Forming a Business:  Tax Considerations
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Forming a Business: Tax Considerations

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Tax Considerations in Choosing a Business Entity for Start-Up Compananies

Tax Considerations in Choosing a Business Entity for Start-Up Compananies

Presented by: Beth A. Di Santo, Esq.

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    Forming a Business:  Tax Considerations Forming a Business: Tax Considerations Presentation Transcript

    • Forming & Advising Businesses Tax Considerations Presented by: Beth A. Di Santo, Esq. New York State Bar Association Seminar
    • I. INTRODUCTION
      • “ Check-the-Box” Treasury Regulations
        • Single member entities (other than state law corporations) are classified as “disregarded entities” for tax purposes
          • “ Disregarded entities” – entity is treated as sole proprietorship and results of business operations are reported 
            • Individual owner—Schedule C Form 1040
            • Corporation—Form 1120
            • Partnership—Form 1065
        • Multiple-Owner Entities (other than state law corporations) are classified as partnerships
        • Exception : Form 8832—SME/MME can elect to be taxed as a corporation
          • Form 2553—SME can then elect “S corporation” status
    • II. CHOICE OF ENTITY
      • Sole Proprietorship
        • General
          • Includes SMLLC that does not elect to be taxed as corporation
          • Not a separate entity for tax purposes, however, is a separate entity for liability concerns (e.g., debts and obligations)
            • Exception: Sole member is required to pay federal employment taxes
          • Business results reported on Schedule C of individual owner’s 1040
          • Single owner’s taxpayer ID is used
    • II. CHOICE OF ENTITY (cont)
      • Partnership (including MMLLC)
        • Not a tax paying entity
        • Partners pay their distributive share of partnership income whether the income is distributed or not
        • Must file Form 1065 information return
          • PS computes taxable income or loss to be reported by each partner on individual returns
          • Exception: Certain “pass through” items are not included in calculation (e.g., charitable contributions are not deducted for partnership income; rather pass through to partners)
    • II. CHOICE OF ENTITY (cont) Partnership
      • Reporting Partnership Income or Loss
        • Income/loss is reported by each partner according to their respective “distributive share”
          • Distributive share--Partner’s interest in the partnership (Reference example p4)
          • Partnership Agreement—sets forth allocation of income and loss items to Partner, which may not always be based on capital contributions due to individual tax situations
          • Allocation vs. Distribution : Allocation does not necessary mean there has been a distribution
            • Remember: Partners are taxed on allocated share of income regardless of whether a distribution occurs
          • Allocations NOT in accordance with PS interests must have “substantial economic effect” to be respected for tax purposes
            • Substantial Economic Effect: An allocation will be valid and respected for tax purposes if over the life of the partnership distributions to each partner equal that partner’s capital contributions, increased by his share of partnership profits and decreased by his share of partnership losses.
    • II. CHOICE OF ENTITY (cont) Partnership
      • Deduction of Losses
        • Generally, partnership losses may be deducted to offset taxable income
          • Exception: Partner deductions for losses on individual tax returns are limited to such partner’s basis in partnership interest.
      • Self-Employment Taxes:
        • Partner’s distributive share of partnership income is subject to self-employment tax
          • A social security and Medicare tax primarily for individuals who work for themselves (similar to the social security and Medicare taxes withheld from the paychecks).
            • The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
          • Exception: LP distributive share or partnership income is NOT subject to self-employment tax.
      • CHOICE OF ENTITY CORPORATION
      • C Corporation
        • Tax paying entity: Pays graduated rates under IRC on Form 1120
        • S/H Distributions: from corporate earnings are taxable to shareholders as dividends
          • Exception: Distributions to employee-shareholders is “reasonable compensation” and taxed as wages not dividends
        • Taxation as Dividends vs. Compensation
          • Dividends Not Deductible: Dividends are not deductible by Corp in determining Corp’s taxable income
            • Double Taxation—Dividends are taxed at Corp level and S/H level
          • Compensation Deductible: not subject to an entity level income tax only S/H level.
    • II. CHOICE OF ENTITY CORPORATION
      • S Corporation
        • Not Tax Paying Entity: Income flows through to S/H individual tax returns but files informational return on Form 1120S
