Tax and Business Entities

1. Tax and Business Entities Decisions, decisions, decisions!

2. Choice of Entity • Compare five major entities: • Sole proprietorships • Partnerships (general and limited) • LLCs • S corporations • C corporations • Tax planning opportunities

3. Sole proprietorship • One owner – non-incorporated • Form 1040 – part of the individual package • Individual tax rates • The owner and business have same tax year • Formation is easy and tax-free • Dissolution is easy and generally tax-free • Tax-free distributions • Unlimited liability Sole Proprietorship

4. Partnership/LLC • 2 or more owners (1 for LLC, 2 for LLP) • Flow through of profit and loss to the owners • Tax is at the owners’ level and tax rates • Same tax year as the owners • Formation is usually tax-free • Dissolution usually tax-free • ‘Usually’ tax-free distributions • Limited liability (except for general partners in a general partnership) Partnership: More than one “sole”!

7. S-Corporation • Limited ownership • ‘Usually’ no tax at the corporate level • Tax is at the owner’s level and tax rates • S-Corp is usually on a calendar year • Tricky rules at a corporate formation • Dissolutions are usually taxable • Distributions are usually tax-free • Limited liability to the owners The Corporate Entity – with a window to the shareholders!

8. S-corporation election

9. C Corporation The “sole-less person” • No restrictions on the type of owner • Separate tax rates for a C Corp • Possible double tax at corporate rates and the owners’ rates • Unrestricted on choice of tax year (almost) • Corps have tricky tax issues at formation • Dissolutions are usually taxable • Distributions are usually taxable

10. Using entities to shift income and employment taxes • Choice of entity can make all the difference

11. C-Corporate double-tax Corporation Taxable income = $100,000 Less tax = $ 22,250 Cash after taxes = $ 77,750 Cash dividends to owner Owner Owner gets $77,750 Less 15% dividends tax rate = $11,168 Cash after taxes = $66,582

12. Sole Proprietorship, LLC, (Partnership) by-pass Sole proprietorship, LLC Taxable income = $100,000 No tax – Cash after tax = $100,000 Income and cash flows to owner Owner Owner gets $100,000 (assume it’s his or her only taxable income) Income tax = $20,401 Self employment taxes = $13,800 Total taxes $34,201 Cash after taxes = $65,799

13. S-corporation by-pass S-corporation Taxable income = $100,000 No tax – cash after tax = $100,000 Income and cash flows to owner Owner Owner gets $100,000 (assume his or her only taxable income) Income tax = $20,401 Employment taxes = $13,800 Total taxes $20,401 Cash after taxes = $79,599

14. C corporation salary ploy C-Corporation Taxable income = $100,000 Pay salary to owner of ( $100,000 ) Taxable income = $0 Salary to owner Owner Owner gets $100,000 (assume it’s his or her only taxable income) Income tax (single) = $20,401 Employment taxes = $13,800 Total taxes $34,201 Cash after taxes = $65,799

15. C corporation rental ploy C-Corporation Taxable income = $100,000 Pay rents to owner of ( $100,000 ) Taxable income = $0 Rental income to owner Owner Owner gets $100,000 (assume his or her only taxable income) Income tax = $20,401 Employment taxes = $13,800 Total taxes $20,401 Cash after taxes = $79,599

16. C corporation timing ploy • Using C-corp year-end flexibility to defer income • Example: Cash basis, January 31 year-end and salaries Profits = $100,000 Feb. 1 Corporation Jan. 31 The owner Jan. 1 Dec. 31

17. The family business ploy Sole proprietorship Taxable income = $100,000 No salary to owner’s children ( $ -0- ) Taxable income = $100,000 Total taxes MFJ (income and self empl) $ 28,300 Cash after taxes = $ 71,700 Two children (under 18) Children get $ -0- Income tax = $ -0- Employment taxes = $ -0- Cash after taxes = $ -0- Total after tax cash = $71,700

18. The family business ploy Sole proprietorship Taxable income = $100,000 Pay salary to owner’s children ( $ 50,000 ) Taxable income = $ 50,000 Total taxes (income and employment) $ 12,050 Cash after taxes = $ 37,950 Two children (under 18) Children get $50,000 (assume it’s their only taxable income) Income tax = $5,330 Employment taxes = $ -0- Cash after taxes = $46,670 Total after tax cash = $84,620

19. C corporation and losses C-Corporation Taxable loss = ( $100,000 ) Tax $ -0- Owner Suppose the owner has $150,000 of taxable earned income Income tax (single) = $34,401 Employment taxes = $15,250 Total taxes $49,651 Cash after taxes = $100,349

20. S corporation and losses S-Corporation Taxable loss = ( $100,000 ) Tax $ -0- Owner (still has $150,000 taxable earned income) Now the owner has $50,000 of taxable income Income tax (single) = $ 7,251 Employment taxes = $ 15,250 Total taxes $ 22,501 Cash after taxes = $127,499

