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

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Presentation on theme: "Jim Colville, CPA 1 Accounting Day A Fresh Look at Choosing the Right Business Entity May 12, 2004."— Presentation transcript:

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

2 Jim Colville, CPA 2 Accounting Day-2004 Presented by Jim Colville, CPA The presentation and sample files related to the presentation are available: © 2004 by James M. Colville May 12, 2004

3 Jim Colville, CPA 3 Choice of Entities Sole Proprietor C Corporation General Partnership Limited Partnership S Corporation Limited Liability Company (LLC) Limited Liability Partnership (LLP) 5/12/04

4 Jim Colville, CPA 4 Choice of Entities Tax Reasons Taxation of Owners Tax on Operations Tax on Dissolution Non Tax Reasons Legal Liability Why? 5/12/04

5 Jim Colville, CPA 5 Liability Exposure Employee Activities Hazardous Activity Debt Professional Services….Malpractice Product Liability Claims Environmental Liabilities 5/12/04

6 Jim Colville, CPA 6 Liability 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. 5/12/04

7 Jim Colville, CPA 7 Sole Proprietor Formation The assets of the business are the assets of the owner. Simply declare the assets as business assets. 5/12/04

8 Jim Colville, CPA 8 Sole Proprietor Operation Keep business records Segregate business and personal activity Taxed on Schedule C, Form 1040 A very basic Flow Through Entity 5/12/04

9 Jim Colville, CPA 9 Sole Proprietor Schedule C Arrives at Net Income from the business Net Income is taxed, flows through to page 1, Form /12/04

10 Jim Colville, CPA 10 Sole Proprietor Schedule C Owner’s draw / salary Taxed on Net Income without regard for draws Fully taxed even with no draws 5/12/04

11 Jim Colville, CPA 11 Sole Proprietor Schedule C A perfect example of a flow-through entity 1. 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 5/12/04

12 Jim Colville, CPA 12 Sole Proprietor 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 5/12/04

13 Jim Colville, CPA 13 Sole Proprietor Protection against legal liabilities None The is no legal distinction between you and your business May find that insurance provides protection (with risk) 5/12/04

14 Jim Colville, CPA 14 Sole Proprietor Simple to begin the business Business License Fictitious Name Business bank account 5/12/04

15 Jim Colville, CPA 15 Sole 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) 5/12/04

16 Jim Colville, CPA 16 Sole 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 later 5/12/04

17 Jim Colville, CPA 17 C - Corporation A separate legal entity apart from its shareholders A separate tax paying entity 5/12/04

18 Jim Colville, CPA 18 C – 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” 5/12/04

19 Jim Colville, CPA 19 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. 5/12/04 C – Corporation— Double Taxation

20 Jim Colville, CPA 20 Pay bonuses to shareholders Deductible by corporation Taxable to shareholder/employee Avoiding double taxation Eliminating/reducing double taxation with deductible payments 5/12/04 C – Corporation— Double Taxation

21 Jim Colville, CPA 21 Eliminating Double Taxation with Deductible Payments Salaries, salaries with bonuses Rents Interest 5/12/04 C – Corporation— Double Taxation

22 Jim Colville, CPA 22 Eliminating Double Taxation with Deductible Payments- continued These payments may be challenged by the IRS, claiming the avoidance of paying dividends. 5/12/04 C – Corporation— Double Taxation

23 Jim Colville, CPA 23 Salaries Reasonable Bonuses can look like dividends as they are paid from excess profits, same definition as dividends. 5/12/04 C – Corporation— Double Taxation

24 Jim Colville, CPA 24 Rent Building / warehouse owned by shareholder Interest Money loaned to the corporation Both can be considered excess as it exceeds FMV 5/12/04 C – Corporation— Double Taxation

25 Jim Colville, CPA 25 Creating interest payments upon formation. Example: Stock Note Note payable90,000 Common stock100,00010,000 5/12/04 C – Corporation— Double Taxation

26 Jim Colville, CPA 26 C – Corporation—Double Taxation Shareholder receives “principle repayment” tax free, plus interest on the note. Viewed as “thin capitalization” 5/12/04

27 Jim Colville, CPA 27 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? 5/12/04 C – Corporation— Double Taxation

28 Jim Colville, CPA 28 Leasing Warehouse Corp #1 Rent(10,000)10,000 Interest (8,000) Property Taxes(2,000) Total Outlays (10,000) Net Depreciation (3,000) Creating a taxable: loss #2 13,000 (8,000) (2,000) (10,000) 3,000 (3,000) breakeven 5/12/04

29 Jim Colville, CPA 29 Benefits: Deductible lease payments (for the corp) Sheltered by depreciation Build equity in the note Enjoy tax free appreciation of the asset 5/12/04 C – Corporation— Double Taxation

30 Jim Colville, CPA 30 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. 5/12/04 C – Corporation— Double Taxation

31 Jim Colville, CPA 31 Disadvantages-Double taxation in all its forms Dividends Sale of Stock 5/12/04 C – Corporation— Double Taxation

32 Jim Colville, CPA 32 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. 5/12/04 C – Corporation— Double Taxation

33 Jim Colville, CPA 33 Liquidation Example: Corporation has greatly appreciated asset(s) Shareholders decide to distribute asset(s) to shareholder(s). 5/12/04 C – Corporation— Double Taxation

