type of Owners........................................................................................10 05 Owner Compensation Strategy....................................................................................11

What’s Inside...

THOUGHT CONTRIBUTORS....................................................................................2

INTRODUCTION.................................................................................................................3

THE ENTITY MYTH..........................................................................................................4

TOP 5 FACTORS TO CONSIDER..............................................................................6

MAKING A HOLISTIC DECISION........................................................................13

01 How entity taxation methods and structures can save costs..................................13

02 How entity structure and taxation choices enable strategic growth.....................15

FINAL THOUGHTS...........................................................................................................16

ABOUT MIDDLETONRAINES+ZAPATA.......................................................17

COMMON ENTITY STRUCTURES & THEIR TAXATION..................5

ABOUT THE S ELECTION..........................................................................................12

Jon Meadows | CPA, JDJon is not only a CPA, he’s also an attorney. He knows the legal and tax implications of an effective entity structure and is an expert at helping small businesses strike the right bal-ance between legal protection and reducing tax liability.

Stan Raines | CPAStan is the resident tax guru when it comes to small- and medium-size businesses and tax strategy. His decades of experience mean he often knows what business owners are going to ask before they do – and what they’re not asking that could cost big bucks, now and in the future.

Wesley Middleton | CPAThe managing partner at MRZ, Wes has advised businesses on strategic tax planning for decades. His tax knowledge and business savvy have saved many a business thousands or hundreds of thousands of dollars (or even the entire business itself!). Check out a fraction of the ideas and answers he’s got at middletonraines.com/blog.

Thought Contributors

How to Slam Dunk Your Entity Selection | 2

Steven Elliott | CPA, MSTAs the Tax Technical Director at MRZ, Steve is all about the details. He has over 30 years of diversified public accounting experience advising high net worth individuals and closely held and family businesses, in addition to deep experience with trusts, partnerships, cor-porations, and not-for-profit entitities. In other words, he knows his stuff!

Introduction Great basketball coaches are excellent strategists. They study the competition, gather advice from experts, scout the best sources, recruit top incoming talent, and put together a winning playbook. When game day arrives, even though there is still much left to chance, these coaches have done their best to set their teams up for the win.

Successful business owners go through a similar exercise when they are just starting out. They do their due diligence, put together a solid plan and team, make sure their core sys-tems are in place, and get their financial and legal affairs in order—including setting up a legal entity with the state in which they operate.

Despite these efforts, however, many business owners may be missing out on significant tax savings because of the entity structure choices they made when they started their com-panies. Many make the common mistake of viewing entity selection as a purely legal de-cision. Failing to understand the huge tax implications of entity choice, they may engage only an attorney when setting up their businesses—to their financial detriment.

This whitepaper offers a solution for making a holistic entity choice that balances legal liability and tax minimization priorities and aligns with owners’ long-term goals for the business.

How to Slam Dunk Your Entity Selection | 3

The Entity Myth

Many business owners confuse their choice of business entity—which at the most basic level comes down to a sole proprietorship, a partnership, an LLC, or a corporation—with taxation of that entity. Legal entity is a state designation chosen upon business formation that has implications on asset protection, structure, compensation, and a number of other important business considerations. But one area that it does not dictate, in and of itself, is how the entity is taxed.

Taxation is determined by the federal election that the owners choose. The taxation meth-od options include:

• Disregarded entity (Schedule C)• Partnership (Form 1065)• S-corporation (Form 1120-S)• C-corporation (Form 1120)

If the owners do not make a specific election, then each legal entity has its own automatic taxation method to which owners are agreeing to by default. For an overview of the most common entity structures and their default and elective taxation methods—as well as rel-ative liability protections—see the chart on the following page.

How to Slam Dunk Your Entity Selection | 4

Common Entity Structures & Their Taxation

How to Slam Dunk Your Entity Selection | 5

Legal Entity/State Designation

Liability Protection

AutomaticElection

Optional Election

Sole Proprietorship/dbaOwners have

unlimited personal liability.

Schedule C S-corp Form 1120-S* ORC-corp Form 1120

Sole Proprietorship, Limited Partnership, Limited Liability Partnership

General partners have unlimited joint and

personal liability. Limited partners

have limited personal liability.

P-ship Form 1065 S-corp form 1120-S** ORC-corp Form 1120

Single-Member Limited Liability Company (LLC)

Member has limited personal liability. Schedule C S-corp Form 1120-S OR

C-corp Form 1120

Multi-Member LLC Members have limited personal liability. P-ship Form 1065 S-corp Form 1120-S OR

C-corp Form 1120

CorporationShareholders have limited personal

liability. C-corp Form 1120 S-corp Form 1120-S

*A sole proprietor would need to form a legal entity before making the S-election.**Partnerships, as well as associations and other entities, must file IRS Form 8832 to elect to be taxed as a corporation before making the S-election.

