KCBA Business Law Section 2/22/2012

SELECTING A FORM OF BUSINESS OVERVIEW

1. Closely-held businesses in the U.S. by the numbers (all are approximate) a. 25+ million businesses b. 99% of all employers c. 50% of all private sector employees d. 70% of Americans first job 2. Three basic tax regimes a. C corps b. S corps c. Partnerships 3. Check-the-box rules a. Created in 1997 – added certainty and ease to the process b. Single owner entities i. Respected at the state level – can be a single-member LLC ii. Either C corp or sole proprietor for tax purposes, however c. Once an entity form is chosen – it is locked in for 60 months unless there is a more-than50% change in ownership d. Tax consequences of switching entity forms can be costly i. It is important to get it right in the beginning – for the most part, it is difficult and expensive to change entity forms

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SOLE PROPRIETORSHIP I)

Attributes 1) Disregarded for tax and legal purposes 2) Owner cannot be employee for tax purposes 3) Tax form: 1040 Schedule C

II) Benefits 1) Losses of the business reduce the owner’s total taxable income 2) Easiest for filing and record keeping purposes 3) Potential for lower marginal tax rate than would be the corporate rate 4) No tax consequences for contribution or withdrawal of profits or property III) Disadvantages 1) Unlimited liability 2) Net earnings subject to payroll taxes 3) Profits are taxed, even if reinvested in the business 4) Compensation paid to owner/employees not deductible 5) No flexibility of accounting period

C CORPORATIONS I)

Attributes 1) Limited liability 2) Double layers of taxation 3) Owner-Employee Transactions i)

Reasonable compensation is deductible by corporate employer

ii) Fringe benefits for employees 4) Tax form: 1120

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II) Organization of C Corporations 1) IRC § 351 i)

Deferred gain or loss on the formation of a corporation so long as certain criteria are met: (A) Property requirement (B) Receipt of solely stock of the transferee corporation (C) Control immediately after the exchange (a) 80% of the total combined voting power of all classes of stock entitled to vote as well as 80% of the total number of shares of all other classes of stock

ii) Boot is taxable (A) If property other than stock is issued, shareholders will pay tax on the boot iii) Shareholder basis (A) Basis of property transferred + grain recognized under IRC § 351(b) – FMV of boot received iv) Corporate basis (A) Corporation’s basis in property received is the basis in the contributed property plus any gain recognized by the shareholder v) If IRC § 351 doesn’t apply: (A) New high basis and holding periods for everyone vi) Accommodation transfers (A) New investors to an existing C corp can have IRC § 351 treatment if 10% test is met III) Distribution of Profits 1) Double Taxation 2) Property Distributions i)

Corporation effects (A) Corporation is subject to tax on the gain from nonliquidating distributions.

ii) Shareholder tax consequences IV) Nontax benefits of incorporation 1) Limited Liability 2) Ease of transferability of interest

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V) Tax benefits of incorporation 1) Excludible fringe benefits 2) Potentially lower marginal tax rate than for the individual owners 3) Reduced Social Security tax burden for shareholder employees 4) Reasonable compensation paid to shareholder employees is deductible 5) Best entity form for attracting venture capital i)

Venture capitalists like preferential tax treatment via dividends, etc.

ii) Best entity for getting an audited track record – necessary when going public VI) Disadvantages of incorporation 1) Control requirement for § 351 treatment 2) Double taxation on distributions of profits and sales of assets i)

Thus – building up and then selling an asset more for the privilege of doing it in a C corp

3) No flow through of losses 4) Net operating losses offer no tax benefit to the owners in the year the corporation incurs them, and cannot be used until the corporation later turns a profit 5) Capital losses can only be used to offset capital gains 6) Basis in stock is static i)

C corp stock basis = what you paid for it. Not impacted by earnings.

ii) Partnership interest basis: increases when partnership makes money, decreases when the partnership loses money 7) Bad entity form if the ultimate plan is a quick exit 8) Non-dividend compensation of owners is subject to payroll tax i)

This can arise even if the owner only sits on the board and has limited discretion

9) Controlled groups of corporations are limited on tax benefits they can take i)

Can’t spread income among controlled companies for lower rates for each

ii) Can’t take accumulated earnings tax credit for all, same with AMTI exception, section 59 tax exemption VII) Conversions 1) Tax consequences usually prohibitive when converting to a partnership. Treated as a liquidation for tax purposes, so there is a double level of tax (both corporate and shareholder level). Tax on appreciation of all assets – treated as if all assets are sold for their FMV. 2) Possible to convert to S Corp if tax traps are avoided Eilers McDonald LLP 1001 4th Ave., Suite 3200 Seattle, WA 98154

PARTNERSHIPS I)

Attributes 1) A partnership is not a “taxpaying” entity, but is a “tax reporting” entity 2) A partner’s basis in a partnership interest is increased by his or her share of partnership income. This basis adjustment reduces the amount of gain recognized when the partner sells his or her partnership interest, thereby preventing double taxation. 3) Character of partnership income flows through to owner 4) Flow through of losses, with limitations 5) Generally, unlimited liability 6) Partners cannot be employees for tax purposes, though they can receive compensation for services 7) Partnership can be either general or limited 8) Governed by the laws in Subchapter K of the Internal Revenue Code 9) Tax form: 1065

II) Formation of Partnership 1) General rule: § 721 – Realized gain or loss on property is not recognized 2) Basis carries over. Precontribution gain and loss allocated to contributing the partner. III) Distributions 1) Generally tax free 2) Basis carries over IV) Liquidations 1) Generally tax free 2) Basis carries over V) Advantages of forming a partnership 1) Only one level of tax 2) Flow through of losses 3) Basis includes liabilities 4) Generally, additional taxes are not imposed on distributions to partners.

