CHOICE OF ENTITY TAX CONSIDERATIONS

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CHOICE OF ENTITY TAX CONSIDERATIONS

• Thomas F. Schnellenberger
• September 20, 2006

1607621
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OVERVIEW
Ms. Big Bucks is contemplating how to organize
her new business

• Sole Proprietorship
• Single Member Limited Liability Company (SMLLC)
• General Partnership
• Limited Partnership
• Limited Liability Company (LLC)
• S Corporation
• C Corporation

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OVERVIEW
Assume the following

• Ms. Big Bucks uses 10 of personal funds and 50
  of funds borrowed from bank
• Year 1 losses 50 (Ms. Big Bucks share)
• Year 2 profits 100 (Ms. Big Bucks share)
• Business is sold at the end of year 2 for 1,000
• Ms. Big Bucks is active in the business

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CHOICE OF ENTITY SOLE PROPRIETORSHIP
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FORMATION
CHOICE OF ENTITY SOLE PROPRIETORSHIP

• Business bank account
• Federal and state Employer Identification Numbers
  (EINs) and other tax registrations
• Licenses
• No liability protection
• Self employment (SE) tax

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Employment Tax Components and Rates
Self-Employed Employer
Employee Individual OAS
DI - Imposed on Earnings up to 94,200
(2006) Employer 6.2
6.2 Employee __ 6.2
6.2 Total OASDI
6.2
6.2
12.4 Medicare Employer (1)
1.45
1.45 Employee ___ 1.45
1.45 Total Medicare 1.45
1.45 2.9 Total

7.65 (1) 7.65 15.3 (2) (1)
Deductible by employer in arriving at employers
taxable income. (2) One-half deductible in
arriving at adjusted gross income.
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FIRST YEAR
SOLE PROPRIETORSHIP
Unless otherwise noted, it has been assumed that
(1) at-risk and passive loss rules are satisfied,
and (2) Ms. Big Bucks has other sources of SE
income against which loss can be
offset. After-tax benefit of 24.72
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SECOND YEAR
SOLE PROPRIETORSHIP
After-tax cost of 49.45
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SALE OF BUSINESS
SOLE PROPRIETORSHIP
Income Tax Cash Sales price
1,000.00 1,000.00 Basis Personal
funds 10 Borrowed funds 50 Year 1 loss
(50) Year 2 profit 100 (110.00) Gain
890.00 Estimated capital gains rate
17 Income tax 151.30 (151.30) Loan
repayment (50.00) Net sales proceeds
798.70
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NET CASH
SOLE PROPRIETORSHIP
Original investment (10.00) First year
tax 24.72 Second year tax
(49.45) Sale proceeds 798.70 Total 763.
97
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CHOICE OF ENTITY SINGLE MEMBER LLC
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FORMATION
SINGLE MEMBER LLC

• Absent an affirmative election to be treated as
  a corporation, Big Bucks LLC will be disregarded
  for income tax purposes i.e., treated as a sole
  proprietorship
• Bank account
• EINs
• Licenses
• Liability Protection
• SE tax

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NET CASH
SINGLE MEMBER LLC
Original investment (10.00) First year
tax 24.72 Second year tax
(49.45) Sale proceeds 798.70 Total 763.
97
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CHOICE OF ENTITY GENERAL PARTNERSHIP
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FORMATION
GENERAL PARTNERSHIP
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NET CASH
GENERAL PARTNERSHIP
Original investment (10.00) First year
tax 24.72 Second year tax
(49.45) Sale proceeds 798.70 Total 763.
97
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CHOICE OF ENTITY LIMITED PARTNERSHIP
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FORMATION
CHOICE OF ENTITY LIMITED PARTNERSHIP

• EINs
• Bank account
• Liability protection for limited partner only
• Deductibility of losses subject to basis, at-risk
  and passive loss limitations
• General partner subject to self-employment tax
  but limited partner is generally not

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FIRST YEAR
LIMITED PARTNERSHIP
(1) Basis limitation results in loss limitation
to Mr. Big Bucks.
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FIRST YEAR MS. BIG BUCKS
LIMITED PARTNERSHIP
After-tax savings of 44.50
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FIRST YEAR MR. BIG BUCKS
LIMITED PARTNERSHIP
No after-tax savings because of basis limitation
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First Year
LIMITED PARTNERSHIP
Guarantee
90 loss
10 loss

LPs basis limitation can be avoided if LP
guarantees at least 10 of bank debt
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SECOND YEAR MS. BIG BUCKS
LIMITED PARTNERSHIP
After-tax cost of 69.25
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SECOND YEAR MR. BIG BUCKS
LIMITED PARTNERSHIP

• After-tax cost of 19.00 (reduced because of
  carryover)
• No self-employment tax because of LP status

