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-taxCorporation
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 ployC-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 ployC-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 lossesC-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 lossesS-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 lossesSole 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!