Business Formations Choosing Your Business Entity

1. www.manetco.com Page 1 Business FormationsChoosing Your Business Entity Randy Hansen Manetco Financial Corp June 1, 2002

2. www.manetco.com Page 2 Problem Conducting business entails a high risk of lawsuits, negligence claims, and personal liability. The U.S. has 7% of the world�s population, and 94% of the world�s lawyers! No other country uses contingency fees as primary reward for attorneys. The U.S. is the most litigious society in the world. Today�s business environment is subject to ever-greater complexity in tax laws. Depending on your business structure, you may be paying more than necessary in tax liabilities. Govt provides benefits to taxpayers who are smart enough to use them. Some businesses pay more taxes than the law requires. The greatest tax liability can be not from what you do, but from what you don�t do. Incorporating a business allows use of tax laws not otherwise available. Solution Choose your business entity wisely!

3. www.manetco.com Page 3 Types of Business Entities Sole Proprietorship Single owner entity, easiest to form and operate, maximum liability General Partnership 2 or more persons own assets together, joint and severally liability Joint Venture Generally used for transactional purposes with 2 or more persons Limited Partnership General partner manages business, limited partner(s) provide capital Limited Liability Partnership Generally for professionals, like a partnership but further limits liability Limited Liability Company Allows �pass-through� like GP but accords limited liability of corporation Corporation Limited liability, separate legal and tax life, constitutional protections �C� corp or sub-chapter �S� tax election

4. www.manetco.com Page 4 Sole Proprietorship Single owner entity � very easy to form and operate, no formalities Liability � unlimited Owner is personally liable for all company obligations & employee actions Owners� risk of loss is unlimited, subject to legal settlement awards If owner is married, community property is also at risk Management � sole discretion of owner Duration � exists as long as owner is competent to manage business Transferability � ownership is easily sold via assets of the business Taxation � all tax liability is at owners personal rate Self employment tax � SS 15.3% wages, no FUI, SUI, or IA on self SE tax is 50% deductible from AGI Most business expense deductions are subject to 2% AGI limit Constitutional Protection Individual rights to due process and counsel

5. www.manetco.com Page 5 General Partnership Multiple owner entity � similar to sole proprietorship but with >1 person Liability � unlimited Partners are personally liable for all obligations & partner actions/torts Partners� risk of loss is unlimited, subject to legal settlement awards If partner is married, community property is also at risk Management � each partner has control, usually vested by agreement Duration � exists as long as partners are want to manage business Transferability � ownership may only be transferred by consent of all pp Taxation � all tax liability is at partners personal rate Partnership is a tax-reporting entity but not a tax-paying entity Self employment tax � SS 15.3% wages, no FUI, SUI, or IA on self SE tax is 50% deductible from AGI Most business expense deductions are subject to 2% AGI limit Constitutional Protection Individual rights to due process and counsel

6. www.manetco.com Page 6 Joint Venture General Partnership typically formed to undertake a particular business transaction or project. Usually has finite life Frequently used in real estate and new product development

7. www.manetco.com Page 7 Limited Partnership Multi-owner entity � General Partner manager / Limited Partner investor Liability � unlimited to GP, limited to capital investment for LP General Partner personally liable for all obligations & partner actions/torts General Partner�s risk of loss is unlimited, subject to legal settlement awards Limited Partner�s risk of loss cannot exceed investment basis Management � general partner has control by agreement Duration � exists as long as General Partner agrees to manage Transferability � ownership may only be transferred by General Partner Taxation � all tax liability is at partners personal rate Partnership is a tax-reporting entity but not a tax-paying entity Self employment tax � SS 15.3% wages, no FUI, SUI, or IA on self SE tax is 50% deductible from AGI Most business expense deductions are subject to 2% AGI limit Constitutional Protection Individual rights to due process and counsel

8. www.manetco.com Page 8 Limited Liability Partnership Multi-owner entity for professionals � hybrid of GP and PSC Liability � affords limited liability to partners like a corporation Management � partner members have control by agreement Duration � exists as long as all partner members agree to manage Transferability � ownership may only be transferred by majority Taxation � all tax liability is at partners personal rate like a GP Constitutional Protection Partnership entity only has rights to due process

