Tax and Business Entities

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!
5
(No Transcript)
6
(No Transcript)
7
S-Corporation

• Limited ownership
• Usually no tax at the corporate level
• Tax is at the owners 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
The sole-less person

• 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

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
Cash dividends to owner
Owner Owner gets 77,750 Less 15 dividends
tax rate 11,168 Cash after taxes 66,582
12
Sole Proprietorship, LLC, (Partnership) by-pass
Sole proprietorship, LLC Taxable income
100,000 No tax Cash after tax 100,000
Income and cash flows to owner
Owner Owner gets 100,000 (assume its his or her
only taxable income) Income tax 20,401 Self
employment taxes 13,800 Total
taxes 34,201 Cash after taxes 65,799
13
S-corporation by-pass
S-corporation Taxable income 100,000 No tax
cash after tax 100,000
Income and cash flows 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
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 its 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

Profits 100,000
Feb. 1
Jan. 31
Corporation
The owner
Jan. 1
Dec. 31
17
The family business ploy
Sole proprietorship Taxable income
100,000 No salary to owners 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 owners 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 its 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
Owner/employee (corporation)
Business owner (sole proprietor)
Assume that the auto is used 50 for
business Total auto expense this year is 10,000
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
Owner/employee (corporation)
Business owner (sole proprietor)
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
No Tax on the transfer
Real estate FMV 1 million Cost 200,000
Owner
29
Example tomorrow
Sole proprietorship, Partnership, LLC, or LLP
The owner takes it back!
No Tax on the transfer
Real estate FMV 1 million Cost 200,000
(still!)
Owner
30
Example today
Corporation The business tax cost of RE is
200,000
No Tax on the transfer
Real estate FMV 1 million Cost 200,000
Owner
31
Example tomorrow
Corporation Taxable income 800,000
The owner takes it back!
Real estate FMV 1 million Tax cost 1,000,000

Owner
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
Owned by Ma Pa
Owned by Ma Pa
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
Now
The dream
34
Ma Pa Kettle sells the land to a separate entity
Owned by Ma Pa
Owned by 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
Sell
Separate entity owned by Ma Pa Kettle
Ma Pa Kettle
Total after-tax cash 3.35 million
35
Now . . . What should be the entity (for the 1st
sale)?

• Two relevant tax code sections
• Sales of property between a gt50 owner and a
  partnership result in ordinary income tax, not
  capital gains IRC 707(b)(2)
• Sales of depreciable property between a gt50
  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 2nd 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 thats a Plan!