Is an LLC the Right Choice for You?

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

Image borrowed from bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a "minimum tax" and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 "Articles of Organization of a Limited Liability Company (LLC)".  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to "pierce the corporate veil" and remove your LLC's limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing them in detail in future posts.  In the meantime, if you have any questions about LLCs please send me an e-mail.

Built-in Gains Tax

If you have been operating your business as a corporation but are now contemplating making the S Election, make sure you speak to a tax advisor about how the Built-in Gains Tax could potentially impact you.

As I discussed in the blog post "Is an S-Corporation Right for You?", an S corporation has all the traditional benefits of a C-Corporation (or what you typically think of as a corporation) including limited liability protection, but like a partnership the owners only have to pay income taxes on the distributed profits once.

The S Election could be made right after the business is incorporated, in which case you do not have to worry about the Built-in Gains Tax. However, the election can also be made years after the corporation has been formed.  In that event, it is important that you understand when the Built-in Gains Tax is triggered and how it operates because it could impact the business decisions you would otherwise make.

The Built-in Gains Tax may also apply if an S-corporation ever acquires assets from a C-corporation in a tax-free transaction.

The purpose of the Built-in Gains Tax is to prevent the shareholders of a C-corporation from converting to an S-corporation with the intend of avoid the tax consequences that would otherwise apply in a liquidation.  In other words, the Built-In Gains Tax is intended to prevent owners of a C-corporation from avoiding the taxes they would otherwise have to pay when shutting down or selling off all or part of their business by converting to an S-corporation.

Essentially, when converting to an S-corporation, the corporation must look at the assets it owned prior to the S Election taking effect and determine if those assets have appreciated in value (a formal appraisal is highly recommended).  If they have, the amount of appreciation on each asset will be known as the net unrealized built-in gain.  If the S-corporation then, within the applicable time period, sells that asset, the corporation (not the shareholders) must pay the Built-in Gains Tax, which is equal to the top marginal corporate tax rate (currently 35%), on the net unrealized built-in gain.

The applicable time period is currently 10 years, but shorter time periods apply to conversions that occurred in prior years.  If the S Election took effect in 2009 or 2010, then the applicable time period is 7 years.  If the S Election took effect in 2011, 2012, or 2013, the applicable time period is 5 years. It is always possible that new legislation will be enacted shortening the applicable time period again, so please talk to a trusted advisor if you are concerned about how the Built-in Gains Tax might affect you.

If you have questions about the Built-in Gains Tax, please send me an e-mail.

Is an S-Corporation Right for You?

You like the idea of forming a corporation because you want the limited liability protection, but the high cost of being taxed twice on the same income is very unappealing.  So then you thought about operating your business as a partnership so that your share of the business income will flow through to you, but the risk of being sued due to the actions of others is just too great.  A limited partnership doesn't work for you either because you want to be the one actively managing your business, not just an investor.  What other options are available to you?  One option is an S-corporation.

Image borrowed from Pacific
Associates Corporation

Every S corporation starts off as a C corporation, or what you may think of as a "regular corporation."  Then, the corporation will make an election, commonly referred to as an S Election, to be taxed under Subchapter S of the Internal Revenue Code. Basically, what this means to you is that taxes are paid at the owner-level rather than at the business-entity level, just like with partnerships.  But unlike partnerships, because an S-corporation is still a corporation it has the benefit of limited liability protection.

The S Election is made by filing Form 2553 with the Internal Revenue Service.  Once the election is made with the IRS, S corporation status is automatically recognized by California.  The election may be filed anytime during the year prior to when the election is to take effect, or within the first 2 months and 15 days of the year in which the election is to take effect.

However, there are restrictions on what corporations can be S-corporations.  First, the corporation must be incorporated within the United States.  Next, all the shareholders (owners) must be either individuals, estates, and certain types of trusts.  An S corporation may not have partnerships, corporations, or non-resident aliens as shareholders.  Additionally, an S corporation may not have more than 100 shareholders, and there can only be one type of stock issued.  The reason there can only be one class of stock issued is that all the shareholders must have the same rights in the corporation.  Finally, an S-corporation is not allowed to engage in certain types of business, such as finance or insurance.  If any of these restrictions are violated, the S-corporation status will be revoked.

S corporations have to comply with the same formalities that their C corporation counterparts do. Some of these formalities are:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

However, this is not an exhaustive list and you should talk to a corporate law attorney to see what other formalities have to be observed.

In future blog posts, we will discuss in more detail the distinctive characteristics of S-corporations and specifically how they differ from other types of entities.

If you would like to talk about the unique tax rules that govern S-corporations and how they may impact your business, please send me an e-mail.

