entrepreneurship

Tax Considerations in Choice of Entity Decision , 2008

Page 1

By

Daniel P. Cooper

Reinhart Boerner Van Deuren s.c.

1000 North Water Street, Suite 2100, Milwaukee, WI 53202

414-298-8134

[email protected]

· There are four primary types of business entities for tax purposes

· C Corporation

· S Corporation

· Partnership (LLC)

· Disregarded Entity

· There are many strategic reasons for choosing one type of entity for tax purposes versus another type.

· Seven primary factors include the following:

· Single versus double tax regime (including flow-through of losses)

· Shareholder eligibility restrictions/capital structure flexibility

· Tax issues on entity formation

· Tax basis step-up on subsequent events

· Subjecting operating income to self-employment taxes

· Flexibility in issuing equity interests for services rendered

· Ability to participate in tax favored reorganizations

Single vs. Double Tax Regime

· A C corporation is a separate taxable entity for tax purposes. Thus, proceeds earned by a C corporation and subsequently distributed to its shareholders will be subject to two levels of tax.

· An S corporation is a separate entity for tax purposes, but its income flows through to its shareholders. Thus, corporate earnings are generally subject to only one level of tax.

· A tax partnership is a separate entity for tax purposes, but its income flows through to its partners. Thus, its operating income is generally subject to only one level of tax.

· A disregarded entity is not treated as a separate entity for tax purposes. Thus, it is ignored and its income is subject to only one level of tax.

Shareholder Eligibility/Capital Structure

· There are no limitations on C corporation shareholders or capital structure.

· S corporations are subject to significant shareholder and capital structure limitations:

· 100 shareholder limit

· Only one class of stock allowed

· Corporations, partnerships and certain trusts are not allowed to be a shareholder

· Nonresident aliens are not allowed to be a shareholder

· There are no limitations on owner eligibility or capital structure for a tax partnership.

Tax Considerations in Choice of Entity Decision (Continued)

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Tax Issues on Entity Formation

· A transfer of appreciated property for stock in a C or S corporation is generally taxable. However, some transfers of appreciated property may qualify for tax-free treatment under section 351 of the Internal Revenue Code.

· Transfers of appreciated property to a tax partnership are generally tax-free under section 721 of the Internal Revenue Code.

· The receipt of vested C or S corporation stock in exchange for services rendered is taxable as compensation income.

· The receipt of partnership equity in exchange for services rendered may or may not generate taxable compensation income depending on the nature of such equity.

Future Tax Basis on Sale of Equity or Death

· A C or S corporation is not eligible to receive a tax basis step-up in its assets solely by virtue of a transfer of equity by a shareholder or on the death of a shareholder.

· A tax partnership can elect to receive certain tax basis adjustments (up or down) in the event that one or more of its owners transfer their equity interests or die.

Self-Employment Tax Issues in Choice of Entity Selection

· Flow-through income from an S corporation is not treated as "net earnings from self-employment." Furthermore, dividends paid by a C or S corporation are not subject to such characterization.

· In certain situations, the IRS takes the position that flow-through income from a tax-partnership constitutes "net earnings from self-employment."

Equity Issued for Services Rendered

· Vested stock in a C or S corporation granted for services rendered is included as taxable income to the recipient to the extent that the fair market value of the equity at the time of grant exceeds the amount (if any) paid for such stock.

· Equity interests granted in a partnership in exchange for services rendered are taxable to the extent of the value of such interest granted. However, there is substantial flexibility in determining the amount (if any) of such taxable gain depending on the type of equity issued.

Capital Interests vs. Profits Interests

· A capital interest is generally an interest that would provide the recipient of such interest with some cash if the partnership were to sell all of its assets and liabilities for their fair market value and liquidate on the day such interest is granted.

· A profits interest is any interest other than a capital interest.