Monthly Archives: February, 2016

Built-in Gains Tax

February 29th, 2016 Posted by Tax No Comment yet

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.

Currently, the applicable time period is 5 years.  However, we strongly advise talking to a trusted advisor to ensure that the law has not changed, and that your circumstances is not affected by special rules.

Is an S-Corporation Right for You?

February 26th, 2016 Posted by Tax No Comment yet

A corporation provides you with limited liability protection, but the high cost of double taxation makes it unappealing to many business owners.  A partnership has flow-through tax attributes so you are only taxed once on your business income, but the risk of being sued because of your partners’ actions is too great of a risk.  A limited partnership isn’t an option for you because all the owners want to be actively involved in managing the business.  A different option that is available to you is an S-corporation.

Image from Pacific Associates Corporation

Image 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.

What is a Limited Partnership?

February 24th, 2016 Posted by Tax No Comment yet

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 an 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.

What is a Partnership?

February 22nd, 2016 Posted by Tax No Comment yet

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 aggregation 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.

Triple Taxation?!?!

February 19th, 2016 Posted by Tax 1 comment

In the last post, we discussed that the major disadvantage to structuring your business as a corporation is that the income is subject to double taxation when distributed to the shareholders. But what happens when a corporation owns another corporation?  Is the income from the subsidiary corporation subject to triple taxation when distributed all the way to the shareholders of the parent corporation?

Image from www.hudsonvalleynewsnetwork.com

Image from www.hudsonvalleynewsnetwork.com

The answer is…maybe 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.”  This deduction allows a corporate shareholder to deduct a certain percentage of the dividends it receives from other corporations from its income.  The amount it is allowed to deduct depends upon its ownership percentage in the other corporation.

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.

Would You Rather Be Taxed Once or Twice?

February 17th, 2016 Posted by Tax 1 comment

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.

Tax-WeightlifterAs you now know, one of the biggest downsides to structuring your business as a corporation is that it is subject to double taxation (see What is a Corporation?). The benefits to structuring your business as a corporation may make it worthwhile, but in this 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 2016, 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.

Protecting Your Liability Shield

February 15th, 2016 Posted by Tax 1 comment

You have established your business as a separate entity with limited liability protection, but that is not enough to protect yourself from legal liability.

Image from www.michaelsmithlaw.com

Image from www.michaelsmithlaw.com

Even for the types of legal liability that limited liability entities are designed to protect you from (see Limited Liability Protection), it will not do you any good if plaintiffs are able to “pierce the corporate veil.” We recommend talking to a business attorney to get a thorough understanding what it means to pierce the corporate veil and what you need to do to prevent that from happening, but this post will provide a general overview based upon California law.

Essentially what it means when a plaintiff is attempting to pierce the corporate veil is that the plaintiff is claiming that your business is really your “alter ego” and not its own separate entity. If a plaintiff is successful, you can be held personally liable for the actions of your business and potentially have your assets seized if there is a judgement against you.

Courts will look at a number of factors to determine whether to pierce the corporate veil.  These factors vary among the states and continues to evolve, so I strongly recommend discussing these factors with a business attorney to ensure that your business is being operated in a while that will protect you.

One factor that courts will consider is whether the entity engaged in fraudulent behavior.  This should be common sense; you cannot reasonably expect to use your business to defraud others and then escape personal liability just because the fraud was committed through a limited liability entity.

Another major factor is whether the business followed the required formalities (see Corporations for a list of some of the required corporate formalities). This factor is more relaxed for limited liability companies (LLC), but even with LLCs there are formalities that must be followed.

The general concept behind piercing the corporate veil is that if you want your business to be treated as a separate legal entity by others, then you must also treat it as a separate legal entity.  This means that even if you are the sole shareholder of a corporation you must hold a Board meeting at least once a year, maintain the meeting minutes, as well as meet all of the other formalities. Likewise, you cannot commingle business and personal funds. You must have a separate bank account for your business and only pay business expenses out of that bank account. If you put all of your personal and business funds into the same bank account, it strongly indicates to a court that you do not consider the business to be its own separate entity. Similarly, if you pay personal expenses out of the business bank account, then it gives the court the impression that it is just another personal account.

Another major factor that courts will evaluate is whether the business is undercapitalized.  This means that when you are first contributing money to the new business it must be a reasonable amount.  For example, if you expect your business to have $5,000 of operational expenses a month, an initial capitalization of $1,000 does not appear to be reasonable.

Finally, a factor that will be considered is the amount of control you are able to exert over the business.  For example, if you are the sole owner of the business then you are fully in control of the business, and it would be easier for a plaintiff to argue that the business is really just an extension of yourself, your “alter ego”.  On the other hand, if you are one of 100 co-owners each owning 1% of the business, it would be very difficult for a plaintiff to argue that the business is your alter ego.
Forming a business entity that has limited liability protection is great, but only if you take the proper steps to protect your liability shield.

Limited Liability Protection

February 12th, 2016 Posted by Tax 6 comments

Many businesses start off as sole proprietorships before the owners choose to create a separate entity for their business, like a corporation or limited liability company (LLC).  A major motivation for these business owners in transforming their business into a separate entity is to gain limited liability protection.

 

liability shieldCorporation, S-corporation, limited liability companies (LLCs), and limited partnerships (for the limited partners only) provide limited liability protection to their owners.