          • Amount of Income/Loss reported: S/H pro rata portion of Corps income determined per share
            • Note: No special allocation of income or loss is allowed as in PS context
        • Requirements for Sub-Chapter S-Corp:
          • No more than 100 S/H (family members=1)
          • Generally only individuals as S/H
            • Exception: (I) must be an S Corp (II) S/H owns 100% of stock (III) Parent elects to treat subsidiary S-Corp as a QSUB (i.e., disregarded entity)
          • No Non-resident aliens as S/H
          • May not have more than 1 class of stock
        • Distributions
          • S/H pays tax on earnings as earned therefore distributions are not taxed
          • S/H Basis in Stock: Increases as S/H reports earnings and decreases as distributions are made
        • S/H share of S-Corp income NOT subject to self-employment tax
        • S/H employee may receive compensation for services, which is subject to employment tax
          • Aggressive Tax planning: Pay little or not compensation and siphon earnings out of S-Corp as distribution (no employment tax due)
            • Risk: IRS my attack this arrangement on the ground of unreasonably low compensation
        • Losses
          • Flow through to S/H on individual return to the extent of basis in stock
          • If losses exceed basis, losses are suspended until S/H basis in stock is increased
    • III. ISSUES ON FORMATION
      • Single Member LLC
        • Transfer of cash or property by single member is generally tax free
      • Partnership
        • No gain or loss recognized on a contribution of property in exchange for Partnership interests
          • Exceptions:
            • Services: Contribution of services generally results in taxable income to contributor unless no capital account is established
            • Appreciated Marketable Securities
            • Disguised sale of property: Simultaneous contribution of property by one partner, cash by another and immediate distribution to property contributor
        • Basis : Crucial for Partnership Taxation
          • Partner’s basis in partnership interest is the amount of money contributed plus the adjusted basis of property contributed
            • Basis increases as P share of partnership income increases and decreases as P share of losses decreases
    • III. ISSUES ON FORMATION (cont)
      • C Corporation
        • No gain or loss recognized on transfer of property to Corp for stock if Corp is controlled by contributing S/H (80%)
          • Exceptions:
            • Gain if liabilities assumed exceed basis of contributed property
            • Services: If services are contributed for stock, service provider recognizes income equal to FMV of stock
      • S Corporation
        • Same rules as above
        • S Election: Form 2553 must be filed on or before March 15 of current tax year
          • NYS: Separate election must be made on NY Form CT-6
        • All S/H must consent to election
    • IV. ISSUES ON SALE OF BUSINESS
      • Sale of Assets
        • Character of Gain: Determined on an asset by asset basis
        • Purchase Price Allocation: Sale of assets not treated as sale of single asset for tax purposes
          • Purchase price is allocated among assets sold in accordance with FMV
          • Allocation of purchase price made by buyer and seller on Form 8594
          • Allocation customarily provision in asset purchase agreement
        • Consideration =
          • purchase price + assumed liabilities
          • purchaser's basis in acquired assets
        • Partnership
          • Contributing partner is allocated “built-in gain or loss” attributed to the asset at the time of sale
          • Built in gain or loss: Gain or loss inherent in an asset at the time contributed to the partnership
        • Business Assets
          • Favorable tax treatment for Sales of Depreciable Personal Property & Real Property owned more than one year: If gains on sale exceed losses, gain is treated as long-term capital gain (rather than ordinary income) while losses exceeding gains are treated as ordinary losses
          • Depreciation Recapture: Seller generally recognizes ordinary income to the extent of the amount of depreciation previously allowed with respect to the property
        • Real Property
          • Purchase price allocation must be agreed between buyer / seller
            • Buyer: May prefer to allocate more to buildings than land b’c buildings are depreciable while land is not
            • Seller: May prefer to allocate less to buildings to minimize depreciation
        • Intellectual Property
          • Franchises, Trademarks and Trade Names: Sales of these items generally result in capital gain or loss
            • Exception: Transfer is not treated as a sale of a capital asset if (i) transferor retains significant power, right or continuing interest or (ii) amounts received or accrued are contingent on productivity use or disposition of the franchise, trademarks or trade names
          • Copyrights & Patents: May tax gains as long-term capital gain (taxed at favorable rates) while losses qualify for ordinary loss treatment
            • Exception: Capital gain treatment is not available for copyrights sold by the creator
