Business entity selection: Choices, choices, choices--which type is best for my company?

Transcription

1 Business entity selection: Choices, choices, choices--which type is best for my company? Please disable popup blocking software before viewing this webcast October 4 th, :30 pm EST

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4 Speakers Joshua Harms Partner Partnership Taxation Meghan Jodz Partner Merger & Acquisition Mario Amaya-Lainez Experienced Manager Washington National Tax Office Dustin Stamper Legislative Director Washington National Tax Office Grant Thornton LLP. All rights reserved. 4

5 Learning objectives Identify the general tax advantages and disadvantages of the various types of tax entities used as business structures Explain the tax considerations and objectives that may be important to certain types of investors and the type(s) of entities that may best help to address them Grant Thornton LLP. All rights reserved. 5

6 Agenda Advantages and disadvantages of business entity types Considerations & objectives for selecting business entity Case studies Tax reform implications Grant Thornton LLP. All rights reserved. 6

7 Types of business entities for tax purposes C corporations S corporations Partnerships Income tax imposed on corporation; dividends are taxed to shareholders Includes LLCs and other entities that file an Entity Classification Election (Form 8832) with the IRS to be classified as a corporation Income/loss flow through to shareholders; tax paid at shareholder level Includes LLCs and other entities that file Election by a Small Business Corporation (Form 2553) with the IRS to be treated as an S corporation Income/loss flow through to partners; tax paid at partner level Includes LLCs with two or more members that do not file Form 8832 with the IRS Disregarded Entities (DRE) Typically, an LLC (SMLLC) that is wholly owned by another person Activity of SMLLC treated as that of its owner Grant Thornton LLP. All rights reserved. 7

8 C corporations Advantages & disadvantages Upon formation Advantages Generally, limited liability No restriction on number or types of shareholders or classes of stock May be publically traded Facilitates raising capital Disadvantages Limitations on tax-free contribution of property (Section 351) Grant Thornton LLP. All rights reserved. 8

9 C corporations Advantages & disadvantages During operations Advantages Shareholders may be employed by C corporation Deferred compensation arrangements Ability to carry back NOLs 2 years and forward 20 years Ability to issue treasury stock as consideration for acquisitions Disadvantages Double taxation: operating income taxed; Dividends taxed Distribution of appreciated property triggers gain at the corporate level, but not loss (Section 311(b)) Audit risk with IRS? Generally required to use accrual basis of accounting for tax purposes Consolidated return regulations give rise to significant complexity and cost Grant Thornton LLP. All rights reserved. 9

10 C corporations Advantages & disadvantages Upon liquidation/exit Advantages May be publically traded Creates liquidity in shares and ease of transacting upon exit Sale of stock taxed as capital gain/(loss) Exclusion of gain/loss on small business stock (Sections 1202 & 1244) Tax-free reorganizations (Sections 355 & 368) Disadvantages Limitations placed on NOLs, credits, and built-in losses following an ownership change Selling business unit rather than the entire company creates structuring challenges Capital gains subject to net investment income tax Distribution of appreciated property triggers gain at the corporate level, but not loss (Section 311(b)) Grant Thornton LLP. All rights reserved. 10

11 S corporations Advantages & disadvantages Upon formation Advantages Generally, limited liability ESOP ownership Disadvantages Limitations on tax-free contribution of property (Section 351) Restrictions on number and types of shareholders Single-class-of-stock requirement Grant Thornton LLP. All rights reserved. 11

12 S corporations Advantages & disadvantages During operations Advantages Single level of tax: pass-through of income/losses to shareholders; limited favorable distribution rule Straightforward allocations of income/loss to shareholders (per share/per day) Shareholders may be employed by S corporation (not within SECA); Passthrough income not subject to SE tax ESOP owner pays zero tax on its allocated S corporation income May use cash basis of accounting for tax purposes (with certain exceptions) Disadvantages No debt basis for share of S corporation's liabilities Inflexible allocations Distribution of appreciated property triggers gain at the corporate level, but not loss (Section 311(b)) Passive investors may be subject to net investment income tax Shareholders subject to passive activity loss and at-risk rules Grant Thornton LLP. All rights reserved. 12

