The company originally has three investors, Dawn, Linda and Mike with different contribution. Dawn is single with no other Jobs, will contribute land and cash with 30% ownership interest. Linda is married, will contribute services with 30% interest. Mike will contribute cash and 40% ownership and he will not involve in the business. They planned to grow the business and seek more owners and capital in he future.
They would borrow $800,000 for building and $300,000 from local bank and $200,000 from Mike for additional cash. They believe the company will take a few years to become profitable. The company will either go public or sell to large retailer after grow. The company has asked us to research what kind of entity to form. A business may choose to operate as either a C corporation, an S corporation, a limited liability company, a limited partnership, or a general partnership. “A general partnership, the liability of each partner for partnership debts is unlimited.
Thus, hese partners are at risk for more than the amount of their capital investment in the partnership. ” In fact, one of the original investors, Mike wants to become a passive investor in CTC and does not liable for all partnership debts. The choice of a general partnership entity is not suggested to CTC, because it is not meet the requirement of its investor. “A C corporation is subject to double taxation. Its earnings are taxed first at the corporate level when earned, then again at the shareholder level when distributed as dividends. It means that the business will be costlier to start than other business ntities. Section 351 governs whether transfers to a corporation are tax-free or taxable. “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation. ” Also, Shareholders do not benefit from corporate losses in a C corporation.
Since Dawn and Linda made a five-year income and loss projections for CTC shown that CTC will have significantly loss on the first three years. A C corporation type of business entity does not allow the investors take any tax advantage on these losses. Therefore, a C corporation is a good choice for CTC during the formation period. When forming a small business as S corporation, double taxation can be avoided compared to the C corporation and there will be no self- employment taxes for individual owners compare to LLC and LP business types.
S corporation allows working owners to be treated as employees, and limits employment tax to reasonable salaries drawn by owners. Also, the losses of S orporation can be flow-through to shareholders’ individual income deduction, subject to basis limitation, at risk limitations and passive activities limitations. If there is any loss not allowed to be deducted in the current year, it will be carried over to the next year. It allows the CTC’s owners be able to deduct the company’s losses in the first three years trom their other income.
But tor CTC, S corporation is not a perfect choice. First, S corporation have limitation on number and type of owners. S corporation should have no more than 100 shareholders and only allowable hareholders, including individuals, certain trust, and estate, and may not include partnerships, corporations or non-resident alien shareholders. The information from CTC shows that the owners have plans to grow the business and seek more owners and capital in the future. Above all, the business type of S corporation means which does not have more than one class of stock.
From the information provided by CTC, the ownership interest of three investors is different. Mike has a 40% ownership interest on his cash contribution, which is higher than Dawn and Linda’s 30% wnership interest. It means the choice of S corporation is not meet the agreement between the three owners. The two types of entity, Limited Partnership and Limited Liability Company are very similar. The tax structure allows anyone or any entity can be a partner. There is only one time federal income tax paid at members-level or partner-level.
Profits and losses of the business may be allocated to owners in any reasonable manner that has substantial economic effect, and differing classes of ownership shares or units may be issued. LLC has nearly unlimited flexibility in the ypes of equity and debt interest that it may issue to its members. Also, in many cases property can be distributed out to a partner in a tax deferred manner. And a purchase of partnership interests can often lead to an increase in the basis of partnership property.
Also, tax free contribution is easy to make, since there is no requirement on recognize any gain on the transfer of property to LLC in exchange for an interest in the LLC. If a member of an LLC contributes property with a built-in gain or loss to LLC, the built-in gain or loss is specially allocated to the contributing ember upon a later taxable disposition of the property by the LLC. Also, in the case, if CTC is a LLC, Linda provide services to CTC in exchange for a vested or nonvested “profit interest”, neither CTC nor Linda is taxable on the exchange or, in the case of a nonvested interest, on the vesting date.
On the other hand, if Linda provides services in exchange for a capital interest, this exchange is generally a taxable event. In general, converting from an LLC to a corporation is not a taxable event. Such a conversion is normally treated as a contribution of the LLC’s assets to a newly formed orporation in exchange for its stock, followed immediately thereafter by a distribution of the stock to the LLC’s members in liquidation. By contrast, converting from a C corporation to an LLC generally taxable to both the corporation and its shareholders.
The conversion of an S corporation to an LLC company normally triggers at least one level of tax. There are disadvantage of LLC that all earning allocated to owners involved in the business are subject to self-employment taxed, and the flexible structure can make accounting for transactions and prepare tax returns more complex. Also, an LLC sometimes be treated as a separate entity for state or local, or foreign, tax purpose. Situation: Property Contribution Additional Capital Needs Future Expansion Selling a portion of business The One Class ot Stock Rule.
An S corporation must be a small business corporation, which can have only one class of stock. If an S corporation issues a second class of stock, it ceases to meet the definition of a small business corporation, and its S corporation status is automatically terminated triggering significant adverse tax ramifications for its owners. A corporation that has issued only one class of stock may conduct its business or enter into agreements that treat certain shareholders or creditors in a manner that causes the company’s actions/agreements to be considered a second class of stock.
The one-class-of-stock rule prevents the corporation from having the complexity related to allocating earnings to multiple classes of owners. A corporation has only one class of stock if all outstanding shares provide for identical rights to stockholders regarding distribution and liquidation proceeds. However, differences in voting ights among shares of stock of a corporation do not automatically indicate that there is more than one class of stock.
A corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors. Relevant toa determination of whether all outstanding shares of stock are of the same class requires that the stock confer identical rights to distribution and liquidation proceeds (versus voting rights) and is based on the terms of the articles of ncorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds 1.
Forming CTC as a limited Partnership Tax factor advantage and disadvantage The partnership as an entity pays no tax. A partner’s tax rate may be lower than a corporation’s tax rate. Dawn: single, no other income, company with no profit, she has no income. Linda, husband has 300,000 income with margin tax rate of 33%. Non-tax factor advantage and disadvantage