CHOICE OF ENTITY
TAX CONSIDERATIONS
Thomas F. Schnellenberger
September 20, 2006
1607621
1
OVERVIEW
Ms. Big Bucks is contemplating how to organize
her new business:
• Sole Proprietorship
• Single Member Limited Liability Company
(“SMLLC”)
• General Partnership
• Limited Partnership
• Limited Liability Company (“LLC”)
• S Corporation
• C Corporation
2
OVERVIEW
Assume the following:
• Ms. Big Bucks uses $10 of personal funds and $50
of funds borrowed from bank
• Year 1 losses = $50 (Ms. Big Bucks’ share)
• Year 2 profits = $100 (Ms. Big Bucks’ share)
• Business is sold at the end of year 2 for $1,000
• Ms. Big Bucks is active in the business
3
CHOICE OF ENTITY
SOLE PROPRIETORSHIP
4
CHOICE OF ENTITY SOLE PROPRIETORSHIP
FORMATION
$50
Bank
Ms. Big Bucks
Note
• Business bank account
• Federal and state Employer
Identification Numbers (“EINs”) and
other tax registrations
• Licenses
• No liability protection
• Self employment (“SE”) tax
5
Employment Tax
Components and Rates
Self-Employed
Employer
Employee
Individual
OASDI - Imposed on Earnings up to $94,200 (2006):
Employer
6.2%
Employee
__
6.2%
6.2%
6.2%
6.2%
12.4%
Total OASDI
6.2%
Medicare:
Employer (1)
1.45%
1.45%
Employee
___
1.45%
1.45%
Total Medicare
1.45%
1.45%
2.9%
Total
7.65% (1)
7.65%
15.3% (2)
(1) Deductible by employer in arriving at employer’s taxable income.
(2) One-half deductible in arriving at adjusted gross income.
6
SOLE PROPRIETORSHIP
FIRST YEAR
Self-employment Tax
Income from Operations
Self-employment Inclusion Percent
($50.00)
(46.18)
Self-employment Tax Rate
x 15.3%
(7.06)
Net Taxable Income
Net Cash
($50.00)*
3.53
(46.47)
Assumed Effective Rate
Tax Cost < savings >
Cash
x 92.35%
Self-employment loss
Self-employment Tax benefit
Income Tax
x 38%
($7.06)
($17.66)
24.72
$ 24.72
Unless otherwise noted, it has been assumed that: (1) at-risk and passive loss
rules are satisfied, and (2) Ms. Big Bucks has other sources of SE income
against which loss can be offset.
After-tax benefit of $24.72
7
SOLE PROPRIETORSHIP
SECOND YEAR
Self-employment Tax
Income from Operations
$100.00
Income Tax
Cash
$100.00
Self-employment Inclusion Percent x 92.35%
Self-employment Income
92.35
Self-employment Rate
x 15.3%
Self-employment Tax
14.13
Net Taxable Income
92.94
Assumed Effective Income Tax Rate
Tax Cost < savings >
(7.06)*
x 38%
$14.13
$35.32
(49.45)
($49.45)
* After-tax cost of $49.45
8
SOLE PROPRIETORSHIP
SALE OF BUSINESS
Income Tax
Sales price
$1,000.00
Cash
$1,000.00
Basis
Personal funds
$ 10
Borrowed funds
50
Year 1 loss
(50)
Year 2 profit
100
Gain
Estimated capital gains rate
Income tax
Loan repayment
Net sales proceeds
(110.00)
890.00
17%
$ 151.30
(151.30)
(50.00)
$ 798.70
9
SOLE PROPRIETORSHIP
NET CASH
Original investment
($10.00)
First year tax
24.72
Second year tax
(49.45)
Sale proceeds
798.70
Total
$763.97
10
CHOICE OF ENTITY
SINGLE MEMBER LLC
11
SINGLE MEMBER LLC
FORMATION
100%
Ownership
Note
Big Bucks
LLC
Ms. Big Bucks
$50
Bank
$10
Absent an affirmative election to be treated as a
corporation, Big Bucks LLC will be disregarded for
income tax purposes; i.e., treated as a sole
proprietorship
• Bank account
• EINs
• Licenses
• Liability Protection
• SE tax
12
SINGLE MEMBER LLC
NET CASH
Original investment
($10.00)
First year tax
24.72
Second year tax
(49.45)
Sale proceeds
798.70
Total
$763.97
13
CHOICE OF ENTITY
GENERAL
PARTNERSHIP
14
GENERAL PARTNERSHIP
FORMATION
Ms. Big Bucks
50%
General
Partnership
Interest
Mr. Big Bucks
$10 $10
Big
Bucks,
General
Partnership
50%
General
Partnership
Interest
Bank
$100
15
GENERAL PARTNERSHIP
NET CASH
Original investment
($10.00)
First year tax
24.72
Second year tax
(49.45)
Sale proceeds
798.70
Total
$763.97
16
CHOICE OF ENTITY
LIMITED PARTNERSHIP
17
CHOICE OF ENTITY LIMITED PARTNERSHIP
FORMATION
Ms. Big Bucks
50%
General
Partnership
Interest
•
•
•
•
•
Mr. Big Bucks
$10 $10
Big
Bucks,
L.P.