9. www.manetco.com Page 9 Corporation Separate legal entity � �C� corp refers to regular state-formed entity Liability � limited Shareholders & Mgt cannot be personally liable for company obligations Shareholders� risk of loss is limited to investment basis Management � broadly controlled Board of Directors elected by Shareholders, appoints management Duration � exists in perpetuity Transferability � ownership is easily transferred via shares of stock Taxation Corporate income tax on net profits � Federal ~34%, State ~9% contingency exemption for accumulated Retained Earnings up $110,000 Employer payroll tax � SS 7.65% wages, F/S UI 3% up to $7K wage/empl Dividends also taxed at shareholder rate (AKA �Double Taxation�) Personal Property tax � exemption in Maricopa County up to $55,000 Constitutional Protection Right to due process/counsel, no privilege against self-incrimination

10. www.manetco.com Page 10 �S� Corp A �C� corp that has filed a �sub-chapter S� election with IRS Only exists for tax purposes, does not otherwise impact corporate operation Election must be requested within 75 days of inception Limited to 75 non-commercial shareholders, may only have 1 class of stock Shareholders must be U.S. residents or resident aliens Taxation P&L usually pass-through to shareholders, though some separately stated Shareholders realize profits as ordinary income Losses are limited to shareholder�s basis, S/H must materially participate Personal Property tax � exemption in Maricopa County up to $55,000 May not retain earnings Limited provision on fringe benefits to employees

11. www.manetco.com Page 11 Limited Liability Company Separate legal entity � hybrid between partnership and corporation Liability � limited Members & Mgt cannot be personally liable for company obligations Members� risk of loss is limited to investment basis Management � closely controlled Usually member controlled, though members may appoint management Duration � Some states limit time, but exists in perpetuity in AZ Transferability � may only be transferred on consent of majority interest Taxation � not taxed as an entity, reports to shareholders Pass-through treatment of P&L like an �S� corp if multiple members Single-member LLCs report income on Schedule C Working members pay self employment tax, passive members do not Personal property tax � exemption in Maricopa County up to $55,000 Constitutional Protection Right to due process/counsel, no privilege against self-incrimination

12. www.manetco.com Page 12 Summary of Business Types

13. www.manetco.com Page 13 Perceptions Delaware Corporations Very flexible statutory laws allowing ease of operation Certain shareholder claims and actions may be limited Now regulated by a corporation commission State income tax at corporate level (~9%) Also requires franchise tax (~$200) �S� Corp election requires owner in-state residence Nevada Corporations Annual corporation maintenance cost = $85. No state income tax No corporation commission No IRS or shareholder reporting Maximum flexibility in ownership transfer Madonna, Prince, Michael Jackson, Chevy Chase all incorporated in NV Out of State Corporations are considered �foreign� in Arizona Additional filing requirements and fees (up to ~$400/yr) Statutory agent and domicile requirements for state of incorporation ($200+)

14. www.manetco.com Page 14 Benefits of C Corporations Income Splitting Optimally allocate income between Corporation and Shareholders Usually benefits higher tax bracket wage earners Fringe Benefits Usually at least partially if not completely tax-free to recipients Usually tax deductible to the corporation Must be made equally available to all employees of a class Dividends From Other Corporations Dividends from non-related corporations are 70% tax-free Normal corporate rate applies to remaining 30% IRC 1202 - Capital Gains to Shareholders 50% of gain on the sale of qualified stock is tax-free if held > 5 years 80% of corporate assets must be used in conduct of business

15. www.manetco.com Page 15 General Tax Impact Sole Proprietorships offer maximum flexibility in passing income through to children (under 18) free of FICA taxes �C� Corps have maximum flexibility to deduct expenses and provide fringe benefits �S� Corps are often advantageous if 1 spouse works a traditional J.O.B. Health insurance provided by working spouse Favorable treatment of long-term gains from corporation LLCs are slightly more flexible than �S� corps allocation of income lower state filing fees and operating costs Note: uncertainty of legal precedent

