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 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 The “sole-less person”

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 Owner Owner gets $77,750 Less 15% dividends tax rate = $11,168 Cash after taxes = $66,582 Cash dividends to owner

12. Sole Proprietorship, LLC, (Partnership) by-pass Sole proprietorship, LLC Taxable income = $100,000 No tax – Cash after tax = $100,000 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 Income and cash flows to owner

13. S-corporation by-pass S-corporation Taxable income = $100,000 No tax – cash after tax = $100,000 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 Income and cash flows to owner

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 Feb. 1 Jan. 1 Dec. 31 Jan. 31 Corporation The owner Profits = $100,000

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 Assume that the auto is used 50% for business Total auto expense this year is $10,000 Business owner (sole proprietor) Owner/employee (corporation)

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 Business owner (sole proprietor) Owner/employee (corporation) Group-term life insurance (up to $50,000)

26. Qualified Fringe Benefit examples 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

27. Property transfers Property transfer: owner business usually tax-free Property transfer: business owner usually tax-free –For a Sole proprietorship, partnership, LLC, LLP Property transfer: business owner usually taxable –For a Corporation

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

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

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

31. Example: tomorrow Corporation Taxable income = $800,000 Owner Real estate FMV = $1 million Tax cost = $1,000,000 The owner takes it back! 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 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 NowThe dream Owned by Ma & Pa

34. Ma & Pa Kettle sells the land to a 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 SellSeparate entity owned by Ma & Pa Kettle Total after-tax cash = $3.35 million Ma & Pa Kettle Owned by Ma & PaOwned by separate entity

35. Now... What should be the entity (for the 1 st 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. Now... should it be an S or C corporation (for the 2 nd sale)? 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

37. Fill out the election, Pa

38. And that’s a Plan!