Presenting a live 90 minute webinar with interactive Q&A Advanced Tax Issues in Entity Selection Choosing the Entity to Meet the Client's Business Strategies and Capital and Compensation Structures TUESDAY, DECEMBER 14, 2010 1pm Eastern 12pm Central 11am Mountain 10am Pacific Td Today s faculty features: Robert M. Finkel, Member, Morse, Barnes-Brown & Pendleton, Waltham, Mass. Ronald P. Wargo, II, Partner, Friedemann Goldberg, Santa Rosa, Calif. Diana C. Espanola, Attorney, Morse Barnes-Brown & Pendleton, Waltham, Mass. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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Advanced Tax Issues in Entity Selection Choosing the Entity to Meet the Client s Business Strategies and Capital and Compensation Structurest December 14, 2010 Robert M. Finkel Diana C. Española 4
Overview of Entity Choices Corporations Fictitious legal entities created by state or federal statute offering limited liability S Corporations Corporation for tax purposes with elective flow through tax treatment Partnerships General ea Partnership at es Limited Partnership Joint Ventures Limited liability Partnerships Limited Liability Companies Fictitious legal entities created by state statute offering limited liability Sole Proprietorships Unincorporated businesses owned and operated by a single individual 5
Overview of Entity Choices C Corporation State Law a corporation is an organization formed with state governmental approval to act as an artificial person to carry on business (or other) activities, which can sue or be sued, and (unless it is non-profit) can issue shares of stock to raise funds with which to start a business or increase its capital. IRC Sec. 7701(a)(3)(3) The term corporation includes associations, joint-stock companies, and insurance companies. 6
Overview of Entity Choices S Corporation A tax corporation that has made an effective election under IRC Sec. 1362 on Form 2553 to be taxed for federal income tax purposes as an S corporation. Basic requirements Eligible entity One class of equity Eligible shareholders Number of shareholders Caution: Many states have their own rules regarding the taxation of S corporations and their shareholders. 7
Overview of Entity Choices Partnership Uniform Partnership Acts Partnership means an association of two or more persons to carry on as co-owners a business for profit. Limited partnership means an entity, having one or more general partners and one or more limited partners. 8
Overview of Entity Choices Partnership IRC Sections 761 and 7701 The term partnership includes a syndicate, pool, joint venture or other unincorporated organization through, or by means of which, any business, financial operation or venture is carried on, and which is not a corporation or a trust or an estate. 9
Overview of Entity Choices Limited Liability Company Limited Liability Partnership Limited liability company -- a separate legal entity formed under state law. LLCs are said to have various characteristics ti of partnership and corporation. Limited liability partnership -- a partnership whose certificate of partnership states that the partnership is a limited it liability partnership. 10
Overview of Entity Choices Limited Liability Company Limited Liability Partnership Classification for tax purposes LLPs are taxed a partnerships (absent election). LLCs with more than one member are taxable as partnerships (absent election). Single member LLCs are disregarded entities (absent election). 11
Overview of Entity Choices Other business relationships Other business relationships Services Co-ownership Ask: Are the participants i t in the same business boat? Elect out of partnership status? IRC Section 761 Example: IRC Section 1031 not available for partnership interests Series LLCs one partnership or more? Proposed Regulations issued September 2010 Consider holding company LLC with single member LLC subs 12
Overview of Entity Choices Formation of Corporations IRC Section 351 Transfers to Controlled Corporations Generally permits transfers of property to a controlled corporation in exchange for equity on a tax-deferred basis. Requirements Property (not services) Transferred (not leased or licensed) Control requirement Permitted Equity (non-qualified preferred stock issues) Watch for boot Debt encumbered property See IRC Section 357(c) Investment company -- See IRC Section 351(e) 13
Overview of Entity Choices Formation of LLCs/Partnerships IRC Section 721 Contributions to Partnerships Generally permits transfers of property to a partnership in exchange for equity on a tax-deferred basis Basic Requirements Type of equity (no restriction) ti Control (Unlike IRC Section 351, there is no control requirement) Property (not services) Watch for debt encumbered property See IRC Section 752 Investment company See IRC Section 721(b) 14
Overview of Entity Choices Subsequent Contributions Control requirement affects subsequent contributions of property Corporations IRC Section 351 Control required (Note: Accommodation transfers are problematic) LLC/Partnerships IRC Section 721 No control required 15
Overview of Entity Choices Operations - C Corporation C Corporations Separate entity taxation Corporate taxation of income and gain No special allocations permitted but multiple classes of stock permitted. Corporate tax rates Carryover of losses 16
