1. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Three Tax Regimes C Corp S Corp Partnership

2. Check-The-Box Same analysis, more certainty Corporate entities are C or S. Partnerships and LLCs under Subchapter K (partnership) unless all consent to C status Single owner entity is C corp or sole proprietor. One owner LLC disregarded. Locked in for 60 months unless more than 50% change in ownership. Tax consequences of switching can be costly. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-1

3. Entity Candidates Sole Proprietorship C Corporation General Partnership Limited Partnership S Corporation Limited Liability Company Professional Limited Liability Company Limited Liability Partnership Limited Liability Limited Partnership Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2

4. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Choice of Entity Factors 1.Future sale potential 2.Different equity interests 3.Earnings bailout 4.Conversion ability 5.Bracket racquet 6.Loss utilizations 7.Control rights 8.Owner fringe benefits 9. Self employment taxes 10. Tax deferral 11. Real Estate 12. Passive activity rule 13. AMT 14. Owner estate planning 15. Going public prospects 16. “Not My Return”

5. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Big Non-Factor Owner Limited Liability

6. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Factor # 1 Future Sale Potential

7. C Corporation Factors Double tax potential No basis booster for income accumulations Tax-free reorganization potential 1045 rollover potential 15% capital gains rate at shareholder level 1202 exclusion (not a big deal now) Ordinary loss treatment under 1244 (no big deal) Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-3

8. C Corp Double Tax Hit on Asset Sale Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-4 C Corp 34% Tax Rate Buyer Assets Cash Shareholders 15% Tax Rate Net Proceeds Summary tax impact on $1,000 gain Corporate tax @ 34% $340 Shareholder Tax 15% of $660 99 Total Taxes $439 Percent 43.9%

9. C Corp Non-Basis Booster Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-5

10. Pass-Thru Entity Basis Booster Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-6

11. Sale Potential of S Corp vs. Sub. K S corp can participate in tax-free reorg. Less ordinary income traps with S corp Basis boosting a push C corp convertibility - S possible with nuisance traps - Partnership and LLC usually prohibitive Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-7

12. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Factor # 3 Earnings Bailout

13. Earnings Bailout of 100k Income C corp C corp P or LLC S Corp Dividend Compensation Distribution Distribution Corp Inc. Tax 22,250 0 0 0 Owner Inc. tax 11,662 28,000 28,000 28,000 Total Income Tax 33,912 28,000 28,000 28,000 End of Story? * Assumes 15% dividend rate and 28% marginal ordinary rate. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-8

14. No Way! C corp C corp P or LLC S Corp Dividend Compensation Distribution Distribution Corp Inc. Tax 22,250 0 0 0 Owner Inc. tax 11,662 26,010 26,010 28,000 Total Income Tax 33,912 26,010 26,010 28,000 Payroll Tax 0 14,212 14,212 (?) 0 Revised Total 33,912 40,222 40,222 28,000 No wonder S is so popular! But is payroll tax really a tax? * Assumes 15% dividend rate and 28% marginal ordinary rate. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-9

15. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Factor # 5 Bracket Racket

16. C Corp Bracket Racket C Corp Rates Married Rates (2005) Up to 50k 15% Up to 14.6k 10% 50K to 75k 25% 14.6k to 59.4k 15% 75k to 100k 34% 59.4k to 119.95k 25% 100k to 335k 39% 119.95k to 182.8k 28% 335k to 10 mill 34% 182.8k to 326.45k 33% 10 mill to 15 mill 35% Over 326.45k 35% 15 mill to 18.3 mill 38% Over 18.3 mil 35% Yellow rates are the opportunity brackets Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-10

17. C Corp Income Split – 150k C Corp Pass Thru Entity C tax on 50k 7,500 Owner income tax on excess 14,236 27,140 Total Income tax 21,736 27,140 Savings of 19.9% * Assumes payroll taxes a push, married couple with two exemptions, use of standard deduction, and year is 2005. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-11

18. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Factor # 2 Different Equity Interests

19. Different Ownership Interests Challenge: Separate control, income, and equity growth. C Corp Tools: Voting and nonvoting stock, preferred stock, hybrids, shareholder debt, employment contracts. S Corp Tools: No preferred or second class of stock. Only voting differences. Least flexible. Partnerships and LLCs: Only limitation is “substantial economic effects” limits of 704. The most flexible option. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-12

20. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Factor # 4 Conversion Flexibility

21. From C corp to - Partnership or LLC: Killer double tax - S corp: Doable but serious traps From S corp to - Partnership or LLC: Painful single tax - C corp: Piece of cake From LLC or Partnership to - C corp: Doable with minor traps - S corp: Doable if qualify - LLC or Partnership: Doable Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-13

22. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2 Factor # 6 Loss Utilization

23. C Corp Losses Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-14 Losses C Corp Shareholders Carry BackCarry Forward Never Pass Thru

24. S Corp, Partnership, LLC Losses Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-15 Losses C Corp Owners Pass Thru Hurdles: Basis limitations (704(d) and 1366(d)) At-risk limitations (465) Passive activity limitations (469)

25. Material Participation Under 469 More than 500 hrs in year Sole participant in activity More than 100 hrs and anyone else More than 100 hrs and more than 500 hrs in significant participation activities 5 of last 10 yrs meet standard Any previous 3 yrs if personal service Regular, continuous, substantial based on all facts and circumstances Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-16