Jim Colville, CPA 1 Accounting Day A Fresh Look at Choosing the Right Business Entity May 12, 2004

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Jim Colville, CPAAccounting Day

A Fresh Look at

Choosing the Right

Business Entity

May 12, 2004

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Jim Colville, CPAAccounting Day-2004

Presented by

Jim Colville, CPA

The presentation and sample files related to the presentationare available:

© 2004 by James M. Colville

May 12, 2004

[email protected]

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Jim Colville, CPAChoice of Entities

• Sole Proprietor

• C Corporation

• General Partnership

• Limited Partnership

• S Corporation

• Limited Liability Company (LLC)

• Limited Liability Partnership (LLP)

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Jim Colville, CPAChoice of Entities

• Tax Reasons

• Taxation of Owners

• Tax on Operations

• Tax on Dissolution

• Non Tax Reasons

• Legal Liability

Why?

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Jim Colville, CPALiability Exposure

• Employee Activities

• Hazardous Activity

• Debt

• Professional Services….Malpractice

• Product Liability Claims

• Environmental Liabilities

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Jim Colville, CPALiability Exposure

Legal Liability is obviously an issue that is beyond the scope of this presentation and must be thoroughly reviewed by legal council.

It is mentioned here as a non tax issue for purposes of awareness only.

There are no simple rules and in today’s legal environment there is no assurance that the courts will follow rules of law and precedence.

I am not an attorney. You are not my client. See your attorney for full coverage on this topic.

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Jim Colville, CPASole Proprietor

• Formation

• The assets of the business are the assets of the owner.

• Simply declare the assets as business assets.

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• Operation

• Keep business records

• Segregate business and personal activity

• Taxed on Schedule C, Form 1040

• A very basic Flow Through Entity

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• Schedule C

• Arrives at Net Income from the business

• Net Income is taxed, flows through to page 1, Form 1040

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• Schedule C

• Owner’s draw / salary

• Taxed on Net Income without regard for draws

• Fully taxed even with no draws

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• Schedule C

• A perfect example of a flow-through entity1.

• The net income of the business is taxed without regard to the amounts paid to the owner.

1-Also referred to as a Pass Through Entity

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• Flow-through concept can be a surprise to new business owners.

• Net income is also subject to Self-Employment Tax (15.3%)

• 92.35%

• Limitations

• 50% deduction

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• Protection against legal liabilities

• None

• The is no legal distinction between you and your business

• May find that insurance provides protection (with risk)

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• Simple to begin the business

• Business License

• Fictitious Name

• Business bank account

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Jim Colville, CPASole Proprietor / SMLLC

• A separate Schedule C is filed for each separate business

• Remember, unlimited liability

• LLCs, by definition, have two or more owners.

• Special rules allow for Single- Member LLCs (SMLCC)

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Jim Colville, CPASole Proprietor / SMLLC

• SMLCC

• SMLLC are disregarded entities, thus reported on Schedule C

• Now, place all businesses or investments in separate LLCs

• File several Schedule Cs

• More on LLCs later5/12/04

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Jim Colville, CPAC - Corporation

• A separate legal entity apart from its shareholders

• A separate tax paying entity

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Jim Colville, CPAC – Corporation—Double Taxation

• Corporation pays tax

• Distributions to shareholders are made from after tax dollars and are taxable to the shareholder

• Results in “double taxation”

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Jim Colville, CPA

• Working owners are employees of the corporation

• As such they are paid a salary for such services (deductible to the corporation).

• Distributions / dividends to shareholders are made after all business deductions, including owners salaries, …. i.e. after tax.

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C – Corporation—Double Taxation

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Jim Colville, CPA

• Pay bonuses to shareholders

• Deductible by corporation

• Taxable to shareholder/employee

• Avoiding double taxation

• Eliminating/reducing double taxation with deductible payments

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Jim Colville, CPA

• Eliminating Double Taxation with Deductible Payments

• Salaries, salaries with bonuses

• Rents

• Interest

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Jim Colville, CPA

• Eliminating Double Taxation with Deductible Payments-continued

• These payments may be challenged by the IRS, claiming the avoidance of paying dividends.

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Jim Colville, CPA

• Salaries

• Reasonable

• Bonuses can look like dividends as they are paid from excess profits, same definition as dividends.

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Jim Colville, CPA

• Rent

• Building / warehouse owned by shareholder

• Interest

• Money loaned to the corporation

Both can be considered excess as it exceeds FMV

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Jim Colville, CPA

Creating interest payments upon formation.

Example:

Stock Note

Note payable 90,000

Common stock 100,000 10,000

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Jim Colville, CPAC – Corporation—Double Taxation

Shareholder receives “principle repayment” tax free, plus interest on the note.

Viewed as “thin capitalization”

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Jim Colville, CPA

Let’s look at leasing a warehouse, owned by the shareholder.

Should the owner contribute the asset to corporation or lease it to the corporation?