Eilers McDonald LLP 1001 4th Ave., Suite 3200 Seattle, WA 98154

VI) Disadvantages of forming a partnership 1) All of the partnership’s profits are taxed to the partners when earned, even if reinvested in the business 2) General partners have no limited liability 3) Owners cannot be employees for tax purposes 4) Generally, partners can not choose a fiscal year for the partnership that differs from the tax year of the principal partner(s) VII) Conversions 1) Can convert to C Corp without too much trouble, just need to avoid tax traps 2) Can convert to S Corp easily if the entity qualifies 3) This is the most flexible entity form if you want to later convert to a different entity form

S CORPORATIONS I)

Attributes 1) Hybrid entity with characteristics both C corporations and partnerships 2) Tax form: 1120S

II) Election of Subchapter S Provisions – requirements 1) Entity and stock limitation i)

Must be a domestic corporation with only one class of stock outstanding

2) Type of stockholder limitation 3) Size limitation 4) Consent in writing to S election III) Termination of S status 1) Can be revoked by election 2) Can terminate if any of the above requirements are violated IV) Operation of S Corporation 1) No entity level of taxation 2) Flow through of losses 3) Taxable items are allocated pro rata to stock ownership 4) Employee status for some members, nonemployee status for others. Eilers McDonald LLP 1001 4th Ave., Suite 3200 Seattle, WA 98154

V) Advantages of forming an S Corporation 1) Limited liability 2) No double taxation 3) Flow through of losses i)

These losses can be used by the s/hs to offset income earned from other sources

ii) However, this is subject to the passive loss activity and basis rules 4) Owners who want to pay themselves with distributions aren’t subject to self employment tax i)

C Corps don’t have this either with dividends, but don’t forget the corporate level tax

5) Shareholders can generally contribute or withdraw $ from an S corp w/out recognizing gain VI) Disadvantages of forming an S Corporation 1) Strict limitations on type and number of shareholders 2) No additional basis for liabilities of S Corporation 3) Nontaxable fringe benefits are generally not available to S Corp s/h employees 4) S Corps can’t defer income by choosing a fiscal year other than a calendar year unless it can establish a legitimate business purpose for it and makes a special election VII) Conversions 1) Can convert to a C corporation, no problem. Can even bail out accumulated S corp earnings tax free for up to a year after converting per § 1371(e). 2) Painful single tax on conversion to partnership

2012 TAX CHANGE HIGHLIGHT

I)

Generally 1) There was no big tax legislation in 2011, but lots of old changes are coming into effect this year. Here is an extension and expansion of Two in particular may be of interest to your clients

II) Military veteran hiring work opportunity tax credit 1) Basically: On 11/21/2011, Obama signed a one-year extension of the WOTC for hiring qualified veterans before 1/1/2013. The definition of qualified veterans was expanded. This gives employers a 40% credit for the first $6,000 of wages paid to qualified veterans, for a maximum WOTC of $2,400 per employee. Eilers McDonald LLP 1001 4th Ave., Suite 3200 Seattle, WA 98154

i)

Note: This reduces the employer’s wage deduction on a dollar-for-dollar basis

2) Eligibility i)

Qualified veteran: a veteran who is certified by the state employment security agency as either: (A) A member of a family receiving assistance under a food stamp program for at least three months, all or part of which is during the 12-months ending on the hiring date; (B) Entitled to compensation for a service-connected disability, and: (a) Has a hiring date that is not more than a year after having been discharged or released from active duty; or (b) Has aggregate periods of unemployment of six months or more during the one-year period ending on the hiring date; (C) Has aggregate periods of unemployment of at least four weeks, but less than six months, during the one-year period ending on the hiring date; or (D) Has aggregate periods of unemployment of at least six months during the one-year period ending on the hiring date.

ii) For purposes of this act, a veteran is defined as: (A) An individual who is certified by the State employment security agency as having served on active duty (other than training) in the U.S. Armed Forces for more than 180 days or having been discharged or released from active duty for a service-connected disability, and not having been on extended active duty within 60 days of the hiring date. iii) The new employee must work approximately 400 hours to qualify for the full credit and at least 120 hours to qualify for the minimum 25% of the credit. iv) IMPORTANT NOTE ABOUT ELIGIBILTY: no requirement that the employee be a recent vet (except for one of the disabled categories). Thus, a recently-unemployed Korean War vet would qualify.

Eilers McDonald LLP 1001 4th Ave., Suite 3200 Seattle, WA 98154