Overview of Entity Choices Operations - S Corporation S Corporations Flow through treatment Timing Character of income, gain or loss Use of losses IRC Section 1367 (outside basis) IRC Section 465 (at risk) IRC Section 469 (passive activity) One class of equity, generally No special allocations permitted Entity level tax on former C corporations IRC Section 1374 tax on built-in Gains IRC Section 1375 tax on corporations with accumulated E+P and passive investment income 17
LLC/Partnerships Timing Character of income gain or loss Use of losses IRC Section 704(d) (outside basis) IRC Section 465 (at risk) IRC Section 469 (passive activity) Overview of Entity Choices Operations LLC/Partnerships Special allocations permitted if allocations have substantial economic effect Economic effect Substantiality 18
Distribution v. Dividend Overview of Entity Choices Non-liquidating Distributions and Dividends Distribution any payment with respect to stock Dividend IRC Section 316 a payment out of earnings and profits or accumulated earnings and profits made with respect to stock Constructive dividends Reasonable compensation issues C corporation S corporation 19
Overview of Entity Choices C Corporation Distributions IRC Section 316 Distributions from current or accumulated earnings and profits Taxation to distributing entity Distributions of money; But consider IRC Section 305 Distributions of appreciated property Impact to owner Dividends Dividends received deduction Non-dividend distributions Return of capital Gain on sale or exchange Accumulated Earnings Tax - IRC Section 535 20
Overview of Entity Choices S Corporation Distributions Impact to owner Distributions from AAA account Distributions of accumulated E+P Impact to entity Distributions from AAA account Distributions of accumulated E+P Distributions of money Distributions of appreciated property Distributions v. salary (reasonable compensation revisited) 21
Overview of Entity Choices LLC/Partnership Distributions Impact on Member/Partner IRC Section 731(a) Distribution of Property Watch for marketable securities IRC Section 731(c) Watch for subsequent sales of distributed property IRC Section 735 Distributions of Money Guaranteed Payments for Services or Property IRC Section 707(c) Deemed Distributions under IRC Section 752 Disguised dsales IRC CSection 707(b) Impact on LLC/Partnership IRC Section 731(b) 22
Overview of Entity Choices Liquidations C Corporations Impact to entity See IRC Section 336/337 Impact to owner See IRC Section 331/332 S Corporations Impact to entity See IRC Section 336/337 Impact to owner See IRC Section 331/332 Partnerships/LLC Impact to entity Impact to owner 23
Overview of Entity Choices Check-the-box Treas. Regs. 301.7701-3 (1997) General rules Statutory corporate business entities are taxed as associations (corporations). Unincorporated entities are taxed as flow-throughs unless an election to be taxed as an association (corporation) is made. Two or more members Taxed as a partnership One member Disregarded d entity Foreign entities: Special rules apply. 24
Star t Business Entity? (Not Trust or Estate). Treas. Regs. 301.7701-3 Flow Chart NO Regulations do Not Apply. YES Is the entity: YES Ineligible to make election Incorporated, Jt. Stock Co., Insur. Co., Bank, PTP, REMIC, or REIT? Entity on per se corporation list? NO In existence pre- Regulations? Reasonable basis NO NO YES Relevant to US. Foreign Business Entity? NO YES YES Exist pre-regs. Classification relevant YES Exist before Regulations? YES NO Grandfathered as partnership NO NO Have 2 or more Members? Classification generally carries over from prior period. No election. YES Member with unlimited liability? NO Defaults to Corp. Pshp. Election required Division or Sole Proprietorship YES Partnership YES 2 or more Members? NO Branch 25
Overview of Entity Choices Check-the-box Form 8832 Entity Classification Election When Made -- Election can be effective 75 days prior to the date filed. Who Makes Election -- Each member of the electing entity who is an owner at the time the election is filed; or any officer, manager, or member of the electing entity who is authorized (under local law or the organizational documents) to make the election. If an election is to be effective for any yperiod prior to the time it is filed, each person who was an owner between the date the election is to be effective and the date the election is filed, must sign. 26
Overview of Entity Choices Check-the-box Subsequent Election by an Entity Election by Partnership to be Classified as a Corporation -- Deemed contribution by partnership of all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter, the partnership liquidates by distributing the stock of the corporation to its partners. Election by a Corporation to be Classified as a Partnership -- Deemed distribution by the corporation of its assets and liabilities to its shareholders in liquidation of the corporation and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. 27
Overview of Entity Choices Check-the-box Other methods of converting from an LLC/Partnership to Corporation Rev. Rul. 84-111 Assets over Interests e t over Assets up Rev. Rul. 2004-59 (state law conversion) 28
