Tax and Business Entities

Decisions, decisions, decisions!

Choice of Entity

• Compare five major entities:– Sole proprietorships– Partnerships (general and limited)– LLCs– S corporations– C corporations

• Tax planning opportunities

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

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”!

S-Corporation

• Limited ownership• ‘Usually’ no tax at the corporate level• Tax is at the owner’s 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!

S-corporation election

C Corporation

• 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

The “sole-less person”

Using entities to shift income and employment taxes

• Choice of entity can make all the difference

C-Corporate double-tax

Corporation

Taxable income = $100,000

Less tax = $ 22,250

Cash after taxes = $ 77,750

Owner

Owner gets $77,750

Less 15% dividends tax rate = $11,168

Cash after taxes = $66,582

Cash dividends to owner

Sole Proprietorship, LLC, (Partnership) by-pass

Sole proprietorship, LLC

Taxable income = $100,000

No tax – Cash after tax = $100,000

Owner

Owner gets $100,000 (assume it’s his or her only taxable income)

Income tax = $20,401

Self employment taxes = $13,800

Total taxes $34,201

Cash after taxes = $65,799

Income and cash flows to owner

S-corporation by-pass

S-corporation

Taxable income = $100,000

No tax – cash after tax = $100,000

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

Income and cash flows to owner

C corporation salary ploy

C-Corporation

Taxable income = $100,000

Pay salary to owner of ( $100,000 )

Taxable income = $0Salary to owner

Owner

Owner gets $100,000 (assume it’s his or her only taxable income)

Income tax (single) = $20,401

Employment taxes = $13,800

Total taxes $34,201

Cash after taxes = $65,799

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

C corporation timing ploy

• Using C-corp year-end flexibility to defer income– Example: Cash basis, January 31 year-end and

salaries

Feb. 1

Jan. 1 Dec. 31

Jan. 31Corporation

The owner

Profits = $100,000

The family business ploySole proprietorship

Taxable income = $100,000

No salary to owner’s 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

The family business ploySole proprietorship

Taxable income = $100,000

Pay salary to owner’s 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 it’s their only taxable income)

Income tax = $5,330

Employment taxes = $ -0-

Cash after taxes = $46,670

Total after tax cash = $84,620

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

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

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

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

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

Example: Non-qualified fringe benefitSole proprietorship

Deductible tax expense = $5,000

Corporation

Deductible tax expense = $10,000

Owner/employee reports taxable income for the fringe benefit

Assume that the auto is used 50% for business

Total auto expense this year is $10,000

Business owner

(sole proprietor)

Owner/employee

(corporation)

Example: Qualified fringe benefitSole proprietorship

Deductible tax expense = $-0- for the owner

Corporation

Deductible tax expense = $cost of insurance

No taxable income for the owner/employee

Business owner

(sole proprietor)

Owner/employee

(corporation)

Group-term life insurance (up to $50,000)

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

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

Example: todaySole proprietorship, Partnership, LLC, or

LLP

The business “tax cost” of RE is $200,000

Owner

Real estate

FMV = $1 million

Cost = $200,000

No Tax on the

transfer

Example: tomorrowSole proprietorship, Partnership, LLC, or

LLP

Owner

Real estate

FMV = $1 million

Cost = $200,000 (still!)

No Tax on the

transfer

The owner takes it back!

Example: todayCorporation

The business “tax cost” of RE is $200,000

Owner

Real estate

FMV = $1 million

Cost = $200,000

No Tax on the

transfer

Example: tomorrowCorporation

Taxable income = $800,000

Owner

Real estate

FMV = $1 million

Tax cost = $1,000,000

The owner takes it back!

Taxable income = $1,000,000

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

Ma & Pa Kettle owns the land as individuals

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

Owned by Ma & Pa Owned by Ma & Pa

Ma & Pa Kettle sells the land to a 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

KettleTotal after-tax cash = $3.35 million

Ma & Pa Kettle

Owned by Ma & Pa Owned by separate entity

Now . . . What should be the entity (for the 1st sale)?

• Two relevant tax code sections:

• Sales of property between a >50% owner and a partnership result in ordinary income tax, not capital gains [IRC §707(b)(2)]

• Sales of depreciable property between a >50% owner of any entity result in ordinary income tax, not capital gains [IRC §1239]

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

Fill out the election, Pa

And that’s a Plan!