Choice of Entity 2012

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Brian T. Whitlock, CPA, JD, LLMTax Partner

CHOICE OF ENTITY – SOUP TO “NUTS”

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Topics

Revisit basic issues with Choice of Entity Case Studies Unusual Issues impacting Choice of Entity

Capital Requirements IRC Sec 1202 and IRC Sec 1045 ESOP and IRC Sec 1042

Alternate Entities Captive Insurance Companies IC-DISCs Cooperatives

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Case Study #2

Don has an opportunity to open an new McDonald’s Franchise in a rapidly growing area of DuPage County.

McDonald’s does not offer any tax advice to its franchisees. McDonald’s tells him that they see franchisees operate in lots of various forms, including Sole Proprietorships, Partnerships, LLCs, C Corporations and S Corporation. It recommends that he consult with his tax advisor, so he calls you.

Where do you start?

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Choice of Entity Comparison

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Case Study #3 – Real Estate Developer

Johnson (80 years of age) personally owns 40 acres of land the near Western Suburbs (Cook/DuPage County). He wants to develop the site with retail shopping, commercial office, townhomes & condominiums.

He and his adult children have experience with building condominiums, townhomes, and single family homes in the past. In 2004 they sold their former company for an amount in excess of $200 million to a public company.

He mothballed the plans 5 years ago, but feels that the time is rapidly approaching to re-launch this development.

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Sole Proprietorship(Ground Floor)

Stage OneInception

Working Within the Entity ToolboxLifecycle of a Family Business Enterprise

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Stage OneInception

General Partnership(addition owner added)

Limited Partnership / LLC(Debt or Private

Placement Capital)

S Corporation(Debt or Private

Placement Capital)

C Corporation(Debt or Private Placement,

and Venture Capital)

Limited Partnership(Passive Investor Added)

Stage Two Adding other

people and/or Raising Capital

Lifecycle of a Family Business Enterprise

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Placement Capital)


Placement Capital)







Stage OneInception

Stage Three Mature

Business

LLC or General Partnership(Joint Venture)

C Corporation(Venture Capital or IPO)

S Corporation(Lower Income TaxAccess Cash Flow)

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Placement Capital)


Placement Capital)







Stage OneInception

Stage Three Mature

Business



S Corporation(Lower Income TaxAccess Cash Flow)

Stage Four Diversification

/ Adding Entities

Limited Partnership(Real Estate related to

Family business)

Limited Liability Company(Non-family management

participation in real estate)

C and S Corporations, LLCs(Multiple locations, products,

services)

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Placement Capital)


Placement Capital)






Lifecycle of a Family Business EnterpriseStage OneInception

Stage Three Mature

Business



S Corporation

(Lower Income TaxAccess Cash Flow)

Stage Four Diversification

/ Adding Entities

Limited Partnership(Real Estate related to

Family business)

Limited Liability Company(Non-family management

participation in real estate)

C and S Corporations, LLCs(Multiple locations, products,

services)

Stage Five End Game

S CorporationAvoid Built In GainsAccess Cash Flow

Family Limited PartnershipAccess Cash Flow

Transfer Value/Keep Control

Limited Liability CompanyAccess Cash Flow

Transfer Value/Keep Control

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Unusual Financing Considerations that Drive Choice of Entity

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Beefco, Inc. is a food processor /distributor operating as an S Corporation. They have revenue of over $500 million per year in the sale of cut and pre-cook meat products to large fast food franchise operations such as McDonalds, Subway & Applebys throughout the Midwest.

They have been approached by their customers to establish operations in North Carolina in order to provide product to franchise operators in that area.

They may need a significant amount of capital and perhaps some creative financing. How will the potential financing impact the choice of entity? How might they restructure?