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SALE OF BUSINESS
LIMITED PARTNERSHIP
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NET CASH
LIMITED PARTNERSHIP
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CHOICE OF ENTITYLIMITED LIABILITY COMPANY
(LLC)
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CHOICE OF ENTITYLimited Liability Company
Similar to limited partnership, but with limited
liability for all.
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SELF EMPLOYMENT TAX
CHOICE OF ENTITY
Treasury issued Proposed Regulations in 1997
which would exclude limited partners and LLC
members from self-employment tax unless
individual has any one of the following
(1) personal liability for debts or claims
against the entity by reason of being
owner, (2) authority to contract on behalf of
the entity, or (3) participates in the entitys
business for more than 500 hours during the tax
year.
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CHOICE OF ENTITYS CORPORATION
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FORMATION
CHOICE OF ENTITY S CORPORATION

• Bank account
• EINs
• S corporation election required
• Licenses
• Liability Protection

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FIRST YEAR
S CORPORATION
Deductibility of loss subject to at-risk, basis
limitation and passive loss rates. Assume
individual is active in business. Salary????
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FORMATION
CHOICE OF ENTITY S CORPORATION
Avoiding Basis Limitation
Ms. Big Bucks
50
100 Stock
Cash 60
Bank
S Corporation
Note Guarantee by Ms. Big Bucks will not create
basis
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SECOND YEAR
S CORPORATION
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SALE OF BUSINESS
S CORPORATION
Income Tax Cash Sales Price
1,000 1,000 Basis Personal funds 10
Loaned funds 50 Year 1 loss lt50gt
Year 2 profit 100 lt110gt Gain
890 Assumed Capital Gains Rate x
17 Income Tax 151.30 lt151.30gt Repay Bank
Loan lt 50.00gt Net Cash 798.70
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NET CASH
S CORPORATION
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WHY NOT AN S CORP?
CHOICE OF ENTITY S CORPORATION vs. PARTNERSHIP

• Only natural persons and certain trusts can be
  shareholders
• Maximum 100 shareholders (family members may be
  treated as one shareholder)
• Only one class of stock permitted (except can
  have differing voting rights)
• No special allocations
• No tax basis for liabilities even if guarantee
• A distribution of appreciated assets from an S
  corporation is a taxable event such a
  distribution from a partnership or LLC generally
  is tax-free
• Salary/payroll taxes

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CHOICE OF ENTITYC CORPORATION
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FORMATION
CHOICE OF ENTITY C CORPORATION

• Bank account
• EINs
• Licenses
• Liability Protection

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FIRST YEAR
CHOICE OF ENTITY C CORPORATION
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SECOND YEAR
CHOICE OF ENTITY C CORPORATION
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SALE OF ASSETS
C CORPORATION
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SALE OF STOCK
C CORPORATION
Income Tax Cash Sales Price
950 950 Basis
10 Net Gain 940 Assumed Capital Gains
Rate x 17 Tax 159.80
lt 159.80 gt Net Cash
790.20 Assume stock sold for 1,000 less
50 bank loan.
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NET CASH
C CORPORATION
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COMPARISON OF NET CASH
CHOICE OF ENTITY
Sole Proprietorship/General Partner 763.97 Lim
ited Partner 769.70 S Corporation
769.70 C Corporation Sale of Assets
481.73 C Corporation Sale of Stock 780.20
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C CORPORATIONDOUBLE TAX ON DIVIDENDS
CHOICE OF ENTITY
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EMPLOYEE FRINGE BENEFITS
CHOICE OF ENTITY
Sole proprietors, partners (including LLC
members) and more than 2 shareholders in an S
corporation are not eligible for the following
tax free benefits

• Group term life insurance
• Disability insurance
• 125/cafeteria plans
• Educational expenses
• Employee-paid parking
• Health and accident plans
• Meals and lodging furnished for the convenience
  of the employer

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EMPLOYEE FRINGE BENEFITS
CHOICE OF ENTITY
To ameliorate adverse tax consequences to
self-employed, a percent of health/medical
insurance costs and actual costs are deductible
in arriving at Adjusted Gross Income

• 2000 60
• 2001/2002 70
• 2003 100
• 2004 100
• 2005 100
• 2006 100

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Choice of EntityMulti-State Operations
Operations in more than one state complicate flow
through entity (partnership (for tax) or S
corporation) operation because

• Each owner must file in multiple jurisdictions
• Entities may be treated differently from state to
  state
• Non-residents may be subject to withholding on
  income

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Choice of EntityObservations
Sole Proprietorship simplest, but no liability
protection.Single Member LLC liability
protection.General Partnership no liability
protection.Limited Partnership liability
protection and no self-employment tax for
L.P.s.LLC liability protection for all and
flexible, but self-employment tax question.S
Corporation liability protection for all, but
not as flexible. Can manage FICA
(self-employment tax).C Corporation liability
protection for all, but double taxation not
attractive.