50%
Limited
Partnership
Interest
Note
Bank
$100
EINs
Bank account
Liability protection for limited partner only
Deductibility of losses subject to basis, at-risk and passive
loss limitations
General partner subject to self-employment tax but limited
partner is generally not
18
LIMITED PARTNERSHIP
FIRST YEAR
Mr. Big Bucks
Ms. Big Bucks
Taxable
Loss
<$10> (1)
Taxable
Loss
<$90>
Big
Bucks,
L.P.
(1) Basis limitation results in loss limitation to Mr. Big Bucks.
19
LIMITED PARTNERSHIP
FIRST YEAR MS. BIG BUCKS
Self-employment Tax
Income from Operations
($90.00)
Income Tax
Cash
($90.00)
Self-employment Inclusion Percent x 92.35%
Self-employment Loss
($83.12)
Self-employment Tax Rate
x 15.3%
Self-employment Tax Benefit
($12.72)
Net Taxable Income
($83.64)
Assumed Effective Income Tax Rate
Tax Cost/(Savings)
(6.36)
x 38%
($12.72)
Net Individual Cash
($31.78)
44.50
$ 44.50
After-tax savings of $44.50
20
LIMITED PARTNERSHIP
FIRST YEAR MR. BIG BUCKS
Self-employment Tax
Income from Operations
Self-employment Inclusion Percent
Self-employment Income < loss >
$0.00
Income Tax
Cash
($10.00)
$0.00
x 92.35%
$0.00
Self-employment Tax Rate
x 15.3%
Self-employment Tax Cost < benefit >
$0.00
Net Taxable Income
0.00
($10.00)
Passive Loss Limitation
10.00
Net Taxable Income
(0.00)
Assumed Effective Rate
x 38%
Tax Cost < savings >
$0
Net Individual Cash
No after-tax savings because of basis limitation
$0
0
$0
21
LIMITED PARTNERSHIP
First Year
Ms. Big Bucks
GP
Mr. Big Bucks
LP
Guarantee
$10 loss
$90 loss
Big
Bucks,
L.P.
Note
Bank
$100
LP’s basis limitation can be avoided if LP guarantees at least
$10 of bank debt
22
LIMITED PARTNERSHIP
SECOND YEAR MS. BIG BUCKS
Self-employment Tax
Income < loss >from Operations
$ 140.00
Self-employment Inclusion Percent
x 92.35%
Self-employment Income < loss >
$ 129.54
Self-employment Tax Rate
x 15.3%
Income Tax
Cash
$ 140.00
<$ 0 >
Self-employment Tax Cost < benefit > $ 19.82
< 9.91 >
Net Taxable Income
$ 130.09
Assumed Effective Income Tax Rate
Tax Cost < savings >
Net Individual Cash
x 38%
$ 19.82
$ 49.43
< 69.25 >
< $ 69.25 >
After-tax cost of $69.25
23
LIMITED PARTNERSHIP
SECOND YEAR MR. BIG BUCKS
Self-employment Tax
Income < loss >from Operations
$0
Tax
$ 60.00
Passive Loss Carryover
< 10.00 >
Net Taxable Income
$ 50.00
Assumed Effective Rate
Tax Cost < savings >
Cash
x 38%
$0
$ 19.00
Net Individual Cash
< $19.00 >
< $ 19.00 >
• After-tax cost of $19.00 (reduced because of carryover)
• No self-employment tax because of LP status
24
LIMITED PARTNERSHIP
SALE OF BUSINESS
Sales price
Basis
Personal funds
Borrowed funds
Year 1 loss
Year 2 profit
Allocable share
Gain
Assumed capital gains rate
Income tax
Repay bank (Allocable Share)
Net sales proceeds
Income Tax
$ 1,000
$ 20
100
< 100 >
200
220
x 50%
< 110 >
$ 890.00
17%
$ 151.30
Cash
$1,000
< 151.30 >
< 50 >
$ 798.70
25
LIMITED PARTNERSHIP
NET CASH
Original Investment
First Year Tax
Ms. Big Bucks
Mr. Big Bucks
< $ 10.00 >
< $ 10.00 >
44.50
-0-
Second Year Tax
< 69.25 >
< 19.00 >
Sale Proceeds
798.70
798.70
$ 763.95
$ 769.70
Total
26
CHOICE OF ENTITY
LIMITED
LIABILITY COMPANY (LLC)
27
CHOICE OF ENTITY
Limited Liability Company
Similar to limited partnership,
but with limited liability for all.
