Chapter 16 Flashcards
Selection Process
The selection process includes consideration of the following factors: ease and cost of formation, complexity of management operation and governance, how transfer-ability and dissolution are achieved, liability protection for owners’ personal assets, and reporting requirements and taxation.
Sole Propriertorship Advantages
Easy to form, simple to operate, easy to sell business assets, few administrative burdens, income is generally passed through to the owner on Schedule C of Form 1040.
Sole Proprietorship Disadvantages
Generally have limited sources of capital, ulimited liability, no guarantee of continuity beyond the prprietorship, business income is subject to self-employment income.
Sole Proprietorship Relevant Forms
Form 1040 Schedule C, form 1040 Schedule SE, form 1040
General Partnership Advantages
More sources of capital than proprietorships, Usually have more management resources available than proprietorship, have less administrative burdens than corporations, income is generally passed through to the partners for tax purposes.
General Partnerships Disadvantages
Transfer of interest is more difficult than proprietorship. Unlimited liability each partner is liabile for partnership debts and obligations. Partnership income tax and basis adjustment rules can be complex. Business net income is subject to self employment tax. Partners are entitled to few tax deductible fringe benefits that are generally available to employees.
Relevant tax forms
Form 1065, form 1065 Schedule K, form 1065 Schedule K-1
Limited Partnerships Advantages
Favorable pass-through partnerships taxation status, have flexibility. Have flexibility to structure ownership interest. Limited partners are not personally liabilty for the debts and obligations of limited partnerships
Limited Partnership Disadvantages
Must file with the state to register. In most states, limited are not liable for debts and other obligations of the limited partnerships as long as they do not engage in management. Losses for limited partners are generally passive losses.
Limited Partnerships vs Partnerships
General partner- always be on the hook for any of the liability on a personal level. Limited partners- only be liable for the assets they contributed to the partnership.
Limited Liability Partnership
Advantages: LLP’s have favorable pass-through partnership taxation status available. LLP’s have flexibility to structure ownership interest. LLP general partners can insulate themselves from the acts of other partners
Limited Liability Partnership Disadvantages
LLP’s are required to file with state to register. LLP’s have unlimited liability for own acts of malpractice.
Family Limited Partnerships Advantages
Control retained by senior family member. Valuation discounts are available for minority interest and lack of marketability. Annual exclusion gifts are generally used to transfer interests to family members. Some creditor protection. Restricution can be placed on transferability of limited partnerships intersts of junior family members. Usually this is an estate planning strategy.
Disadvantages of FLPs
Attorney setup fees and costs. Periodic valuation costs. Operational requirements Potential IRS challenges regarding valuation and discounts.
Limited Liability Companies Advantages
Members have limited liability. Number of members is unlimited but a single member LLC is a disregarded entity for tax purposes. Members may be individuals, corporations, trusts, other LLCs, and other entities. Income is passed through to the members usually on k-1. Double taxation affecting most C corporations is avoided if parnership tax status is elected. Members can participate in managing the LLC. Distrubutions to members do not have to be directly proportional to the members ownership interest as they do for S corporation. Can have multiple classes of ownership. Entity may elect to be taxed as partnership, S corporation, or C corporation.
LLC Disadvantages
May have limited life. Transfer of interests is difficult and sometimes limited by operational agreement. Some industries or professionals may not be permitted to use LLC status. Laws vary from state to state regarding LLCs. Laws are relatively new for LLCs, therefor, limited precedent. For tax purposes the complex partnership rules generally apply. Members not meeting exceptions are subject to self-employment tax on all earned income if partnership is elected.
C Corporations Advantages
Relative ease of ability to raise capital. Shareholders have limited liability. Have unlimited lives. Ease of transfer ability of ownership interest. Generally more management resources. Shareholder employee may receive the full array of employer-provided tax free fringe benefits.
C Corporations Disadvantages
Potential for double taxation due to entity level taxation. Administrative burden. More difficult to form and dissolution can cause taxable gains. Borrowing may be difficult without stockholder personal guarantees which negates part of the advantage of limited liability. Requires a registered agent. Requires a federal tax ID number.
S Corporations Advantages
Income is passed through to the shareholders for federal income tax purposes. Taxed at the individual level which may be a lower tax rate than the applicable corporate rate. Shareholders have limited liability. Distributions form S corporations are exempt from the payroll tax system, assuming the corporation provides adequate compensation to those shareholders who are employees of the corporations.
S Corporations Disadvantages
Limited to 100 shareholders. Only one class of stock is permitted. Cannot have corporate, partnership, certain trusts, or nonresident alien shareholders. Shareholder employees owning more than two percent of the company must pay taxes on a range of employee fringe benefits that would be tax-free to a shareholder employee of a C corporation. The tax rate of the individual shareholder may be higher than the corporate tax rate. Borrowing may be difficult without stockholder personal guarantees, which negates part of the advantage of limited liability.
Requirements for an S-Corp Election
To qualify as a small business corporation, the following requirements must be satisfied: 1. The corporation is a domestic corporation. 2. The corporation has no more than 100 shareholders. 3. The corporation has as its shareholders only individual estates and certain trusts. 4. The corporation does not have a non resident alien as a shareholder. 5. The corporation has only one class of stock outstanding.
S Corporation vs LLC
S corporation must have same class of stock. LLC does not have that restriction. LLC can have foreign investors, partnership, corporation, and trust as entitiy owners, distribute in kind assets to owners without gain recognitio, and have the ability to transfer interest to trust for estate planning, self employment tax on all income for owner and employee.
