Please read the article and answer about questions. Tax Considerations in Choice

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Please read the article and answer about questions.

Tax Considerations in Choice of Entity Decision , 2008, Daniel P. Cooper, Reinhart Boerner Van Deuren s.c.       Email: dcooper@reinhartlaw.com

There are four primary types of business entities for tax purposes

C Corporation

S Corporation

Partnership (LLC)

Disregarded Entity

There are many strategic reasons for choosing one type of entity for tax purposes versus another type.

Seven primary factors include the following:

Single versus double tax regime (including flow-through of losses)

Shareholder eligibility restrictions/capital structure flexibility

Tax issues on entity formation

Tax basis step-up on subsequent events

Subjecting operating income to self-employment taxes

Flexibility in issuing equity interests for services rendered

Ability to participate in tax favored reorganizations

Single vs. Double Tax Regime

A C corporation is a separate taxable entity for tax purposes. Thus, proceeds earned by a C corporation and subsequently distributed to its shareholders will be subject to two levels of tax.

An S corporation is a separate entity for tax purposes, but its income flows through to its shareholders. Thus, corporate earnings are generally subject to only one level of tax.

A tax partnership is a separate entity for tax purposes, but its income flows through to its partners. Thus, its operating income is generally subject to only one level of tax.

A disregarded entity is not treated as a separate entity for tax purposes. Thus, it is ignored and its income is subject to only one level of tax.

Shareholder Eligibility/Capital Structure

There are no limitations on C corporation shareholders or capital structure.

S corporations are subject to significant shareholder and capital structure limitations:

100 shareholder limit

Only one class of stock allowed

Corporations, partnerships and certain trusts are not allowed to be a shareholder

Nonresident aliens are not allowed to be a shareholder

There are no limitations on owner eligibility or capital structure for a tax partnership.

Tax Issues on Entity Formation

A transfer of appreciated property for stock in a C or S corporation is generally taxable. However, some transfers of appreciated property may qualify for tax-free treatment under section 351 of the Internal Revenue Code (I.R. Code).

Transfers of appreciated property to a tax partnership are generally tax-free under section 721 of the I.R. Code.

The receipt of vested C or S corporation stock in exchange for services rendered is taxable as compensation income.

The receipt of partnership equity in exchange for services rendered may or may not generate taxable compensation income depending on the nature of such equity.

Future Tax Basis on Sale of Equity or Death

A C or S corporation is not eligible to receive a tax basis step-up in its assets solely by virtue of a transfer of equity by a shareholder or on the death of a shareholder.

A tax partnership can elect to receive certain tax basis adjustments (up or down) in the event that one or more of its owners transfer their equity interests or die.

Self-Employment Tax Issues in Choice of Entity Selection

Flow-through income from an S corporation is not treated as "net earnings from self-employment." Furthermore, dividends paid by a C or S corporation are not subject to such characterization.

In certain situations, the IRS takes the position that flow-through income from a tax-partnership constitutes "net earnings from self-employment."

Equity Issued for Services Rendered

Vested stock in a C or S corporation granted for services rendered is included as taxable income to the recipient to the extent that the fair market value of the equity at the time of grant exceeds the amount (if any) paid for such stock.

Tax Considerations in Choice of Entity Decision (Continued)

Equity interests granted in a partnership in exchange for services rendered are taxable to the extent of the value of such interest granted. However, there is substantial flexibility in determining the amount (if any) of such taxable gain depending on the type of equity issued.

Capital Interests vs. Profits Interests

A capital interest is generally an interest that would provide the recipient of such interest with some cash if the partnership were to sell all of its assets and liabilities for their fair market value and liquidate on the day such interest is granted.

A profits interest is any interest other than a capital interest.

Our text, Entrepreneurial Small Business, says that the two most prevalent forms of organization are:

               Sole Proprietorships                                                     52.7% of businesses

               General Partnerships                                                    20.9% of businesses

Our text also says that forms of organization that do not shield owners from personal liability open owners to losing their personal assets if things go terribly wrong. The business owners that exist as sole proprietorships and general partnerships needlessly expose themselves to this danger. They hope that a big law suit never comes their way, but why take the chance if you can quite economically provide a protective shield against personal liability by establishing a legal entity such as an LLC, “C” Corp, “S” Corp, Limited Partnership, etc.?

A second determinant in choosing a form of organization for a business is taxation. Some entities are taxed at the corporate level and some have provisions for tax obligations to flow through to the individual owners of the entity. Our text and supplemental reading materials provide good discussions of when the different tax entities should be used. While there is no one right answer in many cases, our text suggests that the default form of organization is an LLC. In other words, unless there are good reasons not to use an LLC (and in some cases there are good reasons), then you should opt for an LLC as your form of organization.

In the Note by Dan Cooper of Reinhart Boerner Van Deuren s.c., the tax considerations in the choice of an entity are discussed. Dan states that there are four primary types of business entities for tax purposes

C Corporation

S Corporation

Partnership

Disregarded Entity

In this discussion, a partnership is any type entity that has more than one member and that has income tax obligations flow through to the owners of the business. This discussion does not imply that one should use a general partnership in a choice of entity decision (because in a general partnership the liability flows through to the owners). Dan Cooper’s partnership discussion relates only to the entity for taxation purposes and would only be of interest to business owners as a partnership with limited liability for the owners – the main point being that for tax purposes the partnership is an entity that has flow through of tax obligations to the owners of the business.

In Dan Cooper’s discussion, a disregarded entity is a legal entity (not a sole proprietor or general partnership) that for tax purposes is treated like a sole proprietor (such as a single member LLC).

In the Entrepreneurship Course, you will be preparing a business plan for a new venture. There is no good reason not to form a legal entity that will shield the business owners from personal liability. This means that a sole proprietorship and general partnership form of organization should not be chosen for your new business venture because these two forms of organization do not shield the owners from unlimited liability.

Questions.

1. Which entity alternative is subject to double taxation?

2. What are the four significant shareholder and capital structure limitations to an “S” corporation?

3. Self-employment tax is not imposed on dividends distributed by what types of entities?

Explanation / Answer

1. A C corporation is a separate taxable entity for tax purposes. Thus, proceeds earned by a C corporation and subsequently distributed to its shareholders will be subject to two levels of tax. So, a C corporation will be subjected to double taxation – one at corporation level and one at shareholders’ level.

2. The four significant shareholder and capital structure limitations to an “S” corporation are:

3. Dividends paid by a C or S Corporation are not subjected to any kind of self-employment tax.

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