Case Study #4

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Unusual Tax Considerations that Drive Choice of Entity

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Section 1202

Revenue Reconciliation Act of 1993 Sec 1045 Rollover of gain in Qualified Small Business Stock

—60 days reinvestment 50% exclusion for gains of Qualified Small Business Stock

—C Corporation—Original Issue Stock after date of enactment

Alternative Minimum Tax Implications IRC Sec 57(a)(7)—7% included as a preference—Effective tax rate at 14%

Creating Small Business Jobs Act of 2010 75% exclusion for stock acquired in 2009 and 2010 100% exclusion for stock acquired in 2011 Section 57(a)(7) would not apply in 2011

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May only be established by Corporate Employer S Corporation - ESOP permitted shareholder (“single” shareholder) PSC ownership restricted to licensed profession = discrimination

Designed to Invest Primarily in Employer Securities Ownership Substantially all Stock can be restricted

to employees and trust Prevent competitors

Plan can contain “Put Option” to require redemption If Employer has a class of SEC Registered Securities, then the

ESOP must permit total participant voting of shares Non-SEC voting only required for sale, reorganization, or liquidation,

dissolution or similar event

Employee Stock Ownership Plans

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Traditional ESOP

Corporation

ESOP TRUST/ Employee Benefit Plan

Contribution in lieu of Cash as pension/profit sharing contribution

Newly Issued stock

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Enhanced deduction available 25% DC Limit Plus interest necessary to service the ESOP debt

C Corporation may deduct ESOP portion of dividend S Corporation ESOP not subject to UBIT on S income Tax-deferred Rollover – Section 1042

Seller of C Corp Shares may rollover proceeds into tax-deferred— Seller must have owned for 3 years— ESOP must own 30% after transfer— Proceeds must be invested in qualified securities (publicly traded)

Seller and Family may not be participants in the ESOP Non-SEC voting only required for sale, reorganization, or liquidation,

dissolution or similar event

Tax Benefits of ESOP

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Illustration of Leveraged ESOP

Lender

CorporationClient

(Grantor)

ESOP TRUST/ Employee Benefit Plan

Stock

Cash

DebtNewly Issued stock

CashDebt

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Export Sales OpportunitiesInterest Charged – Domestic International Sales

Corporation (IC-DISC)

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Understanding Domestic International Sales Corps

Brief history of IC-DISC Requirements of an IC-DISC? Benefits outside of the 15% dividend? Categories of Gross Receipts Identifying Qualified Export Receipts How to calculate the Commission

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The IC-DISC first came about in 1984 I.R.C. Section 991 – 997.

Unlike other exporting incentives the IC-DISC has yet to be challenged by the World Trade Organization (WTO). Extraterritorial Income Exclusion repealed American Jobs

Creation Act of 2004 With the current low dividend rates the IC-DISC is now an

attractive tax saving vehicle.

A Brief History of IC-DISC

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A corporation formed by a U.S. exporter/shareholder and will qualify as an IC-DISC if:

Organization Test— Domestic Corporation— Formed by U.S. exporter/shareholder— The IC-DISC does not have more than one class of stock, which the

stock must have a par or stated value of at least $2,500 on each day of its fiscal year.

— All shareholders consent to the election to be treated as an IC-DISC. (See Form 4876-A)

— Must maintain its own set of books and records.— Cannot be a member of a controlling group of which a Foreign Sales

Corporation is a member.

Requirements for an IC-DISC?

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Not Required of a IC-DISC

It is a “paper” entity. It is not required to have: Office space Employees, or Tangible assets

How it works: Exporting company forms a US corporation that elects to be an

IC-DISC by filing IRS Form 4876-A. Exporting company pays commission to IC-DISC and deducts

the commission as an ordinary business deduction. IC-DISC pays no tax on commission if two operational test met. Shareholders are not taxed until earnings are distributed as

dividends. —Deferred dividends reported on IRS Form 8404 and interest is paid.

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Operational Tests— 95% of its gross receipts are qualified exports receipts

– I.R.C. Sec. 993(a)(1).— 95% of the adjusted basis of its assets on the last day of its taxable year

is qualified export assets (i.e., accounts receivable, temporary investments, export property, and loans to producers).– I.R.C. Sec. 993(b).