See the S-election table on

page 12 for the advan-tages, disadvantages, and

requirements for mak-ing the S-election.

How to Set a Winning Line-up

Just like coaches create a winning starting line-up, business owners should take a de-liberate and comprehensive approach to entity setup to score bigger savings at tax time. Business owners can balance legal liability and tax minimization priorities by considering the following key factors when they are deciding what type of legal entity to set up, and which form of taxation to adopt.

How to Slam Dunk Your Entity Selection | 6

THE TOP 5 FACTORS TO CONSIDER

If the owners’ priority is tax minimization, then the S-corporation election might be the preferred taxation method, as long as the entity is an eligible corporation (see the instruc-tions at www.irs.gov/pub/irs-pdf/i2553.pdf for Form 2553 for more information on who can make the election).

Whereas C-corporation profits are subject to double taxation—once at the corporate lev-el and again when profits are distributed to shareholders—corporations that make the S-election do not pay corporate-level tax. Instead, the IRS views them as pass-through entities in which all profits and losses “pass through” to the owners and are reported on their personal tax returns. Also, distributions of net profit to S-corporation owners can be exempt from self-employment and net investment income taxes.

However, the S-election isn’t for everybody. For example, organizations that need flexi-bility in how they compensate their owners will need to balance that need for flexibility against their tax-saving priorities. (For a summary of the pros, cons, and structural re-quirements of the S-election, see “Should I make the S-election?” on p. 12.)

1. TAX SAVINGS

How to Set a Winning Line-up

How to Slam Dunk Your Entity Selection | 7

The type of business being conducted often narrows the playing field of entity structure choices because of common industry practices or state requirements. This key consider-ation is best illustrated by the following industry examples.

2. INDUSTRY

REAL ESTATE INVESTING

PROFESSIONAL SERVICES

Real estate investing companies bear significant risk due to the nature of their business and therefore opt for an entity structure such as the limited liability company (LLC) that offers owners liability protection. To isolate the risks of var-ious rental properties, investors often set up a separate legal entity for each one. Depending on the number of entities in question, the setup and filing fees for multiple LLCs can add up quickly.

A lesser-known option, the Series LLC, offers significantly lower setup costs but the same legal and tax consequences. With a Series LLC, only the master LLC (i.e., the “parent” in the series) files with the state. No state filings are required to set up subsidiary LLCs in the series.

Typically, professional services firms form partnerships for their flexibility. Part-nerships are easy to set up and maintain, and they are not subject to the formali-ties of a corporation. Personal liability may be limited or unlimited depending on the type of partnership. The partnership is not a separate entity for tax purposes, so profits and losses pass through to the partners’ individual returns based on an allocation method of their choice.

The specific type of partnership formed depends on the profession, as states gen-erally define the entity options for professional services. Doctors in Texas, for example, must form professional associations. Other structures used by profes-sional services firms are professional limited liability companies and professional corporations.

How to Set a Winning Line-up

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From a tax perspective, the federal S-election is not generally recommended for companies that hold real estate because property distributions are taxable at fair market value. Instead, real estate businesses often choose to be taxed as partner-ships, which is the default tax method for multi-member LLCs. Partnership tax rules allow property to be distributed to owners at any time—tax free—and the recipient takes the company’s basis in the property (i.e., there is no taxable gain on the transaction). When property is distributed from a corporation, it must be marked to fair market value, which most often produces a taxable gain. The re-cipient’s basis in the property is the fair market value at the date of distribution.

Oil and gas investing businesses typically form partnerships or LLCs depending on what is most important for the business—tax minimization or liability protec-tion. Oil and gas partnerships in particular provide investors with some unique tax incentives as long as they do not have limited liability in the eyes of the IRS. For more information on those opportunities, see the following video series:

• www.middletonraines.com/blog/common-oil-gas-investor-questions-part-1• www.middletonraines.com/blog/common-oil-gas-investor-questions-part-2

2. INDUSTRY CONT.

REAL ESTATE INVESTING CONT.

OIL AND GAS INVESTING

How to Set a Winning Line-up

Most small- to mid-size business owners are looking for a certain amount of liability pro-tection in their entity structure choices. They want to know their personal assets are safe-guarded from claims and lawsuits initiated by other owners, employees, creditors, and customers. To make an informed entity structure choice, owners need to understand what liability protection each legal entity offers.

The corporation, LLC, limited partnership, and limited liability partnership structures provide different levels of personal asset protection from external claims. With a corpo-ration or LLC, if something goes wrong with a product, the unhappy customer generally can only sue the entity—not the owners or officers.

A limited partnership is formed by one or more general partners and one or more lim-ited partners. Limited partners are often known as “silent partners.” They have personal liability for business debts and other claims, but only up to the total amount they have invested in the company—as long as they are not active participants in the business. Gen-eral partners participate in day-to-day operations and have unlimited personal liability for business debts and other claims, but this liability can be limited by having corporations or LLCs as the general partners.

