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Choice of Business Entity
Jack Cohen, CPA Asset Protection IncSmart.biz Inc
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Types of Entities C CORPORATION S CORPORATION LLC PARTNERSHIP SOLE
What would it be like to be able to choose the way you report and pay taxes? SOLE PROPRIETOR
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Identifying the Objectives Items To consider What’s at Risk?
Tax Savings Asset Protection Management Capitalization Exit Strategies
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Chances of IRS Audit F.Y. 06 Form 1040 Sch. ‘C’ > $100,000 = 3.90%
1120 < 10 Mill. Assets = .80% 1120-S = .38% 1065 = .36%
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Tax Savings Income Tax Payroll Taxes Self Employment
Gift and Estate Taxes
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Asset Protection From:
Business Activities Risk Management Actions Employee Actions
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Management Will management be expanded?
How will management disputes be resolved? How will they be compensated? Equity participation Compensation Additional fringe benefits
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Capitalization – What Form Should it Take?
Debt Pros Interest tax deductible No ownership dilution Flexible rates and terms Increases return on equity Establishes credit rating Cons Personal guarantees Monthly periodic payments Equity Minimum cash outflows Ease of transfer Large source of capital Con Ownership dilution Initial Capitalization Debt Bank loans Home equity loans Family and friends Equity Corporation- stock Partnership- partner interest Limited liability company- member interest
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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
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Exit Strategies Company Family members Stock redemptions Gifting
Competitor Merger Acquisition Asset sale Stock sale Family members Gifting Death transfers Acquisition Management Management buy-out (MBO) Management buy-in (MBI)
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Proprietorships – Non Tax Considerations
Simplicity of form Unlimited personal liability Continuity of existence and transferability of ownership Limited ownership
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Proprietorships – Tax Considerations
Tax Advantages Wages paid to children At-risk rules Fringe benefit via spouse employment No double taxation Tax Disadvantages Self-employment tax All income taxed at individual level Lack of fringe benefits Hobby loss rule
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Proprietorships – Taxation
Tax rate depends on filing status No withholding requirements 15.3% self-employment tax Total net income determines income tax & Social Security liabilities File Schedule C with 1040: Business profit & loss Filing Status: Married, Single, Joint, Head of Household – different rates & thresholds Self Employment Tax: Employer portion of Medicare and FICA
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Taxation of LLC Rev Ruling 99-5; 99-6 SMLLC – Husband or
Single 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
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Real Estate Tip For Maximum Asset Protection Separate SMLLC for each property. Put Real Estate in SMLLC.
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Partnership – Formation Issues
Partnership agreement or operating agreement Buy/Sell agreement Contributions of Assets Limited Life Liability Issues LLP vs. General Partnership
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Partnership – Tax Considerations
Tax Disadvantages Inability to reduce payroll taxes Unfavorable tax treatment of fringe benefits Lack of flexibility to select a tax year end Technical Termination Tax Advantages Tax basis from debt Basis adjustment when partnership interest acquired Tax-free contributions and distributions of property Ability to make special elections No entity level of tax
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Partnership Taxation – Summary
IRS Form 1065 Generates K-1 No “double taxation” Self-employment tax Informational tax return: entity does not pay tax Taxed at partner level Income is taxable for FICA
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S Corporation – Tax Considerations
Tax Disadvantages Fringe benefits Tax year-end Built-in gains tax Excess passive income Basis is reduced even if no tax benefit Tax Advantages No double taxation Pass-through to shareholders No excessive compensation Ability to reduce payroll taxes Ability to use cash method Tax-free withdrawals of equity Possible ordinary loss treatment for stock losses
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‘S’ Corporation Who Can Be Shareholder?
U.S. citizen Estates Single Member LLC 501 (c) (3) Charities Qualified Pension plans Qualified Profit Sharing plans
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‘S’ Corporation Who Can not Be shareholder?
Corporations Partnerships LLC’s (not SMLLC) IRA’S & Roth’s Sep IRA’s & SIMPLE IRA’s Non-Resident Aliens
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S Corporation Taxation – Summary
Must make election: Form 2553 Files Form 1120-S Generates K-1 Informational return Taxed at shareholder level Income tax only on proportionate share of income: No FICA No corporate tax on sale of assets or liquidation 2553: Community Property States require both spouses signatures
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Partnership vs. S Corp– Treatment
Social Security General partners pay FICA on K-1 income Shareholders S Corp K-1 income: no FICA
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Social Security How Much Does Sub ‘S’ Owner Pay?
In % of ‘S’ - more than 50% owned by single shareholder. Compensation To be Reasonable 36,00 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
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Partnership vs. S Corp – Treatment
Ownership Interest S Corp: ownership restricted No more than 100 shareholders Individuals, estates, certain types of trusts No foreign shareholders Only one class of stock allowed Partnership: no restrictions Distributions Partnership: disproportionate distributions allowed S Corp: no disproportionate distributions
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C Corporations – Non Tax Considerations
Limited liability Administrative burden Management and control Continuity of existence and transferability of ownership
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C Corporations – Tax Considerations
Tax Advantages Lower tax rates at many income levels Net income not subject to Social Security Takes maximum advantage of fringe benefit deductions Tax Disadvantages Double taxation of corporate earnings Excessive compensation Personal service corporate limitations Personal holding company accumulated earnings tax- penalty taxes Limitations caused by corporate ownership changes
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C Corporation – Employee Benefits
Salaries Reasonable salaries Garnishment limitations Medical benefits Medical reimbursement plans Health savings accounts Retirement benefits Educational benefits Other benefits
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C Corporations – Taxation
Separate entity – separate taxpayer Files IRS Form 1120 Calendar or fiscal year Dividends not deductible: double tax on profits Isolates state operations for nexus Payroll Sales Property
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Making the Decision Proprietorship S Corporation C Corporation
Proprietorship S Corporation C Corporation Business Income $90,000 W-2 Income - $45,000 Net Business Income Corporate Tax $ - $6,750 Personal Tax $10,136 $11,736 $3,564 FICA & Medicare $12,718 $6,885 TOTAL TAXES $22,854 $18,621 $17,199 MFJ, SD, & Expt
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