Requirements for an IC-DISC?

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Commissions paid by export Corporation to IC-DISC

Fully deductible at regular tax rate Not treated as taxable income by IC-DISC Taxable to Shareholders as a dividend when paid

— Plus low rate of interest Deduct at 35% taxed at 15% (20% Savings)

Flexible ownership Minors (dependents) Parents (dependants) Trusts, partnerships, corporation and foreign persons. Roth IRA? (Deduct at 35% taxed at 0%)

What are the Benefits?

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Illustration

Restaurant Supply and Distribution Company

(S Corporation)

IC-DISC(Tax Exempt C Corporation)

100% OwnerCommissionDividend

Export Sales

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Cooperatives & Subchapter T (an alternative to Franchising)

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Cooperatives

Two Types Exempt cooperatives under IRC§ 501:

—§ 501(c)(12) Cooperatives and Homeowners Associations—§ 501(c)(16) Cooperative Organizations to Finance Farms—§ 501(e) Cooperative Hospital Service Organizations —§ 501(f) Cooperative Service Organizations of Operating

Educational Organizations —§ 521 Farmers' Cooperative Associations

– Land O’ Lakes Non-Exempt Cooperatives - Subchapter T of the IRC

—True Value Hardware—Ace Hardware

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Non-Exempt Cooperatives

A cooperative is a purchasing, marketing, or service enterprise owned by and operated for the benefit of its patrons.

Co-ops are “Hybrid” tax structures Modified Conduit entities Operate partially like C Corporations and partial like a trust

The taxable income of a cooperative is computed like a corporation, except

Allowed to deduct amounts paid within eight and one-half months after the end of the taxable year as patronage dividends

Patronage dividends Paid in cash or in kind (“by certificate”) Dividends are included in the gross income in the year of receipt.

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Captive Insurance Companies

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Captive Insurance Company

A captive insurance company ("Captive") is an insurance company formed by a business owner to insure the risks of related or affiliated businesses.

Business owner creates a Licensed Insurance Company which offers to cover traditional risks

Property Insurance Casualty Insurance

Captive can also cover non-traditional risks

• Business Interruption

• Pollution• Regulatory Exposure• Insurance

Deductibles• Exclusions and

Gaps

• Loss of Key customer or supplier

• Loss of Tenant• Loss of Key Employee• Breach of Contract• Natural Disasters, Terrorism

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Captive Insurance Company

Business Reasons for creating a captive Lower insurance costs

—Share in benefit of low claims—Charge a premium that reflects loss experience

Cash Flow — Invest premium dollars and use investment income to reduce

costs Risk Retention

—Managing risk results in greater profit to owned captive Access Reinsurance market

—Reinsurance is international wholesale market —Lower cost structure = lower cost

Tax Minimization and deferral—Self Insurance is not deductible – premiums paid to a captive are!

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Tax Benefits of Captive Insurance Companies

Subchapter L requires Insurance Companies to be C Corporations

Section 831(b) exempts first $1.2 million of premium from income tax

Premiums in excess of $1.2 million can be sheltered by loss reserves

Insurance companies operate as C Corporations Insurance companies can deduct “reserves”

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IRS Required Elements for Insurance Companies

A Captive must provide Risk Shifting and Risk Distribution

“Risk Shifting” is the actual transfer of Risk from the insured to the Captive Insurance Company

“Risk Distribution” is the Captives exposure to adequate third-party risk to obtain the risk-pooling effect had by traditional insurance companies.

Reduce the possibility that a single claim will exceed premiums received.

Generally, 12 insured's are sufficient (even if subsidiaries, so long as they are not disregarded entities)

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Illustration

Family Owed Captive

Restaurant AS Corporation

Irrevocable Trust for benefit of Client’s Family

Client(Grantor)

Captive Insurance CompanyC Corporation

Premiums

100% Owner

100% Owner

Restaurant BS CorporationPremiums

Choice of Entity 2012

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Transcript of Choice of Entity 2012