Estate Planning Business Formation

Estate Planning: Your Family, Your Wealth, Your Legacy.

Entity Formation

Anyone starting a business today has an increasing number of structures from which to choose.  And with the check-the-box rules, you can select whichever one you want without worrying about the complicated four-factor test that once applied.  Selecting the one that will best suit your needs involves weighing the advantages and disadvantages of each.

There are five basic entity forms to consider when forming a business.

1.    Corporation

2.     General Partnership

3.    Limited Partnership

4.    Limited Liability Partnership (“LLP”)

5.     Limited Liability Company (“LLC”)

Which form is chosen will be driven by your business objectives and the focus will be on how the entity and its owners will be taxed and the extent to which the entity will shield the owners of the business from liabilities arising out of its activities.

Your options fall into three categories:

  • Those that “pass through” taxation to the individual owners without liability protection (sole proprietorships and general partnerships)
  • Those that pass through taxation with liability protection (limited partnerships, limited liability companies [LLCs], limited liability partnerships [LLPs] and S corporations), and
  • Those that are taxed as a separate entity with liability protection for shareholders (C corporations).

The advantage of pass through status is that income tax is generally paid at the shareholder level only.  In contrast, C corporation income tax is paid at both the corporate and the shareholder level.  Dividends are paid from funds that have been taxed at the corporate level, and shareholders pay tax on the dividends they receive. And even though the second tax on dividends is now reduced to 15%, it’s still an additional level of tax.  To avoid this double tax on amounts that exceed reasonable salaries, a C corporation may retain earnings.  But if it does so without a business purpose — other than avoiding tax on the dividends — the IRS may assess an additional accumulated earnings tax.

As the owner of an existing business, you may want to review your business structure periodically to weigh its advantages and disadvantages and how they relate to your company’s future profitability and your objectives.  Even more important, you need to know how these advantages and disadvantages offset each other.

Texas Margin Tax

The Texas Legislature replaced the Texas franchise tax on corporations and LLCs with a novel business entity tax called the “Margin Tax.” The “Margin Tax” is imposed on all business entities other than general partnerships wholly owned by individuals and certain “passive entities.”

The calculation of the Margin Tax is based on a taxable entity’s, or unitary group’s, gross receipts after deductions for either (x) compensation or (y) cost of goods sold, provided that the “tax base” for the Margin Tax may not exceed 70% of the entity’s total revenues. This “tax base” is apportioned to Texas by multiplying the tax base by a fraction of which the numerator is Texas gross receipts and the denominator is aggregate gross receipts. The tax rate applied to the Texas portion of the tax base is 1% for all taxpayers, except a narrowly defined group of retail and wholesale businesses that will pay a 1⁄2 of 1% rate. For calendar year taxpayers, the Margin Tax is payable annually on May 15 of each year based on entity income for the year ending the preceding December 31.

Income Taxes

Texas does not have a personal income tax.  At the federal level, the top individual tax rate and the top corporate rate are now the same, at 35%.  At lower income levels, the C corporation (with the exception of personal service corporations) may have an advantage because it can benefit from lower corporate rates on the first $75,000 of taxable income.

But income tax considerations go beyond a comparison of the top federal income tax rates.  First, you must also consider the impact of state income taxes in the various states where your company does business.  In some states, the combined federal and state rates may be higher for C corporations while in others, individuals are still taxed at higher rates.

Second, a different income tax consideration applies to businesses that are expecting losses.  If owners have enough tax basis in the entity, organizing as an S corporation, LLC or partnership may be beneficial.  Why?  Because these entities allow losses to be passed through to the owners. Thus, owners may realize current tax savings by taking the losses individually.  A new C corporation, on the other hand, generally can only carry forward losses against future corporate income.

Finally, you need to consider whether income or loss that is passed through to an owner is active or passive.  Passive losses are deductible only against passive income or when the passive activity is disposed of.  Generally, if an owner does not materially participate in the business (according to certain participation tests), the income or loss is passive.

If a business could generate passive income for any owner, a structure that allows pass through treatment can be advantageous because it may allow the owner to deduct passive losses from other activities.

Conversely, if a business generates passive losses for any owner, pass-through treatment may be a disadvantage because the owner may not be able to currently deduct the losses.  By contrast, a C corporation is not subject to the same passive loss limitations.

Sale of the Business

The way you structure your business has implications that affect how you will be taxed if you sell it later on.  When considering these implications, you need to examine two areas: the impact on the shareholders and the impact on the corporation.

Shareholder level. A key advantage of a pass through structure is that it may avoid or reduce any capital gains tax on the sale of a business interest.  When an S corporation retains earnings over the years by earning income and not distributing all of it to shareholders, then shareholders’ tax basis stock increases, reducing or eliminating their capital gain on a sale.

For example, assume a sole owner of an S corporation has an original investment of $100,000.  The business retains earnings of $500,000 over a period of years, so the owner’s tax basis increases to $600,000. If the owner then sells the company’s stock for $1 million, the owner’s gain would be $400,000.

In contrast, if the business is a C corporation, the gain would be $900,000 because the owner’s tax basis would remain the $100,000 initially invested. In general, the current maximum tax rate on long term capital gains (for assets held longer than 12 months) is 15%. The tax law reduces the capital gains tax to a maximum 14% on investments in qualified small businesses, but this only applies to original issue stock of certain C corporations purchased after Aug. 10, 1993, and held for at least five years.

The capital gains question has another side.  If an owner plans to keep the business in the family and bequeath his or her interest at death, the capital gains tax may never apply.  Currently, when heirs sell inherited property, they don’t pay capital gains tax on appreciation that occurred before their their loved one’s death.  But when the estate tax is repealed in 2010 under EGTRRA, this step-up in basis will be limited to $1.3 million plus another $3 million for assets going to a spouse.  The limits are adjusted for built-in losses and loss carryover amounts. The law is complex; consult your advisor on how this might affect your estate plan.

Corporate level. On a sale of C corporation assets, there may be a substantial corporate level tax if they are sold for more than their tax basis.  Take an example of a building that was purchased for $1 million and depreciated over a period of years, reducing the tax basis to $400,000.  If the building is sold for $2 million, the corporation pays tax on a gain of $1.6 million.  If the corporation is then liquidated, the shareholders pay a second level of tax.  In contrast, an S corporation usually pays no corporate level federal tax, and sole proprietorships, partnerships and LLCs never do.