    • IV. ISSUES ON SALE OF BUSINESS
      • Consequences to Purchaser
        • Basis to purchaser: Determined by consideration paid + liabilities assumed by purchaser
        • Section 197: Special rules for certain intangible assets (goodwill) and covenants not to compete
          • Purchaser deduction of purchase price for these assets limited to an equal amount over 15 years.
      • Advantages/Disadvantages of Asset Purchase
        • Advantages:
          • Purchaser receives cost basis
          • Purchase does not inherit seller’s liabilities
        • Disadvantages:
          • All contracts must be assigned to transfer assets
          • Seller may recognize ordinary income on sale of certain assets (accounts receivable and inventory)
          • Sale and/or transfer taxes imposed on transfer of assets
          • NYS: Purchaser must file notice of business purchase to ensure that seller complied with sales tax obligations
    • IV.ISSUES ON SALE OF BUSINESS
      • Sale of Interest in Entity
        • Membership Interest in SMLLC
          • Treated as a sale of assets (same issues as above)
          • Transfer: Accomplished by Bill of Sale and Assignment of Membership Interest
            • No need to transfer each asset of LLC
          • Liability: Purchaser inherits all of the liabilities of LLC (known or unknown)
            • Purchaser must conduct thorough due diligence investigation
            • Sale Agreement: representations, warranties and indemnification
        • Partnership or Membership Interest
          • Partner recognizes gain or loss on sale or partnership interest measured by amount realized on sale – adjusted basis
          • Gain or loss recognized is capital (favorable tax rate)
            • Exception: Partnerships with accounts receivable or inventory = partner may be taxed at ordinary income rates
          • Step Up in Basis: Purchaser of the partnership interest is generally entitled to step up (or down, as the case may be) his allocable share of the basis in each partnership asset to reflect the fair market value of the asset, based on the purchase price paid for the partnership interest
          • Same transfer and liability issues as with LLC sale
    • IV. ISSUES ON SALE OF BUSINESS
      • Stock in Corporation
        • Gain: Seller will recognize capital gain or loss on sale (either short-term or long-term capital gains rates depending on duration stock was held)
        • S Corp & Section 338(h)(10) Election
          • If sale of stock is to corporation, purchase of stock treated as purchase of assets
          • Result: Corporation deemed to have sold assets @ FMV and realizing ordinary income on deemed sale; Gain on assets flowing through to selling S/H
          • Selling S/H may negotiate for reimbursement for difference in tax paid (w/out election selling S/H would pay only capital gains rates and not ordinary income)
          • Corporation deemed to liquidate for tax purposes
          • Must be made jointly by seller and buyer
          • NYS: Form of transaction as purchase of stock respected
        • Transfer: Accomplished by Stock Powers; no transfer of assets required
        • Liabilities: Purchaser inherits; due diligence; reps/warranties/indem
    • IV. ISSUE ON SALE OF BUSINSESS
      • Installment Sales
        • General: Disposition of property in which one or more payments are to be received after a year of disposition
          • Installment Method: Gain reported as installment payments are received in proportion of the amount of gross profit (contract price – adjusted basis)
          • Exceptions:
            • Sales of securities traded on established market
            • Sales of inventory
            • Sales where seller receives readily tradable indebtedness
        • Special rules
          • Seller may elect not to use installment method
    • V. PROPERTY DISTRIBUTIONS FROM CORPS & PARTNERSHIPS
      • C Corporations
        • Gain or loss recognized on distributing property to S/H computed based on price equal to FMV
          • Gain is taxed @ corporate level
        • S/H includes FMV of distributed property in income as dividend
      • S Corporations
        • Same as C Corp, BUT no corporate level tax
        • Any gain flows thru to S/H who pays tax on gain and receives an increase in basis of his stock
        • To the extent FMV of distributed property exceeds S/H’s adjusted basis in stock, excess amount is treated as gain on sale of stock
      • Partnerships
        • Generally, no gain or loss is recognized to partnership or partners when partnership distributes property
    • V. PROPERTY DISTRIBUTIONS FROM CORPS & PARTNERSHIPS
      • Estate and Gift Taxes
        • Corporations: Stock owned by an individual will generally be valued initially based on proportionate net underlying asset value of corp’s assets
          • Minority interest or marketability discounts may be applied to initial value
        • Partnerships: Same as above
          • Difference: Discounts available in the partnership context generally allow for more tax-efficient transfers of family wealth than in corporate context.