Business Entity - Comparison Of Forms   

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A few closely related topics & pages From Bob Parrish CPA PC:   

Client Letter - What this idea is about From Bob Parrish CPA PC

Description / Scope  / Skill Level Pre-requisite Knowledge

This page is to help you understand the different forms of doing business.  Since this is important and usually quite complex you should first become familiar with the basics and then consult your CPA and then your attorney.

Topic - Objective - Purpose Why This Is Important: Usefulness General Benefits 7 Objectives: 

This is important from multiple foci.  There are ownership and investor implications.  There are tax considerations.  There are hazards of litigation consideration.  Product liability, personal injury, general liability can all enter into the decision making process.

Time Estimate - can be quite lengthy

Materials  - Equipment-Tools - Library Resources

Who This Applies to: All business startups

When to Perform: Before you fund your business or start any agreements or take any money from investors or lenders.

Special Circumstances: Warnings & Special Circumstances - The  wrong choice can be a financial or tax disaster.

Engagement Status Letter From Bob Parrish CPA PC

You have not engaged Bob Parrish CPA PC, Bob Parrish CPA, pro1040, Consulting on line, any related parties, or the ISP to perform any services for you or offer you advice.  This entire site is for educational or informational purposes only.   You are not to use the forms, concepts, strategies, or knowledge without assistance from a professional.   The author, the corporation, the ISP, Bob Parrish CPA, Bob Parrish CPA, P.C. or other parties related to those or this site do not guarantee or warrantee in any manner the suitability, usefulness, accuracy, timeliness, or results of any portions of this site, nor the links contained in this site which link to other areas.   At times, information is taken from other sources and is believed to be accurate, but no verification or confirmation is performed.  Furthermore, if any federal or state law invalidates a portion of this disclaimer, the other portions still apply.   In addition, any allegations or actions are restricted to arbitration only and must be arbitrated by the Better Business Bureau in Sarasota Florida.  Reading of these pages constitutes complete acceptance and agreement with all disclaimer provisions on all pages of this site. ....... Thursday, February 22, 2007 11:43 AM  

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Learning Objectives (What You Asked) From Bob Parrish CPA PC

 Objective one

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What You Will Need From Bob Parrish CPA PC

Plain English Analysis What it does, Why it works - The Answer, Alternatives From Bob Parrish CPA PC

What it does:

Starting a business or - "Which Form Suits The Owners Best Interest?"

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Why it works:

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

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.

In general we usually advise that real estate be held in the names of both spouses, and do not

Otherwise we strongly recommend the use of a corporation (an S Election may be appropriate), a Limited Liability Company, or in some cases a Family Limited Partnership.

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.

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 partnership (general or limited partnership), the S corporation, the C corporation, and the limited liability company (LLC). 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.

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. Although there are cases in which an S corporation or a C corporation might provide tax advantages over a partnership, these circumstances are relatively rare.

Although the partnership generally provides tax advantages over the corporate alternatives, there may be nontax advantages of the corporate form that make a corporation the preferred entity for certain 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. Personal service businesses and real estate operations are generally conducted through partnerships. In these situations, either (1) personal liability cannot be avoided, (2) sufficient insulation from liability is provided through the limited partnership, contractually with lenders, or through liability insurance, or (3) the tax advantages of the partnership form outweigh personal liability concerns. Other activities, including many manufacturing businesses where insulation from personal liability for all members is usually important and can be achieved under state law, operate through corporations. In these situations, if the requirements of an S corporation can be met, the S corporation is usually selected because of its pass-through character. Large publicly owned businesses operate as C corporations because limited liability for all members is important and the requirements for S corporations cannot be met.

Certain concerns are common to all business plans: risk, finance, control and continuity. If a business is risky (say, if it implies substantial exposure to tort or contract liability), and especially if the business owners have substantial wealth outside the business, the limited liability nature of a corporation makes this form of organization very attractive. However, if the business is relatively risk-free and offers like scope for expansion, and especially if its owners have few assets, the relatively informal sole proprietorship or general partnership seem more attractive. Dissolution and termination of a partnership is much easier than the comparable process for a corporation; and the “red tape” required to start, operate or terminate a noncorporate business is much less extensive than that wound around corporations.

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 taxed like a partnership.

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.

The best choice is the one that provides optimal cash flow and the greatest overall amount of long-term, after-tax income. Especially in a family business, it's appropriate to look beyond the first generation and consider the creation of an estate and the management transition to the next generation.

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 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 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.

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:

(1) General partner. A general partner is a member of a partnership who is personally liable for the obligations of the partnership.

(2) Limited partner. A limited partner is a member of the partnership whose potential personal liability for partnership debts is limited to the amount of money or other property that the partner has contributed or is required to contribute to the partnership. Generally, limited partnership interests are treated as activities in which the investor does not materially participate and to which the limitations on passive activity losses apply.

(3) General partnership. A general partnership is a partnership that is composed entirely of general partners. Basically, under this type of arrangement, all the partners share in the control of the business and also have unlimited liability for partnership debts.