What is a Limited Partnership?

How is a limited partnership different from a general partnership?

In the last blog post, What is a Partnership?, I gave you an overview of general partnerships and some of the advantages and disadvantages of using that type of business entity.  In an attempt to make partnerships a more beneficial business structure, limited partnerships were created.

In a general partnership, every partner is a "general partner."  That means that each partner can be held personally liable for not only his or her own actions, but for the actions of the partnership as a whole, the other partners, and the partnership's employees.

In a limited partnership, there must be at least one general partner but there are also limited partners.  Limited partners have limited liability (see Limited Liability Protection) so they can only be held personally liable for their own actions.

In exchange for having limited liability protection, the limited partners are not allowed to take any active role in the management of the partnership.  I would advise talking to a business attorney about what activities specifically qualify as management activities.

Why would a General Partner want to be in a Limited Partnership?

At first, it does not seem like there would be any advantages to a general partner to being in a limited partnership.  The general partner is still fully liable for the actions of the others, just as in a general partnership.

However, there are two main benefits to this arrangement for general partners.  The first is that it makes it easier for general partners to raise funds for the business through investors.  Many investors would not be interested in becoming a partner with full personal liability for the actions of the other partners.  The second benefit is that this arrangement leaves the general partners in full control of the daily operations of the business and all major business-related decisions.

What are the other benefits of Limited Partnerships?

Limited partnerships, like general partnerships, are pass-through entities for tax purposes meaning that they are not subject to double taxation (see Would You Rather Be Taxed Once or Twice?).  Also, the limited partners only have the amount that they invested in the business at risk.  Creditors cannot attempt to seize their personal assets, and as previously mentioned they are not personally liable for the actions of others in the business.

What are the negatives of Limited Partnerships?

While the limited partners being barred from participating in the management of the business may be a benefit to the general partners, it can be frustrating for the limited partners.  The limited partners invested their money in the business and may have strong opinions about how the business should be run.  However, if they become involved in the management of the business they lose their limited partner status and their limited liability protection.

Another disadvantage to limited partnerships is that the passive activity rules may affect the limited partners ability to deduct business losses.  The passive activity rules will be the subject of a future blog post.

If you would like to learn more about the tax implications of using the limited partnership structure for your business, or the tax implications of any other business decisions, please send me an e-mail.

What is a Partnership?

A partnership is the easiest type of business entity to form.  So easy in fact that partnerships are occasionally unintentionally formed.

A partnership is formed when two or more people engage in a business enterprise for profit. Partnerships are the only type of business entity that do not require any form of paperwork to be filed as part of its formation.

For purposes of this post, when I refer to a "partnership" I mean a general partnership. Limited partnerships will be discussed in the next post.

Although not required to form a partnership, I would recommend talking to a business transactions attorney anytime you are considering going into business with another person.

In some ways, a partnership is the opposite of a corporation (see What is a Corporation?).  Whereas there is a legal fiction that a corporation is a separate and distinct person, a partnership can be viewed more as an aggregate of all the partners.  For example, property can be owned in the partnership's name but really that means that each partner owns a portion of that property.

Also, as previously mentioned, a partnership does not have to follow any type of formalities to be formed.  It is created simply by two or more people engaging in a business enterprise for profit.  It can be a very informal arrangement.  There are no requirements that even a partnership agreement be created, although for practical purposes it is very useful to have a partnership agreement in place.

While partnerships are required to file tax returns, it is simply an "informational" tax return.  The partnership itself does not pay any taxes, and thus unlike a corporation it is not subject to double taxation.  The partnership's taxable income instead flows through to its individual partners who are responsible for reporting the income on their individual tax returns and paying tax on their share of the partnership's income.  The purpose of the partnership tax return is simply to notify the IRS and the relevant state tax collection agencies of the amount of income that the individual partners should be reporting on their tax returns.

The informational tax return that a partnership files is Form 1065.  Form 1065 will show all of the business' revenue, expenses, gains, losses, and tax credits that get passed through to the partners. Each partner, and the relevant tax collection agencies, will then be provided with a Form K-1.  The purpose of the K-1 is to inform the partner of how much income, losses, and other tax attributes have to be reported on the partner's individual tax return and the nature of the income and losses.

There are several disadvantages to operating your business as a partnership.  The first is that your partners must consent to you transferring your ownership interests in the partnership to someone else. Because the defining characteristic of a partnership is that there are two or more people choosing to work together in a business enterprise, it is impossible to have a partnership if the other person refuses to be engaged in a business enterprise with another person.  Therefore, if you want to sell your ownership interest in a partnership to another person your partners have to agree to it.

