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Identifying the Objectives Items To consider
What’s at Risk?
Tax SavingsAsset ProtectionManagementCapitalizationExit Strategies
Chances of IRS AuditF.Y. 06
Form 1040 Sch. ‘C’ > $100,000 = 3.90%1120 < 10 Mill. Assets = .80%1120-S = .38% 1065 = .36%
Management
Will management be expanded?
How will management disputes be resolved?
How will they be compensated? Equity participation Compensation Additional fringe benefits
Capitalization – What Form Should it Take?
Initial Capitalization
Debt Bank loans Home equity loans Family and friends
Equity Corporation- stock Partnership- partner interest Limited liability company- member
interest
DebtPros Interest tax deductible No ownership dilution Flexible rates and terms Increases return on equity Establishes credit ratingCons Personal guarantees Monthly periodic payments
EquityPros Minimum cash outflows Ease of transfer Large source of capitalCon Ownership dilution
Tax Tip
On corporations capitalize for the least amount possible.
Have company “borrow money” from you.Example
$1,000 Stock$99,000 Loan
$100,000 Total Capital
Exit StrategiesCompany
Stock redemptions
Competitor
Merger
Acquisition
Asset sale
Stock sale
Family members
Gifting
Death transfers
Acquisition
Management
Management buy-out (MBO)
Management buy-in (MBI)
Proprietorships – Non Tax Considerations
Simplicity of form
Unlimited personal liability
Continuity of existence and transferability of ownership
Limited ownership
Proprietorships – Tax Considerations
Tax Advantages
Wages paid to children
At-risk rulesFringe benefit via
spouse employmentNo double taxation
Tax Disadvantages
Self-employment taxAll income taxed at
individual levelLack of fringe
benefitsHobby loss rule
Proprietorships – Taxation
Tax rate depends on filing statusNo withholding requirements15.3% self-employment taxTotal net income determines income tax & Social
Security liabilitiesFile Schedule C with 1040: Business profit & loss
Taxation of LLCSingle Member LLC: Disregarded Entity
Rev Ruling 99-5; 99-6 SMLLC – Husband or Husband & Spouse Reported on Form 1040 Can not have any other unrelated owner
“Check the Box” Rules Partnership taxation is default (minimum two members) May choose to be taxed as a corporation
S Corp or C Corp
Real Estate Tip
For Maximum Asset Protection Separate SMLLC for each property.
Put Real Estate in SMLLC.
Partnership – Formation Issues
Partnership agreement or operating agreement Buy/Sell agreement Contributions of Assets Limited Life Liability Issues LLP vs. General Partnership
Partnership – Tax Considerations
Tax AdvantagesTax basis from debtBasis adjustment when
partnership interest acquired
Tax-free contributions and distributions of property
Ability to make special elections
No entity level of tax
Tax DisadvantagesInability to reduce payroll
taxesUnfavorable tax treatment
of fringe benefitsLack of flexibility to select
a tax year endTechnical Termination
Partnership Taxation – Summary
IRS Form 1065Generates K-1No “double taxation”Self-employment taxInformational tax return: entity does not pay taxTaxed at partner levelIncome is taxable for FICA
S Corporation – Tax Considerations
Tax AdvantagesNo double taxationPass-through to shareholdersNo excessive compensationAbility to reduce payroll taxesAbility to use cash methodTax-free withdrawals of equityPossible ordinary loss
treatment for stock losses
Tax DisadvantagesFringe benefitsTax year-endBuilt-in gains taxExcess passive incomeBasis is reduced even if
no tax benefit
‘S’ CorporationWho Can Be Shareholder?
U.S. citizenEstatesSingle Member LLC 501 (c) (3) CharitiesQualified Pension plansQualified Profit Sharing plans
‘S’ CorporationWho Can not Be shareholder?
CorporationsPartnershipsLLC’s (not SMLLC)IRA’S & Roth’sSep IRA’s & SIMPLE IRA’sNon-Resident Aliens
S Corporation Taxation – Summary
Must make election: Form 2553Files Form 1120-SGenerates K-1Informational returnTaxed at shareholder levelIncome tax only on proportionate share of income:
No FICANo corporate tax on sale of assets or liquidation
Partnership vs. S Corp– Treatment
Social Security
General partners pay FICA on K-1 income
Shareholders S Corp K-1 income: no FICA
Social SecurityHow Much Does Sub ‘S’ Owner Pay?
In 2000 78.9% of ‘S’ - more than 50% owned by single shareholder.
Compensation To be Reasonable36,00 taxpayers > $100,000 profits = 0
compensation.2001 – Owner salaries 41.5% of operating profits.2000 – ‘S’ corporations paid 5.7 billion less than if
sole proprietors
Partnership vs. S Corp – TreatmentDistributionsPartnership:
disproportionate distributions allowed
S Corp: no disproportionate distributions
Ownership InterestS Corp: ownership restrictedNo more than 100 shareholdersIndividuals, estates, certain
types of trustsNo foreign shareholdersOnly one class of stock allowedPartnership: no restrictions
C Corporations – Non Tax Considerations
Limited liabilityAdministrative burdenManagement and controlContinuity of existence and transferability of
ownership
C Corporations – Tax Considerations
Tax AdvantagesLower tax rates at
many income levelsNet income not
subject to Social Security
Takes maximum advantage of fringe benefit deductions
Tax Disadvantages
Double taxation of corporate earnings
Excessive compensationPersonal service corporate
limitationsPersonal holding company
accumulated earnings tax- penalty taxes
Limitations caused by corporate ownership changes
C Corporation – Employee Benefits
SalariesReasonable salariesGarnishment limitations
Medical benefitsMedical reimbursement plansHealth savings accounts
Retirement benefitsEducational benefitsOther benefits
C Corporations – Taxation
Separate entity – separate taxpayerFiles IRS Form 1120Calendar or fiscal yearDividends not deductible: double tax on profitsIsolates state operations for nexus
PayrollSalesProperty
Proprietorship
S Corporati
on
C Corporat
ion
Business Income $90,000 $90,000 $90,000
W-2 Income - $45,000 $45,000
Net Business Income
$90,000 $45,000 $45,000
Corporate Tax $ - $ - $6,750
Personal Tax $10,136 $11,736 $3,564
FICA & Medicare $12,718 $6,885 $6,885
TOTAL TAXES $22,854 $18,621 $17,199
MFJ, SD, & Expt
Making the Decision