(4) Limited partnership. A limited partnership is composed of at least one general partner and at least one limited partner. Thus, at least one partner has unlimited liability for the debts of the partnership. Although no formal requirements exist for a corporation to act as a general partner in a limited partnership, the IRS has issued guidelines under which it will issue advance rulings that a limited partnership meets the requirements so as not to be taxed as a corporation. Among these requirements is a minimum capitalization requirement for general partners, including corporate general partner.

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.

The tax treatment of partnerships is discussed at ¶25,341 et seq.

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 nonportfolio 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 tax treatment of S corporations is discussed at ¶33,421 et seq.

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.

Example (1): Sunnydaze, Inc., is a closely held C corporation. For 1996, it had $50,000 in losses from a passive rental activity, $40,000 in income from an active business, and $10,000 in portfolio income. As a closely held C corporation, Sunnydaze may apply its passive losses against its nonpassive business income. However, such losses may not be applied against portfolio income. Thus, in computing its taxable income, the corporation will have a nondeductible passive loss of $10,000 ($40,000 - $50,000 = ($10,000)) that must be carried forward to another year, and $10,000 portfolio income that must be included in current gross income.

Example (2): Assume the same facts as in Example (1) except that Sunnydaze, Inc., is a personal service corporation. In this situation, the modified passive loss rules do not apply and the corporation may not use the $50,000 in passive losses to offset active business income. Thus, the passive losses are carried forward to another year and the $40,000 in active business income and $10,000 in portfolio income must be included in current income.

Limited Liability Companies

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 LLCs resemble 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, LLCs 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).

LLCs 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 LLCs 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.

Example (3): Ronald Hewer acquires a one percent interest in a partnership that owns an office building. He pays $1,000 for this interest. There is a $2,000,000 nonrecourse mortgage outstanding on this real estate and Hewer's basis in his partnership interest is $21,000 ($1,000 paid for the interest and $20,000 as his share of the mortgage). The property generates $170,000 in losses in 1996 and Hewer's share of the losses is $1,700. He may deduct the full amount of his share of the losses, up to his passive loss limitation, if any, because his share does not exceed his basis in his partnership interest ($21,000) even though the losses exceed the amount he paid for his interest ($1,000).

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

Alternatives

Cost v. Benefit Analysis

Other

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Technical Analysis & Citations What It does, Why it works - From Bob Parrish CPA PC

  Law (commentary and citation) Regs (commentary and citation) Cases (commentary and citation)

Law

Regs

Cases

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Tax Killers  From Bob Parrish CPA PC

This is about Activity Based Taxplanning - maximizing deductions, minimizing cash outlay and maximizing the amount of cash retained and the net worth.  Activity Based Taxplanning (ABT) is a methodology developed by Bob Parrish CPA, that assists people with the tax issues by focusing on the activity (or actions - events) that are being undertaken or contemplated (or have already taken place).  The,  research is compiled from the myriad of sources to help you complete the activity with the least tax cost, while maintaining compliance the tax laws, other laws and regulations and place yourself in a position to protect your objectives.

Tax is a subject that many view in order to cut costs.  Taxes are a cost just as any other cost.  It happens this cost is somewhat intangible and is defined by legislation without a tangible item to view and control.  The money is spent and the control of the expenditure is more appropriately administered by someone trained in the law.

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Cost Killers   From Bob Parrish CPA PC

 This is about Activity Based Costing  - methods to cut costs, management accounting, management information systems, decision support systems - in general about being a manager.

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Preparing for your CPA, attorney, or preparing to start your own What to gather - From Bob Parrish CPA PC

Entrance Interview

1041 Organizer

Exit Interview

From Banking Records

From Customer Records

From Signed Documents

From Your Other Business, or Financial Records

From Corporation or Organization Records (meetings, etc.) 

What to do

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Forms - checklists, time-line to do, etc. Assistance - What To Do - From Bob Parrish CPA PC

Assistance - What to do

Forms - Checklists - Etc.

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Spreadsheets & Computations From Bob Parrish CPA PC

Spreadsheet #1

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Contracts, Trusts, etc. From Bob Parrish CPA PC

Agreement #1

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Reports Required From Bob Parrish CPA PC

 Report #1

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Checklists for Deployment  From Bob Parrish CPA PC

 Checklist #1

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Checklist for Monitoring  From Bob Parrish CPA PC

 Checklist #1

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Financial Accounting: Bookkeeping & Financials From Bob Parrish CPA PC

Financial Statement Presentation

Notes to Financial Statements

How to Make Entries

What Kind of Records to Keep

Bookkeeping Methods - Cash, Accrual and Other

How the Business Entity Affects the Recording

Sole Proprietor

Corporation - C & S

Partnerships - General, Limited, Limited Liability Company, Registered Limited Liability Partnership or Company

Trusts

Tax Exempt

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Compliance - what is required for protection, defense, etc.  From Bob Parrish CPA PC

Compliance Checklist

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Alerts & Dangers - Risks, Asset Protection, IRS Defense From Bob Parrish CPA PC

Action Checklist

Alerts & Dangers - Risks

Asset Protection

Your Defense

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