Business Plan Type of Business Services business Can earnings be washed out? Significant ifi Inventory Local property tax exemptions? Investment t Fund Flow though (partnership) entity desired? Incubator or intellectual property development Need to facilitate spin out of assets? 29
Business Plan Location of Business Federal/international tax issues Inbound/outbound issues State tax considerations C Corporations apportionment S Corporations Classification Entity taxation Apportionment Withholding LLC/Partnerships Classification Entity taxation State source/apportionment Withholding Local tax considerations Property tax exemptions Local income taxes 30
Eligible S corporation owners Business Plan Type of owners 100 Shareholders Citizens and residents (including aliens) Certain trusts/estates Certain exempt owners LLC/Partnership owner (practical limitations) UBTI issues ECI issues/filing obligation/withholding Consider alternate structures e.g. blocker C-Corp FIRPTA considerations 31
Business Plan Capital Structure and Financing Plans C Corporations S Corporations One class of equity Voting differences Debt and warrants Phantom Equity LLC /Partnerships Use of warrants Debt and equity shifts Debt basis differences 32
Business Plan Exit Strategy C corporation Stock sale IRC Section 1202 -- Qualified small business stock Asset sale Tax-deferred reorganizations Public offering 33
Business Plan Exit Strategy - S corporation Stock sale IRC Section 338(h)(10) IRC Section 1202 -- Qualified small business stock treatment unavailable Asset sale Tax-deferred reorganizations Public offering 34
Business Plan Exit Strategy - LLC/Partnership Sale of equity IRC Section 1202 - Qualified small business stock treatment unavailable Hot asset rules under IRC Section 751 Availability of IRC Section 754 Election Asset sale Public offering Tax-deferred reorganizations not permitted Convert to corporation first? See West Coast Mktg. Corp. v. Commissioner, 46 T.C. 32 (1966) 35
Advanced d Tax Issues in Entity Selection Ron Wargo rwargo@frigolaw.com
Compensation and Withholding Issues Ability to Attract Key Employees Through Equity Interests Self-Employment Tax Issues Impact of New and Proposed Legislation on Tax Rates 37
Equity Interests Equity Plan Characteristics Eligibility Types of Plans 38
Types of Equity Plans Stock Option Purchase Plans Stock Appreciation Plans Full-value Stock Award Plans 39
Stock Option Purchase Plans Incentive Stock koptions No income on grant No income on exercise No company deduction on exercise Capital gain on sale of stock Non-Incentive Stock Options No income on grant (unless 409A applies) Ordinary income on exercise Company deduction on exercise Capital gain on sale of stock 40
Stock Appreciation Plans Characteristics Tax treatment No tax on grant Tax on exercise Same thing as Phantom Stock 41
Full-Value Stock Award Plans Restricted stock grants May be Taxable as ordinary income upon grant If substantial risk of forfeiture and 83(b) election If no substantial risk forfeiture If taxed, deductible d by company on grant Performance share Plan No tax on grant Ordinary income on exercise 42
IRC Section 409A Huge problem for non-qualified stock options Exempt IF Exercise price equal to or greater than FMV on grant date # shares fixed on option grant date No additional feature for deferral of compensation Must be for common stock of employer 43
Primary concern for private companies Use an appraiser! Expensive Problematic for new investors 44
Self-Employment Tax Issues Tax rate 15.3% 12.4% social security (up to $106,800) 2.9% Medicare (unlimited) Estimated Taxes 1/17/11 4/18/11 6/15/11 9/15/11 45
Partnerships and Self-Employment Tax Guaranteed payments 707(a) Still self-employment to partners Distributions General partners subject to self-employment tax Limited partners not unless guaranteed pmts 46
Special LLC issues LLC members are General partners if: Prop. Reg. 1.1402(a)-2(h)(2) Personal liability for LLC debts Authority under local law to contract for the entity Or participated for more than 500 hours LP treatment for LLC members NOT available for service LLCs 47
Other partnership/llc issues Fringe benefits Partners taxed on group term life insurance under IRC 79 Partners taxed on payments received under accident or health h plans under IRC 105 Health insurance for partners is an IRC 707(c) guaranteed payment Rev. Rul. 91-26 48
Other partnership/llc issues Qualified employee benefit plans LLCs and partnerships can have 401(k) plans Only general partners (LLC members treated as generals) can participate These plans cannot make loans to >10% partners IRC 401(a)(10), 401(c)(1) and (2), 401(d) 49
Impact of New and Proposed Legislation on Tax Rates Patient Protection and Affordable Care Act of 2010 Additional 0.9% Medicare Hospital Insurance tax Self-employed individuals Employees earning more than $200,000 (250K joint filers) Beginning in 2013 3.8% unearned income Medicare contribution >200,000 000 AGI (250K joint filers) 50
Current compromise? Extended to 2012 Individual Income Tax Brackets Personal lexemption Phase Out repeal Pease limitation on itemized deductions repeal Capital gain rates Dividend rates AMT 2010 limits ($47,450/$72,450) 2011 limits ($48,450/$74,450) 51
Questions? Ron Wargo rwargo@frigolaw.com