13 S corporations Advantages & disadvantages Upon liquidation/exit Advantages Sale of stock taxed as capital gain/(loss) Exclusion of gain/loss on small business stock (Sections 1202 & 1244) Rollover of gain from qualified small business stock Disadvantages Distribution of appreciated property triggers gain at the corporate level, but not loss (Section 311(b)) Tax-free reorganizations (Sections 355 & 368) Section 338(h)(10) election, Section 336(e), other deemed asset sale structures Active shareholders pay no net investment income tax on exit Basis build-up for accumulated earnings Grant Thornton LLP. All rights reserved. 13

14 Partnerships Advantages & disadvantages Upon formation Advantages Contributions are generally tax-free (Section 721) Flexibility; no restriction on number or types of partners and no restrictions on classes of interests Flexibility on local law entity type (e.g., LLP, LLC, LP, GP) Disadvantages Contributions to partnerships may not always qualify as tax-free; watch out for disguised sales and other exceptions to nonrecognition! More than one owner required to qualify as a partnership for U.S. federal income tax purposes; interests of other partners must be considered Grant Thornton LLP. All rights reserved. 14

15 Partnerships Advantages & disadvantages During operations Flexible allocations Advantages Flexibility=complexity! Disadvantages Single level of tax: pass-through of income/losses to partners; limited favorable distribution rule Profits interests Basis for partner's share of partnership liabilities Certain distributions may trigger gain Maintaining partnership capital accounts and performing the mechanical rules may be administratively burdensome Individual cannot be employed by partnership (or DRE of partnership) in which he/she is a partner Partners may be subject to self-employment tax Passive investors may be subject to net investment income tax Partners subject to passive activity loss and at-risk rules New centralized partnership audit regime ("BBA") Grant Thornton LLP. All rights reserved. 15

16 Partnerships Advantages & disadvantages Upon liquidation/exit Advantages Basis adjustments ("step-ups") for buyer when partnership interest purchased Liquidating distributions of property generally result in non-recognition of gain/loss (Section 732(b)) Disadvantages Income character issues upon exit (Section 751) Mandatory revaluations for distributed property Mandatory basis step-down in sale or exchange of partnership interests where partnership assets have more than $250k unrealized loss Grant Thornton LLP. All rights reserved. 16

17 Comparison C corporation S corporation Partnership Limited liability Yes Yes Maybe Tax on distributions generally Yes No No Tax rate on operations active 35% 39.6% 39.6% Tax rate on operations passive 35% 43.4% 43.4% Tax on disposition of equity active 23.8% 20% 20% Tax on disposition of equity passive Flexibility of allocations & distributions 23.8% 23.8% 23.8% No No Yes Tax-free property distributions No No Yes Equity-based compensation Yes Limited Yes Grant Thornton LLP. All rights reserved. 17

18 Case study Closely-held business (formation) facts Mother Hen has run a small bakery for years as a sole proprietorship through her wholly-owned single-member LLC, Gluten Good, LLC's, which is a DRE for tax purposes. Sales for Gluten Good, LLC are growing rapidly and she solicits help from her 9 adult children (the "Kids") to keep up with the demands. In addition to paying them a salary for their hard work, Mother Hen would like to grant the Kids an interest in Gluten Good, LLC. What business entity should Mother Hen select for Gluten Good, LLC? S corporation? C corporation? Mother Hen & the Kids Gluten Good, LLC vs. Mother Hen & the Kids Mother Hen & the Kids Gluten Good, LLC S Partnership? Would the considerations be different if there were real estate in the LLC (e.g., farm)? Gluten Good, LLC C What if the LLC had a significant amount of debt? Grant Thornton LLP. All rights reserved. 18