Another disadvantage of partnerships is that you are jointly and severally liable for the actions of the partnership, yourself, your partners, and your employees.  Effectively, this means that your partner, while conducting business for the partnership, could cause injury to another person and you could end up being the one sued for it even though you had nothing to do with the situation other than being a partner in a partnership.

If you would like a referral to a business transactions attorney or would like more information on how partnerships and other forms of businesses entities are taxed, please send me an e-mail.

Triple Taxation?!?!

In the last blog post, Would You Rather Be Taxed Once or Twice?, we discussed that the major disadvantage of corporations is that its profits are taxed twice: once at the corporate level, and once at the shareholder level.   But what if a corporation owns another corporation?  Would the income from the second corporation be subject to triple taxation?

Image borrowed from hudsonvalleynewsnetwork.com

The answer is... maybe and to a certain extent.

Does that clarify things?

In order to lessen the potential impact of triple taxation, within the Internal Revenue Code there is a corporate tax deduction known as the "dividends received deduction."

What the dividends received deductions does is allow a corporate shareholder to deduct from its income a certain percentage of the dividends it receives from other corporations that it owns based upon its ownership percentage.

If a corporate shareholder owns less than 20% of another corporation, it is entitled to deduct from its income 70% of the dividends it receives from that corporation.  If the corporate shareholder owns between 20% and 80% of another corporation, then it is entitled to deduct 80% of the dividends it receives from that corporation.  Finally, it a corporation owns greater than 80% of another corporation, it is entitled to deduct 100% of the dividends it receives from that corporation.

There are several limitations placed upon the dividends received deduction, including the: taxable income limitation, the holding period limitation, and the debt-financed dividends received limitation.

Under the taxable income limitation, the amount of the dividend received deduction cannot exceed a certain percentage of the corporation's taxable income.  For corporations that would be entitled to a 70% dividends received deduction, the amount of the deduction cannot be greater than 70% of the corporation's taxable income.  Likewise, for corporations that would be entitled to an 80% dividends received deduction, the amount of the deduction cannot be greater than 80% of the corporation's income.  However, there is no such restriction for corporations that would be entitled to a 100% dividends received deduction.  Also, the taxable income limitation does not apply if the dividends received deduction either creates or increases a corporation's net operating loss.

Under the holding period limitation, a corporate shareholder must hold the shares of the distributing corporation's stock for a period of more than 45 days.

Under the debt-financed dividends received limitation, the deduction  is disallowed if debt was used to finance the purchase of the other corporation's stock.  Therefore, if a percentage of the stock was purchased using debt, then the dividends received deduction is reduced by that percentage.

If you would like to learn more about the dividend received deduction, please feel free to send me an e-mail.

Would You Rather Be Taxed Once or Twice?

Would you rather pay taxes on the same income once or twice?

I am going to make a wild guess that 99.9% of you do not want to pay any more taxes than necessary, so you would prefer not to pay taxes on the same income twice.

If you read my one of my previous posts, What is a Corporation?, you know that the biggest downside to structuring your business as a corporation is that it is subject to double taxation. You also know that there are benefits to structuring your business as a corporation that may make it worthwhile to you to be subjected to double taxation. In this blog post, I will attempt to give you a more thorough understanding of what double taxation means so that you can make an informed decision.

Being subject to double taxation means that income earned by a corporation is taxed at the corporate level and then again when it is distributed to the shareholders.

To better understand what this means, lets look at an example.  For purposes of this example, lets say that both the corporate and individual tax rate is 15%, there are no state taxes, and there are no personal deductions, exemptions, or credits (or anything that really allows for tax planning).

Alex is the sole shareholder of ABC Inc.  In 2015, ABC Inc. earns a net profit of $100,000.  Because ABC Inc. is a corporation, it has to pay $15,000 in federal taxes.  This leaves ABC. Inc. $85,000 which it distributes to Alex.  Alex then has to recognize that $85,000 as dividend income and pay $12,750 more taxes on it.  This leaves Alex with only $72,250 of the original $100,000.

On the other hand, what if ABC Inc. was not subject to corporate taxes but instead all of its income flowed through to Alex?  In that case, Alex would pay $15,000 in federal taxes and be left with $85,000 instead of only $72,250.

A major reason why many business owners decide to structure their businesses as S-corporations, partnerships, or limited liability companies (LLCs) is that these can be taxed as "flow through" entities.  That means that the income flows through the business entity and is only taxed at the owner level.  There are restrictions and other drawbacks to these "flow through" entities that will be discussed in future blog posts, but the single level of taxation is a benefit that should not be ignored when you decide on what type of entity is right for your business.

If you have any questions about how various types of business entities are taxes, please feel free to send me an e-mail.