1. From Partnership to Corp: Option 1 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-1 Corp Stock Tax Impacts: No gain or loss recognized Partnership’s asset basis transfers to C corp Partnership terminated Owner’s stock basis equals basis in partnership interest (adjusted for debt transfers to corp) Owners not original issuees – 1244 impact and potential S election impact in year 1 Owners Partnership Assets & liabilities Stock in liquidation

2. From Partnership to Corp: Option 2 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-2 Corp Stock Tax Impacts: No gain or loss to Partnership or Corp Partnership terminated No gain or loss to owners unless money in excess of basis is distributed Owners’ basis in assets equal basis in partnership interests, which carries over to Corp and determines Owners’ basis in stock Owners original issuees of stock Owners Partnership Assets & liabilities Assets and liabilities in liquidation

3. From Partnership to Corp: Option 3 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-3 Corp Stock Tax Impacts: No gain or loss to Partnership or Owners Partnership terminated No gain or loss to Corp unless money in excess of basis is distributed Owners’ basis in stock equals basis in partnership interests, which carries over to Corp and determines Corp’s basis in assets Owners original issuees of stock Owners Partnership Partnership Interests Assets and liabilities in liquidation

4. Check The Box No need to form corp or transfer assets and liabilities Entity remains the same – only tax status changes Reduces paperwork and third party hassles Tax consequences same as option 1- Partnership contribution followed by Partnership liquidation No corporate “trappings” benefits No S status capacity No tax-preferred employee benefits to owner/employees Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-4 From Partnership to Corp: Option 4

5. Piece of Cake No entity change nor need to transfer assets and liabilities Entity remains the same – only tax status changes Revoke S election (takes majority) or cease to qualify as S Specify effective date to ease accounting and tax hassles. Default date is first day of next taxable year unless revocation before 15 th day of 3 rd month of current year Mid-year effective date creates short S year and short C year – allocation options No election back into S status for 5 yrs Bailout S earnings that have already been taxed to shareholders – 1371(e) one year bailout period Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-5 From S status C status

6. Problem 5-A: Colson Inc. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-6 C Corp Three Golfer Owners Two Limited Partnerships One Toiler Owner Two Golfer Owners Common & Preferred Big Loans Common & Preferred Common & Preferred Challenge: Convert to Pass Thru Entity

7. Convert to LLC or Partnership? Prohibitively tax expensive Full recognition of all asset gains at corporate level Full recognition of capital gains at shareholder level S corp only viable option Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-7 Problem 5-A: Colson Inc.

8. Election Mechanics Election effective on first day of following year 2 ½ month retroactive election not possible because not eligible shareholder on 1 st day of current year Must be eligible for S at time of election – no disqualified shareholders or 2 nd class of stock S tax year calendar year unless sustain business purpose proof burden for fiscal year All shareholders must consent (Form 2553) – community and joint interest owners Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-8 Problem 5-A: Colson Inc.

9. S Eligibility Problems Limited partnerships not eligible S shareholders Preferred stock not permitted with S status Shareholder loans could trigger one class of stock requirement Any stock options held by toiler owner or other owners could violate one class of stock requirement Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-9 Problem 5-A: Colson Inc.

10. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-10 Getting rid of ineligible shareholders: Partnership shareholders: Redeem stock or have stock distributed to eligible partners Corporate Shareholder: Redeem stock; merge or reorganize to eliminate corporate shareholder; have corporate shareholder distribute or sell stock to eligible S shareholders Non-qualified trusts and estates: Redeem stock or distribute to qualified S shareholders C to S Conversion: Getting Eligible

11. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-11 Getting rid of second class of stock issues: Preferred stock: Redeem or E Reorg (“Reclassification”) Risky debt: Reform to fit within safe harbor of 1361(c)(5)(B) Options and warrants “in the money”: Buy back or have them exercised. Options and warrants “not in money”: Make sure strike price is at least 90% of FMV. May present too tough of a valuation issue. Best course may be to buy back or trigger exercise. C to S Conversion: Getting Eligible

12. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-12 Nothing Too Tough: Written unconditional promise to pay on demand or at time certain Interest rate and payments not contingent on profits, discretion, etc. Debt not convertible to stock Creditor eligible S shareholder or party in business of loaning money Note: Safe Harbor protects only S election – has no impact on broader tax debt-equity issues Debt Safe Harbor of 1361(c) (5) (B)

13. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-13 1.LIFO Inventory Trap – LIFO inventory reserve recaptured over four years 2.C Corp E & P Trap – Post-conversion distributions in excess of S corp accumulated adjustment account will trigger taxable dividends to shareholders to extend of C corp E & P 3.The Passive Income Trap of 1375 4.The BIG Tax Trap of 1374 Potential Conversion Tax Traps

14. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-14 Royalties Dividends Interest Annuities Sales or exchanges of stocks or securities Note: Looks more like portfolio income. But for 1375 purposes, called “passive income” DO NOT CONFUSE WITH 469 PASSIVE INCOME S Passive Income – Not Like the Other Passive

15. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-15 Passive Income S Penalties Penalty One : S Corp has accumulated earnings and profits for three years and passive S receipts more than 25% total receipts. S election terminated. 1362(d)(3) Penalty Two: S Corp has accumulated earnings and profits and passive S receipts more than 25% total receipts. Entity level tax equal to 35% of “excess net passive income.” How to calculate: - First, “net passive income” = passive income less passive expenses - Second, ratio with numerator equal passive income over 25% of gross receipts and denominator equal to total passive income - Third, multiple “net passive income” by ratio to arrive at “excess passive income” - Limit – excess passive income can’t exceed corp’s taxable income

16. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-16 1.Be aware – keep an eye on receipts 2.Bail accumulated C Corp E & P at 15% rate with 1368(e)(3) election 3.Distribute or sell investments that trigger passive S to get below 25% 4.Increase active receipts relative to passive – do more business or stick additional operation or active business in S Stay Clear of Passive S Penalties

17. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-17 C to S: The “BIG” Tax Trap Huge exception to “no entity tax” rule Applies only when C corp has converted to S corp Purpose is to limit ability to convert and then sell and strip income with no double tax hit “BIG” stands for “Built-in-Gain” May also have built-in loss Major factor in converting from C to S corp. Although BIG tax can be rough, nothing compared to going from C Corp to partnership or LLC

18. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-18 How “BIG” Trap Works Determine built-in gain or loss at time of conversion for all assets. This is gap between FMV and basis. Requires appraisals If asset sold during 10 years after conversion (“recognition period”), any gain or loss recognized up to “Built-in” amount taxed at corporate level Tax rate is highest corporate rate – 35% Income still taxed at shareholder level, but BIG tax treated as loss. 1366(f)(2) BIG income may not exceed corp income for year if taxed as C corp. Carry forward any excess

19. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-19 How “BIG” Trap Works BIG income from any sale may not exceed total BIG income at conversion less BIG income previously recognized. Carry-over BIG income potential in non-recognition transactions (i.e. 1031, 1034), tax-free corporate reorgs. Installment sales during 10 year period that defers income beyond ten year window doesn’t help. Recognition period extended. Recognized BIG losses during 10 year window can offset recognized BIG income.

20. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-20 Convert early, carefully document assets at conversion Pre-conversion – hang onto losers, but watch out for “loss stuffing” Collect zero basis receivables before conversion. May require factoring Accrue bonuses and similar expenses prior to conversion – counts in reducing total built-in amount at conversion Match BIGs and BILs during 10 year recognition period to extent possible Use non-recognition transaction (1031, 1033) to get through non-recognition period Work goodwill/going concern valuation Strategies to Mitigate BIG Tax

21. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-21 No termination of partnership for tax purposes under 708 No sale, exchange or liquidation of owners’ interests No close of the entity’s tax year No tax year close with respect to any owner No need to obtain new federal tax ID number From Partnership to LLC Status (Rev. Rule 95-37)

22. Problem 5-B: Larson Electronics, LLC Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-22 LLC 80% LLC Interests Admit two new partners – each 10% Tax status of entity converts from sole proprietorship to partnership. Joel deemed to have sold 20% of each asset in taxable transaction. Recognizes gain. Joel and new partners deemed to have made tax-free 721 transfers to a new partnership New partners’ basis in partnership interest is amount paid Joel. Joel’s basis is basis in assets deemed transferred. LLC takes carryover basis and tacked holding period Joel New Partners 80% of Assets 20% of Assets 20% LLC Interests 20% of Assets Cash & notes

23. Problem 5-B: Larson Electronics, LLC Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 5-23 LLC Conversion to C Status Joel and New Owners make 351 tax free transfer of LLC interests to new C corp for stock. Joel and New Owners stock basis equal to LLC basis. Tacked holding period. On liquidation of LLC, C corp’s basis in assets equals basis in LLC interests received from Joel and New Owners. No gain or loss to C corp. unless money in excess of basis received. No gain to LLC. Joel and New Owners original issuees of C corp stock Joel New C Corp Assets in Liquidation 20% LLC Interests New Owners Stock 80% LLC Interests Stock