19 Case study Closely-held business (formation) Partnership Gluten Good, LLC grants profits interests to the Kids Property contributions Tax-free to Mother Hen & the partnership (Section 721) Section 704(c) applies for any difference between tax basis and FMV Different types of partnership interests Capital interest to Mother Hen for contributed property Profits interests to the Kids for the provision of services May not be taxable if provisions of Rev. Proc and are met (if applicable) Share of partnership income Flexibility in allocations; may bring complexities! May be subject to SE tax & Medicare tax Salary The Kids are no longer permitted to be employees of Gluten Good, LLC (and receive W-2 wages); the partnership must report salary as guaranteed payments Guaranteed payments (and distributive share of partnership income) subject to SE taxes Partnership capital account maintenance Distributions generally tax-free to the extent a partner has basis (Section 731) Liability allocations to partners provide basis Single level of tax BBA? Mother Hen & the Kids Gluten Good, LLC Grant Thornton LLP. All rights reserved. 19

20 Case study Closely-held business (formation) S corporation Gluten Good, LLC files Form 2553 (Election by a Small Business Corporation) with IRS & Mother Hen gifts stock of Gluten Good, LLC to the Kids Property contributions Tax-free to Mother Hen Control test is met (Section 351) Different classes of stock not permitted Restrictions on number and type of future shareholders Share of S corporation income Pro-rata allocations May be subject to Medicare tax if any of the shareholders becomes passive Generally not subject to SE tax Salary The Kids may continue to be employees of Gluten Good, LLC and receive W-2 wages Not subject to SE tax Distributions Must track AAA account Distributions of appreciated property triggers gain recognition at the corporate level Single level of tax Income tax Tax-free reorganizations Mother Hen & the Kids Gluten Good, LLC S Grant Thornton LLP. All rights reserved. 20

21 Case study Closely-held business (formation) C corporation Gluten Good, LLC files Form 8832 (Entity Classification Election) with the IRS; Gluten Good, LLC subsequently issues stock options to the Kids Property contributions Tax-free to Mother Hen Control test is met (Section 351) Different classes of stock permitted Salary The Kids may continue to be employees of Gluten Good, LLC and receive W-2 wages Not subject to SE taxes Double level of tax Income & distributions Distributions of appreciated property triggers gain at the corporate level (Section 311(b)) Ease of raising capital Mother Hen & the Kids Gluten Good, LLC C Grant Thornton LLP. All rights reserved. 21

22 Case study Closely-held business (exit) The business of Gluten Good, LLC continues to thrive since becoming a regarded entity for U.S. federal income tax purposes. Several outsiders have expressed interest in investing. Mother Hen & the Kids are looking for an exit strategy, but are open to retaining some rollover equity in Gluten Good, LLC. How should their exit be structured in an IPO, Private Equity, or strategic buyer situation if they were formed as: An S corporation, A C corporation, or A partnership? Grant Thornton LLP. All rights reserved. 22

23 Case study Acquisition of target assets facts PE firm ("PEG") is looking into a new investment strategy by buying into a widget manufacturing business. PEG's investors are indifferent to pass-through income (via partnership) vs. blocked income (via C corporation). PEG investors are to receive 8% preferred return, payable to the extent of available cash flow. In the future, PEG will look for additional bolt-on acquisitions in this industry. How should the acquisition vehicle be structured, given future plans? Corporation? Investors PEG seller Target assets Partnership? Grant Thornton LLP. All rights reserved. 23

24 Case study Acquisition of target assets C Corporation PEG forms Newco, a C corporation PEG contributes cash to Newco & Newco borrows money to buy target assets Investors Target's assets are stepped up to FMV Distributions from Newco to PEG/Return on investment? PEG What about future acquisitions? Newco $$ Target assets Seller Target assets Grant Thornton LLP. All rights reserved. 24

25 Case study Bolt-on acquisitions Stock purchase Newco borrows money to buy New Target stock Newco & New Target file consolidated return Investors New Target's assets are not stepped up to FMV Is there a way to structure a step up in assets? PEG Any rollover equity? Distributions from Newco to PEG/Return on investment? Newco $$ New Target stock Seller New Target Grant Thornton LLP. All rights reserved. 25

