Time Estimate: Who

Here is a summary of some information to consider when you are purchasing or starting a business.

There are some simple rules to think about:

• Find Someone To Help
• Keep More Of What You Earn
• Protect More Of What You Keep

Primary Planning Points:  One of your primary concerns is to protect the business assets and to protect personal assets. Another concern is to reduce income taxes or payroll taxes where you can. Another concern is for retirement planning. Eventually you will want to consider estate planning.

If the business has real property (Land - Building - etc.): In general, for married persons, we usually advise that real estate should be held in the names of both spouses, and do not have both spouses sign the debt or guarantee debts of the business.  The real property should generally be owned (in the name of) the individual in most circumstances.  Real property used by the business will then be rented to the business.  You would hold the real estate in your individual names and the operations of the business would be done in of the alternative forms of doing business.  There will be circumstance where Real property might be placed into a trust, Family Limited Partnership, LLC or occasionally an S Corporation. Use caution if more than one person will be owning the real estate.  In most circumstances this will unwittingly create a partnership!  Federal law is not the same as state law on this.   Watch your attorney - even if a lawyer!  Many lawyers are not trained on the tax law and may not realize that for filing your income tax elections federal law will prevail over the state statute.

I must emphasize one more time seriously consider the forms other than sole proprietorships.

The choice of business entity involves selecting among four options:

• The sole proprietorship
• the partnership (general or limited partnership),
• the corporation (S corporation, the C corporation), and
• the limited liability company (LLC, or Registered Limited Liability Partnership).

The partnership, whether general or limited, and the LLC afford the most favorable tax consequences to most business organizers. If taxes were the only concern, almost all businesses would be operated in these forms.  The danger of the general partnership is the absolute and full liability of the owners.

Some choices, such as between a general or limited partnership and a C corporation, affect both the legal relationships involved in doing business and the tax consequences. Other choices, however, affect only the legal relationships or the tax consequences, but not both.

Thus, the choice between an S corporation and a C corporation affects only taxes; the choice between a general partnership and a limited partnership generally affects only the business relationships among partners and between the partnership and third parties, but generally does not affect the way in which the partnership is taxed. The sole proprietorship, which is an option for a business conducted by a single individual, is not a separate legal entity.

In most cases, the tax burden of operating a business through a C corporation is significantly greater than if a pass-through entity is used. The C Corporation usually should be selected only if there are significant advantages that cannot be achieved through a partnership or S Corporation.

As compared with an S corporation, the partnership has the advantage of providing significant flexibility in the economic and tax allocations of financial interests. Moreover, the ability to pass through tax losses and distribute proceeds of refinancing without immediate tax consequences is greater for partnerships, largely because of the rules regarding debt. It is also much easier for a partnership to avoid unintended consequences; depending upon particular circumstances, a corporation may encounter formidable hurdles regarding qualification as an S corporation and maintaining S Corporation status. There are many cases in which an S corporation or a C corporation might provide tax advantages over a partnership. For a small business, or a sole owner business, the S Corporation may be the best alternative.

Although the partnership generally has its own tax advantages, there may be non-tax advantages of the corporate form that make a corporation the preferred entity for many businesses. The most notable advantage of the corporate form is limited liability. Some businesses select the corporate form to insulate the owners from personal liability. This does not mean that the corporation should be selected whenever the members are concerned about incurring personal liability. As a matter of state law, personal liability arising from many types of activities, including the practice of law and medicine cannot be avoided by the use of a corporation. Moreover, when personal liability can be limited by the choice of entity, the partnership form can provide some measure of protection. Members not active in the day-to-day operations of the business may achieve limited liability if the partnership becomes a limited partnership under state law. Partners active in the day-to-day operations of the business (for whom the limited partnership does not offer protection) may, in certain cases, achieve some protection through the use of a corporate general partner or an LLC.

As a broad generalization, the tax advantages of the partnership form, weighed against the limited liability generally provided by the corporate form, have resulted in the following pattern.

All businesses need to raise and manage money. A large corporation often finds it easier than an unincorporated business to borrow, to attract and retain talented employees, and to accumulate goodwill. In addition, a corporation can raise capital by selling shares of its stock; shares of stock also can be used to reward successful employees. However, the corporate form is not magic, and smaller corporations will experience the same kinds of problems raising capital and attracting staff, as do smaller unincorporated organizations. Even limited liability is often illusory, because lenders usually require the owners of small closely held corporations to personally guarantee payment of corporate notes. Tax factors, however, do play an important role in the choice of form decision. A "regular" corporation (a "C corporation") faces double taxation, because the corporation's after-tax income, passed on to its shareholders in the form of dividends, is taxed again to the shareholders; an S corporation does not encounter double taxation because it is a pass through entity.

In a sole proprietorship, the sole proprietor controls. A partnership must decide how authority is shared among the partners, who makes decisions and what mechanisms are used when partners disagree. A Corporation is, theoretically at least, managed by its board of directors; in a corporation with few shareholders, serious conflicts can develop over control of the board.