In a limited liability partnership, all partners are “limited” in that they are not personally liable for the malpractice of other partners. However, all partners have unlimited personal liability for business debts.

The sole proprietorship and general partnership structures provide no personal liability protection. Another important point to keep in mind is that no legal entity protects per-sonal assets if an owner, member, or officer personally guarantees a business loan.

3. LIABILITY PROTECTION

How to Slam Dunk Your Entity Selection | 9

How to Set a Winning Line-up

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When a company has a large number of owners, there is a greater potential for conflicting interests. These organizations may need the formality of a corporation. Required share-holder meetings, notices, and votes help ensure that opposing viewpoints are heard and weighted fairly. On the other hand, a company with only a few owners may deem the cor-porate formalities unnecessary.

The number and type of shareholders also can affect taxation methods. The federal S-elec-tion is only available to organizations with fewer than 100 shareholders. Businesses with foreign and entity owners also are not allowed to make the S-election.

4. NUMBER AND TYPE OF OWNERS

How to Set a Winning Line-up

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Owner compensation is a key factor in a company’s plan for growth, and it has significant tax impacts on both the business and the owner(s). Profit-sharing strategies also may need to be adjusted over time for a variety of reasons. Thus, it is important to understand the flexibility—or lack thereof—that the tax rules for different entity structures offer in this regard.

Partnerships provide organizations with more flexibility in distributing profits. When an entity is taxed as an S-corporation, prof-its and losses must be allocated pro rata, but partnership tax rules allow disproportionate distribution, which may accelerate the growth of certain businesses. Distributing profits by book of business, for example, enables professional services firms to reward the owners who make the biggest impact on current-year income.

C-corporations pay salaries, which are taxed at the individual level, and they may distribute profits (aka dividends), which are taxed at both the corporate and individual levels. For companies that plan to reinvest their net profits to grow the business instead of paying dividends, electing to be taxed as a C-corporation may be better than making an S-election.

In an S-corporation, owners must be paid a reasonable salary, and they pay personal income tax on those salaries as well as their pro rata share of net profits, whether or not they actually receive any cash distributions.

5. OWNER COMPENSATION STRATEGY

a note on RETIREMENT PLANS

The type of retirement plan you can offer your employees depends

on your entity type. Retirement plans also have tax implications. If you plan

to offer this benefit, be sure to discuss your options with your

legal and tax advisors.

About the S-election

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SHOULD I MAKE THE S-ELECTION?PROS CONS

Owners can avoid the 15.3% self-employment tax on profits and distributions.

Net profits are taxable to owners on their personal tax returns and must be allocated,

whether or not distributed, according to ownership interest.

Active owners can avoid the 3.8% net investment income tax.

Owners must be paid salaries deemed reasonable by the IRS.

Owners share in profits, which are reported on their personal returns, and therefore are subject

only to a single level of taxation.

Property distributions are taxable at fair market value.

Owners share in losses and can use them to offset other earned income on their personal tax returns.

Setup for an S-corporation may be more expensive and complex than for a partnership

or an LLC.S-corporations report income on an informational tax return (Form 1120-S), rather than a Schedule C, which is one of the most scrutinized tax forms

by the IRS.

Fringe benefits offered to most shareholders may not be fully deductible.

Owners can enjoy limited personal liability according to the provisions of the legal entity.

There are limits on the total number and type of owners allowed (see below).

This federal tax election is available to any qualifying legal entity that is or has elected to be taxed as a corporation as follows:

All owners must consent to making the election.

The S-election form (IRS Form 2553) must be timely filed.

Owners must be U.S. citizens or residents.

No more than 100 shareholders are allowed (husband and wife count as one).

Owners must be individuals, estates, exempt organizations, or certain trusts (see “Who May Elect” in the instructions for Form 2553). They cannot be C-corporations, other S-corporations, LLCs, partnerships, or certains trusts.

Only one class of stock is allowed.

The organization must hold annual meetings and record meeting minutes.

STRUCTURAL REQUIREMENTS

Score More Points with an Informed Decision

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By taking a balanced approach to entity structure decisions—giving equal weight to legal and tax implications—business owners can set themselves up for significant cost savings and strategic growth opportunities.

HOW ENTITY TAXATION METHODS & STRUCTURES CAN SAVE COSTS

S-CORPORATIONS: PAYROLL TAX SAVINGS

Regardless of the legal entity type, the S-election often provides a distinct tax benefit, primarily because it enables owners to avoid certain types of employ-ment taxes. For example, LLCs that elect to be taxed as S-corporations can realize significant payroll tax savings when they wish to take money out of the business. By default, multi-member LLCs are taxed as partnerships. Under the partner-ship taxation method, LLC owners are not viewed as employees by the IRS; they are simply owners who report all net profits and losses of the business on their personal tax returns. Those profits are subject to both individual income and self-employment (Social Security and Medicare) taxes. Because self-employed owners are viewed as both employers and employees, they owe both shares of employment tax.