26 Case study Acquisition of target assets purchased directly by PEG Investors Seller forms PRS, LLC and contributes all of its assets ("Target assets") into PRS, LLC PEG purchases 100% PRS, LLC interest from Seller PRS, LLC does not make an entity classification election to be treated as a corporation Target assets stepped up to FMV Alternative structure? PEG PRS, LLC $$ 100% PRS, LLC interest Seller What about future acquisitions? Target assets Grant Thornton LLP. All rights reserved. 26

27 Case study Acquisition of target assets rollover equity Seller forms PRS, LLC and contributes all of its assets ("Target assets") into PRS, LLC PEG purchases 90% PRS, LLC interest from Seller; Seller retains 10% interest Investors PRS, LLC becomes a partnership for U.S. federal income tax purposes Bifurcated asset basis PEG deemed to purchase 90% of each of Target assets & contribute to the partnership at value=basis Seller contributes 10% of Target assets to the partnership at carryover basis (Sec. 704(c) property) PEG $$ 90% PRS, LLC interest Seller PRS, LLC amends its operating agreement to provide for PEG's preferred return; after preferred return is satisfied, income and loss are shared 90/10. PRS, LLC Alternative structure? What about future acquisitions? Target assets Grant Thornton LLP. All rights reserved. 27

28 Tax reform: Impact on entity choice? Republicans released tax reform framework on Sep. 27 that could alter the math on entity choice with varying rate cuts for individuals, pass-throughs, and corporations: 20% corporate rate 25% pass-through business rate 35% top rate on individual income Plus the flexibility to add higher rate to maintain progressivity No information on investment income Grant Thornton LLP. All rights reserved. 28

29 Tax reform: Pass-through income defined Characterizing pass-through income: 20% v. 25% doesn't look too different than 35% v. 39.6% BUT How much income will qualify for 25% reduced rate and how much will be taxed at 35% (or higher) rate for compensation? Grant Thornton LLP. All rights reserved. 29

30 Pass-though income options Reasonable compensation standard, potentially with certification Return on capital calculation Rate only for retained earnings Leading proposal: 70/30 split! Effectively creates a blended rate of 32% Personal service businesses and passive shareholders could be omitted Grant Thornton LLP. All rights reserved. 30

31 Comparing C to pass-through Rate comparison by entity Type of business income Current law top rate Pass-through: Active 39.6% Pass-through: Passive 43.4% C corporation: Distribute all earnings 50.5% C corporation: Distribute ½ of earnings 42.7% C corporation: Retain all earnings 35% Includes 3.8% Medicare tax on investment income, but not FICA or SE tax on earned income Grant Thornton LLP. All rights reserved. 31

32 Comparing C to pass-through Rate comparison by entity Type of business income Current law top rate Framework top rate with 70/30 split Pass-through: Active 39.6% 32% Pass-through: Passive 43.4% 25% or 35% C corporation: Distribute all earnings 50.5% 39% C corporation: Distribute ½ of earnings 42.7% 29.5% C corporation: Retain all earnings 35% 20% Includes 3.8% Medicare tax on investment income, but not FICA or SE tax on earned income Grant Thornton LLP. All rights reserved. 32

33 Corporate integration Senate considering 25% corporate rate and 40% deduction for dividends paid to shareholders 15% rate on distributed earnings and likely to be lower than passthrough rate even adding dividend tax on top Rate difference on retained earnings expected to be 5 percentage points Would C corporations become a tax shelter? Grant Thornton LLP. All rights reserved. 33

34 Speakers Joshua Harms Partner Partnership Taxation Meghan Jodz Partner Merger & Acquisition Mario Amaya-Lainez Experienced Manager Washington National Tax Office Dustin Stamper Legislative Director Washington National Tax Office Grant Thornton LLP. All rights reserved. 34

35 Questions? Grant Thornton LLP. All rights reserved. 35

36 Disclaimer This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered For additional information on matters covered in this presentation, contact your Grant Thornton, LLP adviser Grant Thornton LLP. All rights reserved. 36

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