Continuity is the fourth universal concern. A sole proprietorship dies with its owner. Generally, the death of a partner does not dissolve the partnership. A corporation (whether S or C) has perpetual existence, and stock can be sold or bequeathed freely. The shares of a public corporation are relatively easy to sell and easy to value; shares in closely held corporations are less liquid, but provisions for redemption of shares can ease liquidity problems.

The best choice in a particular situation might be to start the business as a proprietorship or partnership, take advantage of start-up losses to shelter other income, then incorporate as the business becomes profitable and needs an infusion of new capital. An inactive investor might prefer a limited partnership, because it avoids double taxation; an investor who is actively concerned in the management of the business might favor incorporation (for limited liability), perhaps with an S election to avoid double taxation. It should be noted that, under the passive activity rules, losses from investments in businesses in which the investor does not materially participate cannot be used to offset other income, such as salary, interest, dividends, and active business income.

If the business is started by a family and used for family income splitting, and if capital is a material income-producing factor, a family partnership may be better than a C corporation. If the business is a personal-service business, an S corporation is a very attractive choice; even if capital is a material income-producing factor, the planning team should consider the S election.

Participants in a business who make capital contributions disproportionate to their share in profits may insist upon a fixed priority return on their investment. This type of arrangement is easy to provide for in either a general or limited partnership by issuing debt or by inserting specially tailored distribution rules in the partnership agreement. Such returns may also be provided if the business is conducted in a C corporation, although there may be a risk in certain situations that the purported debt will be recharacterized as equity. Priority and disproportionate returns are more difficult to arrange in an S corporation because of the S corporation status requirement that the corporation have only one class of stock and the potential recharacterization of debt as a second class of equity. Such re-characterization would cause a termination of the S Corporation status.

If a business is expected to have significant losses in the early years of operation, it may be desirable to operate as a pass-through entity in order to make the losses available to the owners. The use of a partnership or S corporation can accomplish this goal. A major difference between an S corporation and a general partnership is that, within certain limits and subject to the at-risk and passive activity loss rules, losses financed by a business's borrowing from third parties can be passed through to partners by partnerships but not to shareholders by S corporations. The losses from an S Corporation are limited. The limit is based upon the amount invested in the stock and loans from the shareholder to the corporation. (Other factors can play a part in this computation, I will not cover them here.)

If profits are expected from the outset, a pass-through entity is still likely to be the more desirable choice. Although it is possible that the corporate tax burden under the C Corporation alternative may be less than under a pass-through entity, the prospect of a second tax at the shareholder level strongly militates against choosing the C Corporation.

The primary purpose of any tax shelter is to pass the tax and financial benefits of the shelter through to its individual investors. Any form of organization that prevents or restricts this flow of benefits to the individual investors is not an appropriate form for doing business as a tax shelter. Thus, a "regular" corporation (a subchapter C corporation) is not generally used as a tax shelter structure because tax benefits, such as depreciation and tax credits, attributable to it cannot readily be passed on to the shareholders.

An individual investor who is interested in a tax-sheltered investment need not turn to either a partnership or an S corporation to find a tax shelter. It is possible for the individual to own assets directly and obtain the same tax and financial benefits that are offered through ownership interests in either partnerships or S corporations. For instance, an individual who owns a working interest in oil or gas property derives the same basic tax benefits that participation in larger tax shelters offers (tax deductions and the postponement of the recognition of income). Similarly, those engaged in a real estate trade or business may deduct losses relating to rental real estate, and investors not in a real estate trade or business may deduct up to $25,000 per year in losses derived from rental real estate.

The individual who directly acquires assets has certain advantages not available with an investment joined into with others. He has direct control over the selection and management of the assets. He also has control over the liquidation of his investment. However, the investor who acts alone may lose some important advantages he could enjoy as an investor in a larger tax shelter, such as professional management of the assets and a smaller outlay of his own funds in order to participate in the shelter.

Partnerships are nontaxable entities that act as conduits for transferring income or loss and such items as tax credits directly to the individual partners, who then report the appropriate amounts on their own tax returns.

The following definitions are crucial to an understanding of how partnerships operate as tax-sheltered investments:

Limited partnerships are the often-used vehicle for tax-sheltered investments because, while a limited partner has a limited financial risk in the partnership, she can obtain short-term tax advantages that are sometimes greater than the original investment. However, now limited partnership interests are, in most cases, considered interests in passive activities due to the fact that it is presumed that the limited partner does not materially participate in the activity.

Losses from passive activities generally can be used only to offset income from passive activities no matter what the form of ownership might be. Therefore, while partnerships may remain the predominant form of holding certain types of tax-sheltered investments, other forms of doing business, such as real estate investment trusts, real estate mortgage investment conduits or S corporations, may find favor among investors for their particular characteristics. However, taxpayers may not bypass the limitations imposed by the passive loss rules merely by virtue of the form in which they conduct their particular business.

Special provisions apply to "publicly traded partnerships" (PTPs). Basically, under these special provisions, the passive loss rules must be applied separately to items from each PTP. This means that a taxpayer's net passive activity income or loss from a PTP is not treated as passive income under the passive loss rules. Thus, a loss from a PTP can be applied only against the PTP's future non-portfolio passive income. This special limitation on PTPs severely restricts their use as a tax shelter vehicle. Publicly traded partnerships are not widely used because of the special restrictions that apply to them.