Actively participating owners of LLCs taxed as S-corporations, by contrast, are viewed as employees and must be paid reasonable salaries. Those reasonable sal-aries are subject to both individual income and employment taxes. However, all other S-corporation profits and distributions are exempt from employment taxes and net investment income taxes because such distributions are not viewed as employee wages.

Before You Convert

Before making the S-election, existing C-corporations should be sure to use up any net operating loss (NOL) carryforwards. S-corporations are ineligible for the tax-saving benefit of NOL deductions, so any remaining NOL carryforwards would be forfeited upon conversion. For more information, download the IRS publication on NOLs at www.irs.gov/pub/irs-pdf/p536.pdf.

C-corporation-to-S-corporation conversions also may trigger built-in gains (BIG) tax, so businesses that have large asset portfolios should be sure to consult with a professional advisor to determine the BIG tax implica-tions of making the S-election. (Learn more at www.middletonraines.com/blog/why-built-in-gains-are-a-big-deal.)

Score More Points with an Informed Decision

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The use of a partnership structure can enable oil and gas investors to deduct IDCs on their personal tax returns—saving them tons of money at tax time—but only if they own those interests through an entity that does not limit their liabil-ity with respect to the working interest. For more information on this unique set of tax incentives, click here.

Business owners looking for limited personal liability can avoid the double-tax-ation costs of a C-corporation by forming an LLC. Absent a really strong reason to form a C-corporation, such as a foreign owner or high risk of legal action, an LLC will likely be a better choice because it provides equivalent liability protec-tion without the C-corporation formalities and additional layer of tax.

LLCs also have lower state filing fees than C-corporations, and they offer the management flexibility of a partnership. Businesses with multiple distinct activ-ities should consider the Series LLC for even lower setup costs.

OIL & GAS PARTNERSHIPS INTANGIBLE DRILLING COST (IDC) DEDUCTIONS

LLCS LIABILITY PROTECTIONS WITHOUT DOUBLE TAXATION & EXPENSIVE FILING FEES

Score More Points with an Informed Decision

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Partnership and C-corporation tax rules allow businesses to offer incentivized compen-sation plans, such as profit-sharing based on book of business, which may help accelerate growth. Owner compensation restrictions are a limitation of S-corporations. Specifically, the IRS says S-corporations must pay owners reasonable salaries and distribute all re-maining profits based on ownership interest. S-corporation rules also limit the number and type of shareholders, which could hinder companies that wish to offer stock options to employees.

Most companies that intend to go public form a C-corporation for the liability protection, formal structure, and ease of transferring shares. Companies hoping to attract venture capital often form C-corporations, since most investors are concerned with capital appre-ciation.

Because C-corporation owners pay personal income taxes only when profits are distribut-ed as dividends, C-corporations also may be best for businesses that intend to reinvest net profits toward company growth, rather than distributing them to shareholders.

HOW ENTITY STRUCTURE & TAXATION CHOICES ENABLE GROWTH

Avoid Common Mistakes

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Without a fundamental understanding of entity structures and their tax and legal im-plications, many business owners miss out on the cost-saving potential of making an ap-propriate initial entity structure selection that balances the key factors discussed in this whitepaper. In fact, owners should consider these factors before they ever complete the first page of the state filing paperwork.

Further, by failing to look at entity structure considerations as their businesses grow and change, they will miss second, third, and fourth chances to take advantage of the benefits their ideal entity structure offers. Entity structure should be re-evaluated throughout the life of a business—as economic conditions, tax laws, and other external risk factors change; as the number of shareholders grows; as owners enter and exit; and the list goes on.

The good news is that initial and regular consultation with both legal and tax professionals can help business owners avoid all of these missteps.

A DREAM TEAM CAN LEAD YOU TO VICTORY

Engaging only an attorney when setting up a new business is a common mistake. Enti-ty choice is more than just a legal decision; there are important tax implications as well. So it is wise to get a CPA’s advice when forming a new business—as well as for periodic re-evaluation of entity type—to make sure your entity choice is aligned with your growth strategy.

To help you determine the best entity choice for your long-term business goals, assemble an advisory “dream team” that includes tax and legal professionals who understand what scenarios put your personal assets at risk, what protection each entity type offers, and the associated tax implications. With this advisory team in place, you are in a better position to strike the ideal balance between liability protection and tax cost minimization.

Looking for insights and ideas right now? Check out our new Resources Library at www.middletonraines.com/resources for tax tools, calculators, and

a variety of industry-specific information.

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