21. Sole proprietorship and losses Sole proprietorship Taxable loss = ( $100,000 ) Tax $ -0- Owner (still has $150,000 taxable earned income) Now the owner has $50,000 of taxable income and SE income Income tax (single) = $ 7,251 Employment taxes = $ 7,650 Total taxes $ 14,901 Cash after taxes = $135,099

22. Using the “employee” status of an owner • A business owner cannot be an employee of his or her: • Sole proprietorship • Partnership • LLC or LLP • A business owner can be an employee of his or her • C Corporation • S Corporation

23. And “employee” status has some curious implications • Salaries and regular compensation • Income to the employee • Deductible tax expense to the company • Qualified fringe benefits • Tax exempt (or deferred) income to the employee • Deductible tax expense to the company

24. Example: Non-qualified fringe benefit Sole proprietorship Deductible tax expense = $5,000 Corporation Deductible tax expense = $10,000 Owner/employee reports taxable income for the fringe benefit Owner/employee (corporation) Business owner (sole proprietor) Assume that the auto is used 50% for business Total auto expense this year is $10,000

25. Example: Qualified fringe benefit Sole proprietorship Deductible tax expense = $-0- for the owner Corporation Deductible tax expense = $cost of insurance No taxable income for the owner/employee Owner/employee (corporation) Business owner (sole proprietor) Group-term life insurance (up to $50,000)

26. C Corporation Accident & health plans Group term life insurance Meals & lodging Dependent care assistance Educational assistance Workers comp Adoption assistance program Employment achievement award No additional cost service Qualified employee discount Working condition fringe De minimis fringe On-premise athletic facilities S Corporation Dependent care assistance Educational assistance Workers comp Adoption assistance program Employment achievement award No additional cost service Qualified employee discount Working condition fringe De minimis fringe On-premise athletic facilities Qualified Fringe Benefit examples

27. Property transfers • Property transfer: ownerbusinessusually tax-free • Property transfer: businessownerusually tax-free • For a Sole proprietorship, partnership, LLC, LLP • Property transfer: businessownerusually taxable • For a Corporation

28. Example: today Sole proprietorship, Partnership, LLC, or LLP The business “tax cost” of RE is $200,000 No Tax on the transfer Real estate FMV = $1 million Cost = $200,000 Owner

29. Example: tomorrow Sole proprietorship, Partnership, LLC, or LLP The owner takes it back! No Tax on the transfer Real estate FMV = $1 million Cost = $200,000 (still!) Owner

30. Example: today Corporation The business “tax cost” of RE is $200,000 No Tax on the transfer Real estate FMV = $1 million Cost = $200,000 Owner

31. Example: tomorrow Corporation Taxable income = $800,000 The owner takes it back! Real estate FMV = $1 million Tax cost = $1,000,000 Owner Taxable income = $1,000,000

32. How to use the tax rates • Ordinary tax rates • Highest marginal federal tax rate = 35% • Examples: Wages, interest income, sale of inventory • Long-term capital gains • Highest marginal federal tax rate = 15% • Examples: Sale of stocks, investments

33. Ma & Pa Kettle owns the land as individuals Owned by Ma & Pa Owned by Ma & Pa Land (40 acres) LTCG asset (15% tax) FMV = $3 million Tax cost = $1 million If sold, tax = $300,000 After-tax cash = $2.7 million Land (40 one-acre parcels) Inventory asset (35% tax) FMV = $4 million Tax cost = $1 million If sold, tax = $1,050,000 After-tax cash = $2.95 million Now The dream

34. Ma & Pa Kettle sells the land to a separate entity Owned by Ma & Pa Owned by separate entity Land (40 acres) LTCG asset (15% tax) FMV = $3 million Tax cost = $1 million Sold, tax = $300,000 After-tax cash = $2.7 million Land (40 one-acre parcels) Inventory asset (35% tax) FMV = $4 million Tax cost = $3 million Sold, tax = $350,000 After-tax cash = $675,000 Ma & Pa Kettle Sell Separate entity owned by Ma & Pa Kettle Total after-tax cash = $3.35 million

35. Now . . . What should be the entity (for the 1st sale)? • Two relevant tax code sections: • Sales of property between a >50% owner and a partnership result in ordinary income tax, not capital gains [IRC §707(b)(2)] • Sales of depreciable property between a >50% owner of any entity result in ordinary income tax, not capital gains [IRC §1239]

36. C corporation $1 million gain $340,000 corporate tax $660,000 cash distribution $99,000 tax on dividends Total tax = $439,000 on the $1 million gain S corporation $1 million gain No corporate tax $1 million gain and cash distributed to Ma & Pa Total tax to Ma & Pa = $350,000 on the $1 million gain Now . . . should it be an S or C corporation (for the 2nd sale)?

37. Fill out the election, Pa

38. And that’s a Plan!