Chapter Three: Choosing a Legal Entity: Risk Management, Raising Capital, and Tax Management

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Chapter ThreeChoosing a Legal Entity Risk
Management, Raising Capital, and Tax Management
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Strategy

• Entity Choices
• Sole Proprietorships
• Partnerships
• Limited Liability Companies
• Corporations

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2 Basic Entity Choices

• Double Taxed Entities
• (C Corporations)
• Flow-through entities

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Capital Raising

• Investor Side
• Funds received from outsiders are neither taxable
  to entrepreneurs nor operations.
• The return on investment is however taxable.

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Firms Side

• Interest payments are tax deductible and dividend
  payments are not.
• Preferred stock have priorities over common stock
  holders.
• For flow-through entity, payments of profits to
  owners are non-deductible unless they represent
  interest.

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Strategy

• Tax Aspects of Forming the Entity
• When enterprise is formed, the even is tax
  deferred to both the entity and its owners.
• When a corporation is first formed the
  transactions costs are related to capital
  structure.
• Tax problems occur when noncash property is put
  into the corporation

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Strategy

• Section 351 Tax Deferral
• The owner transfers property to the corporation
• In return, receives shares in the corporation
• Immediately after the transfer, the shareholder
  who transferred the property in owns at least 80
  of the value and voting power of the
  corporations shares.

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Strategy

• Entity Metamorphosis
• The process in which a sole proprietorship turns
  into an S Corporation or a Limited Liability
  Company.
• Management Control
• A sole proprietorship has whole control of the
  organization.
• Limited partners have less control and through
  silent partners.
• General partnership is divided amongst the owners
  of the company.

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Anticipating and Timing Issues

• Advantage of timing is best for C Corporation
• It is easy to adjust income between entity and
  its shareholders
• Can pay dividends to its shareholders in the
  lowest tax bracket.
• Flow-through entities is more controlled because
  cash method of accounting can be used.

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Anticipation and Timing Issues

• Anticipation Policy Changes
• Strategic tax planning anticipates actions by
  competitors in the markets.
• Tax policies favor flow-through entity and LLCs
  because they are being replaced by S Corporation
  and limited partnerships.

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Value-Adding

• Adjusting Value-Adding for Risk
• Short Run Cash flows can vary and losses may
  occur
• Long Run potential for serious loss such as
  lawsuits or bankruptcy.
• A startup C Corporation, a net loss for the year
  must be carried forward to the next tax year
  until there is positive taxable income.
• For established C corporations, losses can be
  carried back five years and carried forward 20
  years.

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Value-Adding

• Transaction Costs and Value Adding
• Sole Proprietorship is the cheapest entity to
  form.
• Next cheapest is a general partnership.
• LLCs are typically higher cost to form.

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Negotiating

• C corporations provide some flexibility when
  owners are employees of the corporation.
• Salary payments are useful for splitting the tax
  liability between the corporation and the owner.
• Perquisites are the ultimate tax shelter for a C
  corporation.

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Transforming

• C corporations can transform ordinary income into
  capital gain income by liquidating all or part of
  shareholders interests.
• Compared to paying with dividends (35) the owner
  would only have to pay the (15) on the amount
  gained from the sale of the stock.

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Putting It All Together Applying SAVANT to
Entity Choice

• Scenario You and an associate start a business
  that produces business software. You each
  invested 10,000 to pay the programmers. You
  have no formal agreements. You have a 150,000
  job in another company and 500,000 net worth.
  Your friend earns 10,000 a year and has 5,000
  in savings. You require 200,000 to rewrite the
  software for the larger business.

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Putting It All Together Applying SAVANT to
Entity Choice

• Strategy
• Choose either S Corporation or LLC
• Limited partnership is a bad idea because of both
  partners managing the company.
• Timing Issues
• Use flow-through then convert to a C corporation

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Putting It All Together Applying SAVANT to
Entity Choice

• Value-Adding
• Double tax of C corporation can be mitigated
  through salary payments
• Negotiating
• LLC has flexibility of allocating losses among
  owners
• Transforming
• S corporation favored when business fails because
  possible use of Section 1244 stock
• Conclusion
• Open as LLC

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Specialized Legal Forms

• Real Estate Investment Trusts (REIT)
• Tax Free if
• Has less than 100 shareholders
• 95 or more of its income comes from real estate
• Distributes at least 95 of its income each year