Check-The-Box Same analysis, more certainty Corporate entities are C or S. Partnerships and LLCs under Subchapter K (partnership) unless all consent to C status Single owner entity is C corp or sole proprietor. One owner LLC disregarded. Locked in for 60 months unless more than 50% change in ownership. Tax consequences of switching can be costly. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-1

Entity Candidates Sole Proprietorship C Corporation General Partnership Limited Partnership S Corporation Limited Liability Company Professional Limited Liability Company Limited Liability Partnership Limited Liability Limited Partnership Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-2

Future Sale Potential C Corporation Factors Double tax potential No basis booster for income accumulations Tax-free reorganization potential 1045 rollover potential 15% capital gains rate at shareholder level 1202 exclusion (not a big deal now) Ordinary loss treatment under 1244 (no big deal) Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-3

C Corp Double Tax Hit on Asset Sale Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-4 C Corp 34% Tax Rate Buyer Assets Cash Shareholders 15% Tax Rate Net Proceeds Summary tax impact on $1,000 gain Corporate 34% $340 Shareholder Tax 15% of $ Total Taxes $439 Percent 43.9%

C Corp Non-Basis Booster Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-5

Pass-Thru Entity Basis Booster Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-6

Sale Potential of S Corp vs. Sub. K S corp can participate in tax-free reorg. Less ordinary income traps with S corp Basis boosting a push C corp convertibility - S possible with nuisance traps - Partnership and LLC usually prohibitive Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-7

Earnings Bailout of 100k Income C corp C corp P or LLC S Corp Dividend Compensation Distribution Distribution Corp Inc. Tax 22, Owner Inc. tax 11,662 28,000 28,000 28,000 Total Income Tax 33,912 28,000 28,000 28,000 End of Story? * Assumes 15% dividend rate and 28% marginal ordinary rate. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-8

No Way! C corp C corp P or LLC S Corp Dividend Compensation Distribution Distribution Corp Inc. Tax 22, Owner Inc. tax 11,662 26,010 26,010 28,000 Total Income Tax 33,912 26,010 26,010 28,000 Payroll Tax 0 14,212 14,212 (?) 0 Revised Total 33,912 40,222 40,222 28,000 No wonder S is so popular! But is payroll tax really a tax? * Assumes 15% dividend rate and 28% marginal ordinary rate. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-9

C Corp Bracket Racket C Corp Rates Married Rates (2005) Up to 50k 15% Up to 14.6k 10% 50K to 75k 25% 14.6k to 59.4k 15% 75k to 100k 34% 59.4k to k 25% 100k to 335k 39% k to 182.8k 28% 335k to 10 mill 34% 182.8k to k 33% 10 mill to 15 mill 35% Over k 35% 15 mill to 18.3 mill 38% Over 18.3 mil 35% Yellow rates are the opportunity brackets Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-10

C Corp Income Split – 150k C Corp Pass Thru Entity C tax on 50k 7,500 Owner income tax on excess 14,236 27,140 Total Income tax 21,736 27,140 Savings of 19.9% * Assumes payroll taxes a push, married couple with two exemptions, use of standard deduction, and year is Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-11

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com High Income Rate Status Quo Obama Income Tax 35.0% 39.6% Payroll Tax 2.9% 6.9% Inc. Tax Offset (.5%) (1.4%) Phase-Outs 0.0% 3.0% Total 37.4% 48.1% “Modest Drop” of 17.12%

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Earnings Bailout Status Quo Obama C Corp Dividends 43.9% 47.2% C Corp Comp 37.4% 48.1% LLC / Partnership 37.4% 48.1% S Corp Dividend 35.0% 42.6%

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Earnings Reinvested Status Quo Obama C Corp 34.0% 34.0% LLC / Partnership 37.4% 48.1% S Corp Dividend 35.0% 42.6%

Different Ownership Interests Challenge: Separate control, income, and equity growth. C Corp Tools: Voting and nonvoting stock, preferred stock, hybrids, shareholder debt, employment contracts. S Corp Tools: No preferred or second class of stock. Only voting differences. Least flexible. Partnerships and LLCs: Only limitation is “substantial economic effects” limits of 704. The most flexible option. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-12

Conversion Flexibility From C corp to - Partnership or LLC: Killer double tax - S corp: Doable but serious traps From S corp to - Partnership or LLC: Painful single tax - C corp: Piece of cake From LLC or Partnership to - C corp: Doable with minor traps - S corp: Doable if qualify - LLC or Partnership: Doable Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-13

C Corp Losses Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-14 Losses C Corp Shareholders Carry BackCarry Forward Never Pass Thru

S Corp, Partnership, LLC Losses Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-15 Losses C Corp Owners Pass Thru Hurdles: Basis limitations (704(d) and 1366(d)) At-risk limitations (465) Passive activity limitations (469)

Material Participation Under 469 More than 500 hrs in year Sole participant in activity More than 100 hrs and anyone else More than 100 hrs and more than 500 hrs in significant participation activities 5 of last 10 yrs meet standard Any previous 3 yrs if personal service Regular, continuous, substantial based on all facts and circumstances Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-16

Nuisance C Traps (Not Choice Factors) Accumulated earnings trap - Penalty tax on excess income accumulations - Rate now low 15% (may go back up) - No tax on accumulations for reasonable business needs - Minimum credit of 250k (150k for professional service organizations) - Nuisance trap that requires awareness and basic planning Personal holding company trap - Penalty tax on excess accumulations of investment income, incorporated talent income, and shareholder rental income - Rate now low 15% (may go back up) - Closely held and 60% requirements for tax to apply - Remedial action is to bailout income via dividends or compensation Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-17