16. www.manetco.com Page 16 �Corporate Mechanics� Formation ($250 +) Check name availability � reserve as needed ($0 - $500) File Articles of Incorporation with ACC ($50-$65) Publish AOI-paper of general circulation for 3 consecutive pubs ($150-$200) Apply for Federal TIN, ADOR ID, ADES Withholding license ($0) Fund the entity if a corporation (issue stock) File IRS sub-chapter �S� election within 75 days if appropriate Apply for local permits and city licenses as needed ($25-$50) Adopt Bylaws, appoint Board of Directors and Management team ($0) Establish corporate records book and corporate seal Articles, Bylaws, meeting minutes, shareholder records, executive decisions Maintenance ($50 - $100/yr) File annual reports with ACC ($45) Maintain business licenses ($10 - $50) Conduct shareholder meetings, maintain corporate records Termination File Articles of Dissolution with ACC ($50-$65) Advise IRS & State agencies of �Final Filing� on returns

17. www.manetco.com Page 17 Tax Concerns Payroll Taxes Withhold and remit payroll taxes to proper tax authority FICA withhold 7.65% from employee plus 7.65% employer match Personal income, per IRS/state withholding tables Unemployment insurance (FUI/SUI) ~3-4% of first $7,000 per employee Industrial accident (IA) Req�d for employees but not for owner/operators Trust Fund Recovery Penalty allows IRS to substantiate personal liability Corporate Income Tax (only on retained earnings) 15% to $50K, 25% to $75K, 34% to $100K, 39% to $335K, 34-38% $335K+ Independent Contractor Vs. Statutory Employee? Statutory employee is supervised and adheres to employer rules/guidelines Independent contractor is self-directed, working with minimal mgt direction Management personnel are required to be statutory (work for BOD) Use an employment agreement if receiving third party contract pay Statutory employees are subject to payroll withholding taxes Independent Contractors are not subject to withholding taxes Keep ALL employee and contractor records!

18. www.manetco.com Page 18 Record Keeping IRS does not prescribe any record keeping method as long as records accurately reflect the business� operations Take record keeping seriously, otherwise you invite disaster! If IRS finds insufficient records in an audit they may disallow deductions Records are vital at year end to determine business taxes DO NOT rely on your memory, use day planner, journal, etc. Do it yourself or hire someone, but JUST DO IT! Expect average rates of $50-$100/month depending on services Tax deductible, let Uncle Sam �subsidize� the expense Organize Expenses by category (file folders, envelopes, etc) Maintain records for 3 years minimum, up to 7 yrs if possible Reimbursement plans should be �accountable� plans General records that must be saved Income sources, expense receipts, asset records, mileage/contact logs Electronic records are acceptable, but may need hardcopy to substantiate The more detailed the better, avoid time �gaps�

19. www.manetco.com Page 19 Deductible Expenses Any expense that is reasonably necessary for operation of the business Useful life < 1 year or <$80,000 - otherwise must be depreciated Salaries, T&E, meals (50%), For T&E spouses must be employed or have legitimate business reason Rents, utilities Car expenses, repairs and maintenance (pro-rated or standard allowance) Bad Debts Taxes, licenses, interest, depreciation Advertising Clubs, professional associations, subscriptions Marketing spiffs and qualified award plans Fringe benefit plans Life/health insurance, retirement plans, education, child care, tax prep, legal plans Home office deductions

20. www.manetco.com Page 20 Tax Strategies Lending money to your corporation Must have adequate capitalization Repayment must be on fixed terms Interest rate must be reasonable (market based) Hold company stock beyond 1 year for LT capital gain Lease personal assets to your corporation Must be an operating lease, not a capital lease Must have fixed terms and periodic payments Property may also be depreciated on your personal tax return Borrow money from your corporation Must have fixed amortization with unconditional repayment terms. Must be collateralized and assignable May be interest free up to $10,000 � otherwise market rate Pitfalls Undercapitalized, poor record keeping, co-mingled assets Personal Holding Company tax if > 60% passive revenue Accumulated Earnings tax on R/E in excess of $250,000 (also AMT)

21. www.manetco.com Page 21 Small Business Assistance Tax Attorneys (most expensive) 3 years post-bac study in law with emphasis on taxation CPAs Bachelor�s degree in accounting and completion of standardized exam Enrolled Agents 80 hours of IRS approved TAX training & completion of standardized exam Accountants May or may not be formally trained, no specific criteria Book-keeping/payroll services May or may not be formally trained, no specific criteria Tax Software (least expensive) Generally requires a minimal aptitude for tax and accounting procedures Non-profit & government agencies AZ Department of Commerce, Arizona Small Business Association S.C.O.R.E. Local Chambers of Commerce