28
CHOICE OF ENTITY
SELF EMPLOYMENT TAX
Treasury issued Proposed Regulations in 1997 which would
exclude limited partners and LLC members from selfemployment tax unless individual has any one of the
following:
(1) personal liability for debts or claims against
the entity by reason of being owner,
(2) authority to contract on behalf of the entity, or
(3) participates in the entity’s business for more
than 500 hours during the tax year.
29
CHOICE OF ENTITY
S CORPORATION
30
CHOICE OF ENTITY S CORPORATION
FORMATION
Ms. Big Bucks
Cash
$10
100%
Stock
S
Corporation
•
•
•
•
•
$50
Note
Bank account
EINs
S corporation election required
Licenses
Liability Protection
Bank
31
S CORPORATION
FIRST YEAR
Income <loss> from Operations
Basis Limitation
Net Taxable Income <loss>
Assumed Effective Rate
Tax Cost <savings>
Net Cash
Income Tax
Cash
< $50* >
$0
40
< $10 >
x 38%
< $3.80 >
3.80
$3.80
* Deductibility of loss subject to at-risk, basis limitation and passive
loss rates. Assume individual is active in business. Salary????
32
CHOICE OF ENTITY S CORPORATION
FORMATION
Avoiding Basis Limitation
Ms. Big Bucks
$50
Note
Cash
$60
100%
Stock
Bank
S
Corporation
Note: Guarantee by Ms. Big Bucks will not create basis
33
S CORPORATION
SECOND YEAR
Tax
Cash
Income <loss> from Operations
$100
$0
Suspended Loss Deductible
< 40 >
Net Taxable Income
$ 60
Assumed Effective Rate
x 38%
Tax Cost <savings>
$22.80
Net Cash
< 22.80 >
< $22.80 >
34
S CORPORATION
SALE OF BUSINESS
Sales Price
Basis
Personal funds
Loaned funds
Income Tax
Cash
$ 1,000
$ 1,000
$10
50
Year 1 loss
<50>
Year 2 profit
100
<110>
Gain
$ 890
Assumed Capital Gains Rate
x 17%
Income Tax
$ 151.30
<151.30>
Repay Bank Loan
< 50.00>
Net Cash
$ 798.70
35
S CORPORATION
NET CASH
Original Investment
First Year Tax
<$10.00>
3.80
Second Year Tax
<22.80>
Sale
798.70
Total
$769.70
36
CHOICE OF ENTITY
S CORPORATION vs. PARTNERSHIP
WHY NOT AN S CORP?