34 Jim Colville, CPA 34 Liquidation Upon distribution, treated as deemed sale, taxable to corporation Distribution is taxed to the shareholder 5/12/04 C – Corporation— Double Taxation

35 Jim Colville, CPA 35 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. 5/12/04 C – Corporation— Double Taxation

36 Jim Colville, CPA 36 Pays cash to shareholders The resulting cash is paid to the shareholders Taxable to shareholders 5/12/04 C – Corporation— Double Taxation

37 Jim Colville, CPA 37 When C-Corporations May 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. 5/12/04

38 Jim Colville, CPA 38 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 5/12/04 When C-Corporations May be Attractive

39 Jim Colville, CPA 39 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 5/12/04 When C-Corporations May be Attractive

40 Jim Colville, CPA 40 Partnerships 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 5/12/04

41 Jim Colville, CPA 41 Partnerships Then: Got a “bad name” during the 1980s, especially limited partnership. Partnership tax rules became more complicated due trying curb the abuses. 5/12/04

42 Jim Colville, CPA 42 General 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 5/12/04

43 Jim Colville, CPA 43 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. 5/12/04 General vs. Limited Partnerships

44 Jim Colville, CPA 44 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. 5/12/04 General vs. Limited Partnerships

45 Jim Colville, CPA 45 Limited partnerships or LLCs (discussed later) Outside investors find unlimited liability unacceptable. Thus, prefer either: 5/12/04 General vs. Limited Partnerships

46 Jim Colville, CPA 46 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 5/12/04

47 Jim Colville, CPA 47 Certain venture capital investments Business start-ups with expected losses the initial years (pass-through taxation) Partnership Taxation Type of entities best suited for partnerships 5/12/04

48 Jim Colville, CPA 48 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. Partnership Taxation Types of businesses best suited for partnerships 5/12/04

49 Jim Colville, CPA 49 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 5/12/04

50 Jim Colville, CPA 50 Check the box regulations allow an election on how to be taxed Most commonly, partnership taxation LLCs How is an LLC taxed? 5/12/04

51 Jim Colville, CPA 51 Partnership taxation (same for both) Limited liability (LLC) Ability to use SMLLC LLCs Partnership or LLC? 5/12/04

52 Jim Colville, CPA 52 Types of businesses best suited for partnerships Substantially the same as previous slides 5/12/04 LLCs

53 Jim Colville, CPA 53 Pass through taxation Substantially the same as previous slides 5/12/04 LLCs

54 Jim Colville, CPA 54 S 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) 5/12/04

55 Jim Colville, CPA 55 S Corporations Only individuals, estates, certain types of trusts as shareholders Shareholders must be U.S. Citizens or resident aliens Limited to one class of stock 5/12/04

56 Jim Colville, CPA 56 Let’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

57 Jim Colville, CPA 57 Let’s Look at the Differences 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 5/12/04

58 Jim Colville, CPA 58 Let’s Look at the Differences No basis adjustment for retained earnings C Corporations-Disadvantages 5/12/04

59 Jim Colville, CPA 59 Let’s Look at the Differences Existing C Corporations desiring pass through taxation One owner Continuity of life S Corporations 5/12/04

60 Jim Colville, CPA 60 Let’s Look at the Differences Tax deferred contributions of assets Special allocations Pass through taxation Basis adjustment from operations LLC / Partnerships 5/12/04

61 Jim Colville, CPA 61 Let’s Look at the Differences Initial and subsequent contributions Plus earnings Less distributions (draw) Less losses Plus share of debt Basis adjustment from operations 5/12/04

62 Jim Colville, CPA 62 Let’s Look at the Differences Basis adjustment due to CorpP/S Initial contribution P & L0900 AB1001,000 SP 2,000 Gain1,9001,000 Basis adjustment from operations 5/12/04

63 Jim Colville, CPA 63 Partnerships 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. 5/12/04

64 Jim Colville, CPA 64 Let’s Look at the Differences 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. 5/12/04

65 Jim Colville, CPA 65 S Corporations 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 5/12/04

66 Jim Colville, CPA 66 S Corporations 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. 5/12/04

67 Jim Colville, CPA 67 S Corporations 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. 5/12/04

68 Jim Colville, CPA 68 S Corporations 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. 5/12/04

69 Jim Colville, CPA 69 Qualified 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 /12/04

70 Jim Colville, CPA 70 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) 5/12/04

71 Jim Colville, CPA 71 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). 5/12/04

72 Jim Colville, CPA 72 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. 5/12/04

73 Jim Colville, CPA 73 QSBCs 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. 5/12/04

74 Jim Colville, CPA 74 LLCs 5/12/04 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

75 Jim Colville, CPA 75 LLCs 5/12/04 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

76 Jim Colville, CPA 76 LLCs 5/12/04 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

77 Jim Colville, CPA 77 LLCs 5/12/04 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.

78 Jim Colville, CPA 78 Selecting the Best Entity 5/12/04 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.

79 Jim Colville, CPA 79 Selecting the Best Entity 5/12/04 Planning Seek professional guidance. Legal CPA

80 Jim Colville, CPA 80 Selecting the Best Entity 5/12/04 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

81 Jim Colville, CPA 81 Selecting the Best Entity 5/12/04 Thank You


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