Problem 3-A: Lucy Catering Driving factors for Lucy: Earnings bailout - no double income taxes and no or low self-employment taxes Separate tax entity - single owner LLC would be disregarded entity Passive income potential for Lucy, possibly sheltered by passive losses from other ventures Limited liability - trucks on road and 10 employees No need for owner/employee fringe benefits Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-18 Recommendation: S Corp

Problem 3-B: Management Consulting Firm Driving factors for Sam, Larry, and Joe: Fringe benefits for themselves Earnings all bailed as compensation income Limited liability from negligence of other owners and employees Business service income vehicle - not likely sale candidate Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-19 Recommendation: C Corp

Problem 3-C: Roger Specialized Shop Driving factors for Roger: Maximum control (Board control) - no hassles from minority owners Income bailout to minority owners - no double income taxes or self-employment taxes Protected compensation contract and bonus program Limited liability - machines, employees and contracts Passive income to minority owners Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-20 Recommendation: S Corp

Problem 3-D: Roger Revised Plan Driving factors for Roger: Losses passed through to investors Beat basis and at-risk hurdles for investors Maximum control - no hassles from minority owners Income bailout to minority owners when turn profitable - no double income taxes or self-employment taxes, preferably passive income Protected compensation contract and bonus program Limited liability - machines, employees and contracts Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-21 Recommendation: LLC or Limited Partnership with Roger- owned S Corp general partner

Problem 3-E: Rhonda Flash Application Driving factor for Ronda: Ability to attract venture capital Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-22 Recommendation: C Corp

The 1561 Trap The 1561 Trap - No multiple C Corp benefits to group Only one Section 11 bracket racket Only one 250k accumulated earnings tax credit Only one 40k corporate AMTI exemption Only one $2 million Section 59 tax exemption Big Issue: What is controlled group? Three types Parent-Subsidiary controlled group Brother-Sister controlled group Combined controlled group Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-23

Parent- Sub Controlled Group Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-24 Parent C Corp Sub 1 C Corp Sub 2 C Corp Sub 3 C Corp Sub 4 C Corp 80% % of voting or total share value of each corp owned by other corps in group, and - 80% of voting or total share value of at least one corp owned by a common parent corp.

Brother- Sister Controlled Group Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com or Fewer Persons 50% or fewer individuals, estates, or trusts - Own 50% of voting or total share value of both - Consider only minimum common ownership in each entity Brother C Corp Sister C Corp 50% +

Combined Controlled Group Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com or Fewer Persons 50% or more corps part of parent-sub or brother-sister controlled group, and - At least one corp both a common parent of parent- sub group and a member of brother-sister group Brother C Corp Sister C Corp 50% + Sub 1 C Corp Sub 2 C Corp 80% +

Controlled Group Attribution (1563) Options - Deemed exercised 5% partners - proportional interests 5% trust and estate beneficiaries 5% corporate shareholder - proportional interests Spouse Minor children (under age 21), but not adult children unless If person owns more than 50%, considered owner of stock owned by parents, grandparents, grandchildren and children over age 21 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-27

Problem 3-F: Three C Corp Plan Stock Ownership Minimum Common Ownership X Corp Y Corp Z Corp X-Y X-Z Y-Z Jim 10% 40% 30% 10% 10% 30% Linda 80% 5% 25% 5% 25% 5% Sam 10% 55% 45% 10% 10% 45% Totals 100% 100% 100% 25% 45% 80% X and Y Not Brother-Sister X and Z Not Brother-Sister Y and Z Brother-Sister Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-28

Problem 3-G: Medical Supply JV Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-29 Key factors for ABC Inc. and Smith Enterprises: Move funds with no tax impact (pass thru entity) Flexibility with income and cash distributions Contract control provisions that protect both Limited liability - separate employees S Corp not option - ineligible shareholders Recommendation: LLC

Problem 3-H: Jones 482 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-30 Jones C Corp Newco C Corp Individual Shareholders Bargain Sale Imputed Income Imputed Dividend Imputed Contribution Income imputed at both corporate and shareholder levels

Problem 3-H: Jones Industries Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-31 Key factors for Jones Industries: Avoid 482 trap risks Separate offshore buying entity Common control No tax hassles on dealings between entities Pricing flexibility between entities Recommendation: Consolidated Group with C Corp Holding Company Parent

Problem 3-I: Jerry Yacht Company Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-32 Key factors for Jerry: Preferred cash flow to investors Special and different profit and loss allocations (30%-70% profits and 99%-1% losses) Jerry in complete control No double tax or self-employment tax hassles Pass thru of profits and losses Limited liability - yacht building and sales Recommendation: LP with S Corp General or LLC

Problem 3-J: Golfer Grow and Sell Company Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-33 Key factors for five Golfer owners: Basis build-up on income accumulations No double tax on sell-out Tax-free corporate reorg potential No ordinary income on entity ownership sale Limited liability exposure Equal control Recommendation: S Corp

Problem 3-K: Wharton Subs Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 3-34 Key factors for Wharton Enterprises Multiple separate entities Wharton parent owner of all entities Consolidated operations for tax purposes Preserve pass thru benefits Minimize or eliminate conversion hassles Recommendation: Maintain existing S Corp with new corporations being Qualified Subchapter S Subs under 1361(a)(3)