•
•
•
•
•
•
•
Only natural persons and certain trusts can be shareholders
Maximum 100 shareholders (family members may be treated
as one shareholder)
Only one class of stock permitted (except can have differing
voting rights)
No special allocations
No tax basis for liabilities even if guarantee
A distribution of appreciated assets from an S corporation is a
taxable event; such a distribution from a partnership or LLC
generally is tax-free
Salary/payroll taxes
37
CHOICE OF ENTITY
C CORPORATION
38
CHOICE OF ENTITY C CORPORATION
FORMATION
Ms. Big Bucks
Cash
$10
100%
Stock
C
Corporation
•
•
•
•
Bank account
EINs
Licenses
Liability Protection
$50 Cash
Note
Bank
39
CHOICE OF ENTITY C CORPORATION
FIRST YEAR
Income <loss> from Operations
< $ 50 >
Net Operating Loss Carryover
< $ 50 >
40
CHOICE OF ENTITY C CORPORATION
SECOND YEAR
Income <loss> from Operations
$ 100
Net Operating Loss Carryover Used
<
Net Taxable Income
$ 50
50 >
Assumed Effective Rate
x 18%
Net Cash Cost to Corporation
$
9
41
C CORPORATION
SALE OF ASSETS
Sales Price
Corporate
Corporate
Individual
Individual
Income Tax
Cash
Income Tax
Cash
$1,000
$1,000
Basis
Original Investment
$10
Bank Loan
50
Net Cash Investment
from Operations
41
Net Gain
Assumed Corporate Rate
Corporate Tax
< 101 >
899
x 40%
$ 359.60
< 359.60 >
Repay Bank Loan
< 50.00 >
Net Cash to Distribute
$ 590.40
Individual Basis
$ 590.40
< 10.00 >
Net Gain
580.40
Assumed Capital Gains Rate
x 17%
Tax
98.67
Net Cash
$ 590.40
(98.67)
$491.73
42
C CORPORATION
SALE OF STOCK
Sales Price
Basis
Income Tax
Cash
$ 950*
$ 950
10
Net Gain
$ 940
Assumed Capital Gains Rate
x 17%
Tax
$ 159.80
Net Cash
*Assume stock sold for $1,000 less $50 bank loan.
< 159.80 >
$ 790.20
43
C CORPORATION
NET CASH
Sale
Sale
of
of
Assets
Stock
< $10 >
< $10 >
First Year
-0-
-0-
Second Year
-0-
-0-
Sale
$ 491.73
$ 790.20
Net Cash
$ 481.73
$ 780.20
Original Investment
44
CHOICE OF ENTITY
COMPARISON OF NET CASH
Sole Proprietorship/General Partner
$763.97
Limited Partner
769.70
S Corporation
769.70
C Corporation – Sale of Assets
481.73
C Corporation – Sale of Stock
780.20
45
CHOICE OF ENTITY
C CORPORATION
DOUBLE TAX ON DIVIDENDS
Tax
Cash
Corporate Profit
$100
$100
Assumed Effective Corporate Tax Rate
x 40%
Income Tax
$ 40
< 40 >
Cash Available for Distribution
$ 60
$ 60
Assumed Effective Individual Tax Rate
x 17%
Income Tax
Net Cash
$10.20 <10.20>
$49.80
46
CHOICE OF ENTITY
EMPLOYEE FRINGE BENEFITS
Sole proprietors, partners (including LLC members) and more
than 2% shareholders in an S corporation are not eligible for the
following tax free benefits:
•
•
•
•
•
•
•
Group term life insurance
Disability insurance
§125/cafeteria plans
Educational expenses
Employee-paid parking
Health and accident plans
Meals and lodging furnished for the convenience of the
employer
47
CHOICE OF ENTITY
EMPLOYEE FRINGE BENEFITS
To ameliorate adverse tax consequences to self-employed, a
percent of health/medical insurance costs and actual costs are
deductible in arriving at Adjusted Gross Income:
• 2000
60%
• 2001/2002
70%
• 2003
100%
• 2004
100%
• 2005
100%
• 2006
100%
48
Choice of Entity
Multi-State Operations
Operations in more than one state complicate flow through entity
(partnership (for tax) or S corporation) operation because:
• Each owner must file in multiple jurisdictions
• Entities may be treated differently from state to state
• Non-residents may be subject to withholding on income
49
Choice of Entity
Observations
Sole Proprietorship – simplest, but no liability protection.
Single Member LLC – liability protection.
General Partnership – no liability protection.
Limited Partnership – liability protection and no self-employment
tax for L.P.s.
LLC – liability protection for all and flexible, but self-employment
tax question.
S Corporation – liability protection for all, but not as flexible. Can
manage FICA (self-employment tax).
C Corporation – liability protection for all, but double taxation not
attractive.
50