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Jim Colville, CPALeasing Warehouse

Corp #1Rent (10,000)

10,000

Interest (8,000)

Property Taxes (2,000)

Total Outlays (10,000)

Net - 0 -

Depreciation (3,000)

Creating a taxable: loss

#2 13,000

(8,000)

(2,000)

(10,000)

3,000

(3,000)

breakeven

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Jim Colville, CPA

Benefits:

• Deductible lease payments (for the corp)

Sheltered by depreciation

• Build equity in the note

• Enjoy tax free appreciation of the asset

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Jim Colville, CPA

The leasing is mentioned here as an example to reduce corporate tax and protect it from liability.

The concept applies to LLCs and S Corps as well, with minor differences due to pass-through taxation and P/S and S Corp rules.

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Jim Colville, CPA

Disadvantages-Double taxation in all its forms

• Dividends

• Sale of Stock

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Jim Colville, CPA

Sale of Stock

• Stockholder’s basis is not adjusted upward for the corporation’s taxable income.

• The more retained earnings, the more value created, increasing capital gain upon sale.

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Jim Colville, CPA

Liquidation

• Example:

• Corporation has greatly appreciated asset(s)

• Shareholders decide to distribute asset(s) to shareholder(s).

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Jim Colville, CPA

Liquidation

• Upon distribution, treated as deemed sale, taxable to corporation

• Distribution is taxed to the shareholder

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Jim Colville, CPA

Example #2

• Corporation sells all assets and liabilities for a large gain

• It now has a balance sheet of all cash and retained earnings.

• The corporation pays tax on the gain, reducing available cash for distribution.

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Jim Colville, CPA

Pays cash to shareholders

• The resulting cash is paid to the shareholders

• Taxable to shareholders

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Jim Colville, CPAWhen C-CorporationsMay be Attractive

• The owner places a high priority on limited liability

• The graduated corporate rates counteract the ill effects of double taxation

• Double taxation can be mitigated by draining off corporate income in the form of deductible payments to or for the benefit of the owner.

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Jim Colville, CPA

• The owner wants to set up a vehicle of the future transfer of ownership interests to family members

• The employment tax savings of operating as a C Corporation are significant

• The tax benefit of deducting 100% of medical insurance premiums is significant

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When C-CorporationsMay be Attractive

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Jim Colville, CPA

• Limiting liability is a critical concern

• Only one owner (thus P/S etc. are not available)

• Can’t be operated as a LLC or LLP due to state law or professional standards

• Cannot live with legal uncertainties of LLCs

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When C-CorporationsMay be Attractive

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Jim Colville, CPAPartnerships

Very popular up to the mid-to-late 1980s

• Pass through taxation, especially with losses

• Joint venture projects.

• Limited liability could be [partially] achieved with a Limited Partnership

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Then:

• Got a “bad name” during the 1980s, especially limited partnership.

• Partnership tax rules became more complicated due trying curb the abuses.

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Jim Colville, CPAGeneral vs. Limited Partnerships

• General Partners are jointly and severally liable, without limitation, for all the debts and obligations of the partnership.

• General Partners can also be legally bound by actions taken by any of the other partners

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Jim Colville, CPA

General vs. Limited Partnerships

• Limited Partners are generally not at financial risk with respect to partnership debts and obligations.

• The limited partner’s worst case scenario is losing the amounts invested.

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Jim Colville, CPA

• Must have at least one general partner

• Limited partners may not participate in management of the partnership

• The limited partner’s worst case scenario is losing the amounts invested.

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Jim Colville, CPA

• Limited partnerships or

• LLCs (discussed later)

Outside investors find unlimited liability unacceptable. Thus, prefer either:

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Jim Colville, CPA

• Corporate joint ventures

• Real estate investment and development activities (preferred returns, special allocations, etc.)

• Oil and gas

Partnership Taxation

Type of entities best suited for partnerships

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Jim Colville, CPA

• Certain venture capital investments

• Business start-ups with expected losses the initial years (pass-through taxation)


Type of entities best suited for partnerships

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Jim Colville, CPA

• Certain professional practices with specially tailored ownership interests that reflect each member’s contributions along with pass through taxation.

• Family limited partnerships used as an estate planning tool.


Types of businesses best suited for partnerships

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Jim Colville, CPA

• Limited liability A separate legal entity (apart from its owners/members) and

• Pass through taxation

Limited Liability Companies-LLCs

What is an LLC?

Best of both worlds

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Jim Colville, CPA

• Check the box regulations allow an election on how to be taxed

• Most commonly, partnership taxation

LLCs

How is an LLC taxed?

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Jim Colville, CPA

• Partnership taxation (same for both)

• Limited liability (LLC)

• Ability to use SMLLC

LLCs

Partnership or LLC?

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Jim Colville, CPA

Types of businesses best suited for partnerships

Substantially the same as previous slides

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LLCs

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Jim Colville, CPA

Pass through taxation

Substantially the same as previous slides

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LLCs

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Jim Colville, CPAS Corporations

A regular corporation electing S Corporation tax treatment.