What protection limited liability provides exactly does vary from state to state, so for purposes of this discussion we will focus on California law.  We recommend talking to a business attorney about limited liability as case law is constantly evolving.  As the name implies, the legal protection offered is limited to certain types of liability.

The first type of legal protection that limited liability provides is from personal liability for the entity’s debts.  For example, Jason owns a corporation, ABC Inc.  ABC Inc. borrowed $100,000 from XYZ Lending, but business has not been doing well and ABC Inc. is no longer able to make the required payments on its loan.  XYZ Lending is able to sue ABC Inc. and potentially seize its assets to attempt to be repaid, but it is unable to recover anything from Jason personally.

The other type of legal protection that limited liability provides is personal liability for the actions of co-owners or employees of the business.  For example, Steven owns Delivery Inc., a successful package delivery corporation.  Delivery Inc. employs several drivers.  One day, one of Delivery Inc.’s drivers ran a red light while delivering packages and hit a pedestrian.  The pedestrian sued Delivery Inc. for damages, but is unable to sue Steven personally.  However, if Steven had run the business as a sole proprietor he could have been held personally liable for the actions of his employee and had his assets seized.

However, even with limited liability protection you remain personally liability for your own actions.  If you personally injure another person, for instance, then you are potentially liable regardless of whether your business has limited liability protection.  As an aside, this is a reason to consider purchasing insurance regardless of whether your business has limited liability.

Because limited liability protection can frustrate plaintiff’s attempts to collect damages, plaintiffs will often try to get around this liability shield by “piercing the corporate veil” (a legal concept that will be explained in the post).

What is a Corporation?

February 10th, 2016 Posted by Tax No Comment yet

You have friends that keep telling you that you should incorporate your business, but you always brush them off.  You just have a small business, not a giant entity like GE or Apple.  What advantage is there for your business to incorporate?

The truth is that you can incorporate your business regardless of its size.  The decision on whether to incorporate should instead be made based upon your situation and goals, the advantages offered by a corporate structure, and the costs to operating as a corporation.

Image from www.cgglobal.com

Image from www.cgglobal.com

When making this decision, I recommend talking to a trusted adviser such as a business attorney or a CPA so that you fully understand the potential impact that this decision can have.  In this post, we will discuss in general what a corporation is and the advantages and disadvantages of operating your business under a corporate structure, including the tax impact.

 

As opposed to a sole proprietorship, a corporation is a legal entity that is separate and distinct from you as its owner (shareholder).  There is, essentially, a legal fiction that a corporation is its own person.  What exactly that means has been the subject of many Supreme Court cases and continues to evolve, but for purposes of our discussion it means that the corporation can: enter into contracts, purchase assets, loan and borrow money, sue or be sued, and pay taxes.

Corporations are organized under state law and must recognize certain formalities.  These vary to some degree from state to state so for purposes of this discussion I will be discussing the formalities that California corporations are subject to.  Some of these formalities include:

  • 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.

This is not an exhaustive list of the corporate formalities that must be followed by a California corporation, so we strongly recommend talking to a business transactions attorney if you are contemplating incorporating your business.

As mentioned in the previous post, Why Form a Business Entity?, one of the primary benefits of forming a corporation is that it has limited liability protection.  Because of the importance of limited liability, it will be discussed in the next blog post.  For now, the general rule is that your financial risk is limited to the amount of your investment.

Another benefit of the corporate form of business ownership is that your ownership interests can, relative to other forms of business ownership, be easily transferred to another individual.  Your ownership interest in the corporation is represented through shares of stock, and generally there are no restrictions on you in transferring your ownership of the stock to another person.  To be clear, this does not necessarily mean that there is an active market for your stock, but once there is a buyer the sale process is much simpler than, for example, the sale of a partnership interest.

However, one of the main drawbacks to the corporate form of business ownership is double-taxation. As I mentioned, a corporation is a separate legal entity that is subject to taxation.  That means that any income that the corporation earns will be taxed first at the corporate level.  If that income is then distributed to the shareholders, it may be taxed again at the individual level (the taxation of distributions will be discussed further in a future blog post).

A shareholder-employee can avoid double taxation by withdrawing money from the corporation in the form of wages or salary.  Wages and salaries are deductible to the corporation, so the shareholder employee will effectively only be taxed on that income once.  However, the IRS has broad authority to determine what is actual compensation and what are disguised dividends, and make adjustment accordingly.

Why Form a Business Entity?

February 8th, 2016 Posted by Tax 2 comments

Congratulations!  You have turned your passion into a business, and you are doing everything you can to make sure that it is a success.

You’ve heard people talk about incorporating their business or forming a partnership or an LLC, and now you are wondering if that is the right thing to do for your business.

Table borrowed from www.strategicofficesupport.com

Table borrowed from www.strategicofficesupport.com

It may be, but there are a few factors that you need to consider before you decide.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity’s assets (i.e., not your personal assets) are at risk of loss.  For example, let’s say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are different tax implications to however you choose to structure your business.  For example, certain business structures would treat your income as “self-employed income” which affects how it is taxed.

Finally, you should consider the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS (they are all the time), but many tax professionals believe that sole proprietors are audited more frequently.  This is an important consideration because even though you will be filing your taxes properly an IRS audit is still expensive.