An S corporation is a corporation that has elected, through its shareholders, not to be subject to federal income tax. Instead, all the shareholders of the corporation must include their share of corporate income, deductions, losses, and tax credits on their individual tax returns. The S Corporation resembles a partnership in that it acts as a nontaxable conduit that passes all tax-related items on to its investors. For this reason, the S Corporation, in the appropriate situation, makes it a viable form in which to operate a tax-sheltered investment. Ownership of stock in an S corporation does not automatically make the investment passive for purposes of the passive loss rules. If the shareholder qualifies as a material participant in the business activity, losses generated by an S corporation can be used to offset other "active" income or portfolio income of the investor.

While partnerships and S corporations have many similarities, they also have significant differences in their operation and in their tax treatment of some items. Therefore, before deciding on whether to operate a tax shelter as either a partnership or an S corporation, a careful comparison must be made between the two forms of operation and a decision must be made as to which form of doing business offers the most advantages to the individual investors.

The passive activity loss rules apply to personal service corporations (see Code Sec. 469. This rule was designed to prevent individuals from being able to shelter income derived from the performance of personal services by creating personal service corporations and then acquiring tax-sheltered investments at the corporate level.

In this context, the term "personal Service Corporation" means a corporation the principal activity of which is the performance of personal services by employee-owners in certain fields, such as health, law, engineering, etc. The term "employee-owner" means any employee who owns, on any day during the tax year, any of the outstanding stock of the corporation. However, a corporation is not considered a personal service corporation unless more than 10 percent of the value of its stock is owned by employee-owners.

In a modified form, the passive loss rules apply to closely held C corporations (see Code Sec. 469. In this context, the term "closely held" means any C corporation if at any time during the last half of the tax year more than 50 percent of the value of its outstanding stock is owned, directly or indirectly, by or for five or fewer individuals. If a closely held corporation also can be classified as a personal service corporation, then the corporation is subject to the passive loss rules as they apply to personal service corporations (see above).

Under the modified passive loss rules, closely held C corporations may use losses and credits from passive activities as an offset against income and taxes stemming from its active business interests, that is, trade or business income that is not from a passive activity. However, the closely held C Corporation may not use passive losses to offset portfolio income, for example, interest and dividends.

This is a modification of the passive loss rules that generally provide that losses from a passive activity may not be used to offset income from an active trade or business or to offset portfolio income.

A relatively new form of business entity is the limited liability Company (LLC). The LLC is neither a partnership nor a corporation, but it combines some of the major advantages of both forms of doing business.

The primary advantage of an LLC is that the entity is not subject to tax as a corporation. It is like a partnership or S corporation in that all the tax attributes are passed down from the entity to its owners. Another important advantage is that no LLC owner has personal liability for the entity's debts. In this regard, the LLC resembles corporations. In addition to this, the members of an LLC have the freedom of partners in allocating entity tax items in the manner that partnerships can but that S corporations cannot.

Further, LLC's do not have specific limitations on make-up or operation, such as which owners can participate in management (limited partners cannot), the number of owners (a maximum of 75 shareholders for S corporations), and the types of owners (there can be no corporations, partnerships, nonresident alien shareholders in an S corporation, and only certain types of trusts). Finally, owners can exchange property for membership interests without recognition of gain or loss (a corporate exchange of property for stock is not recognized only if the transferors are in control of the corporation after the exchange).

The IRS has issued a private ruling approving the conversion of a limited partnership to an LLC without the partnership being considered terminated, thus resulting in the recognition of gain or loss (IRS Letter Ruling 9010027).

LLC's must be set up under a state-adopted statute allowing them. Almost every state has adopted an LLC statute. The only jurisdiction that has not adopted LLC's is Hawaii.

Although the use of an S corporation allows the pass-through of most items of depreciation or tax credits, such deduction amounts (assuming the passive loss rules do not bar deduction) can be deducted only up to the amount of the taxpayer's basis in his corporate stock, and this basis does not include any nonrecourse debt of the S corporation. On the other hand, a partner's share of nonrecourse debt equals the partner's share of partnership minimum gain, plus the amount of any taxable gain that would be allocated to the partner if the partnership disposed of all partnership property subject to the nonrecourse liabilities in full satisfaction of the liabilities. Any amount of nonrecourse liability unaccounted for above is allocated in accordance with the partner's share of partnership profits (see Reg. §1.752-3.

Thus, tax shelters such as real estate partnerships that operate with a substantial amount of nonrecourse debt where there is no personal liability on the mortgage encumbering the realty (nonrecourse mortgages that are exempt from the at-risk rules) are constituted as partnerships rather than S corporations because each partner's basis in the partnership will reflect his share of the debt, thus increasing his basis above the amount of cash and other property contributed to the partnership.

In a situation such as Example (3), a sole proprietorship is like a partnership in that the owner's basis in the property generally is the amount paid for it, and this amount can include nonrecourse debt that is excepted from the at-risk rules.

Bob Parrish