Subject to many special [restrictive] rules:

• Must be a domestic corporation

• Limited to 75 shareholders(previously 35)

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• Only individuals, estates, certain types of trusts as shareholders

• Shareholders must be U.S. Citizens or resident aliens

• Limited to one class of stock

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Jim Colville, CPALet’s Look at the Differences

• No limitation as to number of owners

• Continuity of life

• Graduated tax rates can be a benefit

• Deducting employee benefits

• Formation from contribution of assets or existing business is tax deferred (§351)

C Corporations-Advantages

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• Double taxation

• No pass through taxation

• Loss of capital gain treatment

• Net capital losses non deductible

• Net capital gains taxed at the regular corporate rates (no capital gain rates)

C Corporations-Disadvantages

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• No basis adjustment for retained earnings

C Corporations-Disadvantages

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• Existing C Corporations desiring pass through taxation

• One owner

• Continuity of life

S Corporations

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• Tax deferred contributions of assets

• Special allocations

• Pass through taxation

• Basis adjustment from operations

LLC / Partnerships

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• Initial and subsequent contributions

• Plus earnings

• Less distributions (draw)

• Less losses

• Plus share of debt

Basis adjustment from operations

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Basis adjustment due to Corp P/S

Initial contribution 100 100

P & L 0 900

AB 100 1,000

SP 2,000 Gain 1,900 1,000

Basis adjustment from operations

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• Stepped up basis received from new partner buying in.

• Keeping Inside and Outside basis the same (§ 754 election)

• Thus, new partner’s basis is equal to amount invested.

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Of course, the P/S / LLC owners are taxed on the earnings in full each year, which gives basis.

If the corporate shareholder(s) take equivalent salaries, both sets of owners has substantially equivalent income, the corporate owners do not obtain increase in basis.

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Although S Corporation “Acts” like P/S taxation, there are significant differences.

No stepped-basis for new shareholders (no §754 election)

No basis adjustment for share of debt

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Ability to minimize self-employment tax. Payable lower salary, take remains as dividend, which is not subject to SE tax.

Cannot take zero salary, by definition providing services, therefore, pay is considered salary.

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QSubs

S Corporation are now allowed to have one or more wholly owned Qualified Sub S Subsidiaries (QSSS or QSubs).

Treated as a disregarded entity, thus no separate tax return.

The operation are considered to be carried on by the parent S Corporation.

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QSubs

A perfect set of tools for, let’s say, placing multiple real estate projects in separate QSubs, legal liability protection at its best, and having simplified tax reporting.

The same scenario can be accomplished with LLCs with SMLLCs.

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Jim Colville, CPAQualified Small Business Corporations

QSBCs

A Qualified Small Business Corporation (QSBC) is simply a C corporation eligible for two special tax breaks under the Internal Revenue Code. QSBCs were created as a small business tax incentive by the Revenue Reconciliation Act of 1993.

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Jim Colville, CPAQSBCs

QSBCs

Specifically, certain shareholders of the QSBC stock may qualify for exclusion of up to 50% of their gains from sales of shares. The gain exclusion is unavailable to shareholders that are C corporations (IRC §1202)

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QSBCs

The Taxpayer Relief Act of 1997 added a QSBC stock sale gain rollover rule that may actually prove to be more beneficial that the 50% gain exclusion. Under the gain rollover rule, taxable gains can be deferred indefinitely by rolling over QSBC stock sale proceeds into new investments in QSBC stock (IRC §1045).

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QSBCs

QSBCs are treated as “regular” C corporations for all other legal and federal income tax purposes. As a result, the other advantages and disadvantages of C corporations status apply to QSBCs.

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Caution: The QSBC qualifications rules, contained in IRC §1202, are detailed and relatively complex. They are not described her because such complexity is beyond the scope of this article and it is simple more efficient to read the language of the Code section itself. You should review §1202carefully before concluding that a corporation will meet the definition of a QSBC.

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Jim Colville, CPALLCs

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Compared to Partnerships

• Generally superior

• Partners are jointly and severally liable for all debts and obligations

• General partners have the power to bind the P/S. LLCs

• Taxation is generally the same

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Compared to Limited Partnerships

• Generally superior

• Limited partnership must have at least one general partner.

• Can be resolved with a corporate GP, owned by the partners, generally a S Corporation

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Compared to Limited Partnerships

• Limited Partners can be found to be a “general partner” if too active in the business. Not an issue with LLCs.

• There is still legal uncertainties with regard to full legal liability protection for LLCs

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Compared to Corporations

• Pass through taxation.

• LLC must have two members (or be a SMLLC)

• LLC members basis is continued to be adjusted for increases and decreases in the business equity. The “inside” and “outside” basis are generally equal.

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Jim Colville, CPASelecting the Best Entity

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• All have their benefits and disadvantages.

• Once in existence, don’t rush to change for change sake.

• Your golfing friend’s entity choice most likely is not best for you.

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• Planning

• Planning

• Planning

• Seek professional guidance.

• Legal

• CPA

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Is this all there is?

• Today was just an overview

• Hopefully you caught some ideas, arming with you with better questions for the next step

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Thank You

[email protected]

800-491-7700

Documents

Jim Colville, CPA 1 Accounting Day A Fresh Look at Choosing the Right Business Entity May 12, 2004