Facts: After 20+ years of working for other firms, Penelope (enrolled agent, age 41), Mark (CPA, age 43), and John (CVA, age 65) want to leave the firms they are currently employed by and become their own bosses. Penelope specializes in taxes, Mark is the auditor, and John is a business valuation expert. There are so many options available as to how they can structure the new business. The appropriate business entity for any individual(s) will depend on their particular facts and circumstances. You are a valued colleague and friend of this threesome, and they have come to you seeking advice as to how to structure their new business. They have the knowledge to figure it out themselves but are looking for the advice of an unbiased third party. Please consider the following tax and nontax considerations as you recommend an entity choice to Penelope, Mark, and John.
Part I: Discuss the various forms of organization that are available to Penelope, Mark, and John. In general terms, the entity that you will be choosing will be some form of partnership. In broad definition, a partnership is defined as a single business where two or more people share ownership, with each partner bringing specific contributions to the business. Since each member of the partnership will be taking on specific functions and liability with the partnership, it is extremely important that all agree on the specific structure that the partnership will take. The purpose of this memo is to provide an educated and unbiased opinion on what structure that partnership should take. Partnerships are commonly organized as General Partnerships, Joint Ventures, or Limited Partnerships (limited liability).
For the purposes of this memo, we will stick to forms of Limited Partnerships as the current economic climate necessitates a business structure that limits the liability of its owners. Common forms of Limited Partnerships are Limited Liability Partnerships (LLP), Limited Liability Company (LLC), S Corporations (S Corp), and C Corporations (C Corp). Limited Liability Partnerships (LLP) are similar to general partnerships with the exception that they allow two classes of partners: those with full management control and those with no personal interest or liability beyond their investment (1). On the other hand, a Limited Liability Company (LLC) is a flexible form of business arrangement that melds characteristics of both partnerships and corporate structures. It is technically not a corporation, but a legal form of business entity that provides limited liability to its owners. Each owner in an LLC is considered a “member”, with profits and losses being “passed through to their personal tax returns (2). An S Corporation (S Corp) is a type of corporation that is created through a special tax election.
This election is beneficial when it comes to avoiding double-taxation. If a business is able to meet the S Corporation criteria, it will be able to reap the primary advantage of an S Corp which is tax savings. This is due to the fact that an S Corporation allows its employees to take a “reasonable” salary, limiting the income subject to income taxes and saving the rest of the corporation’s profits to be taxed at a lower rate as a “distribution” (3). Finally, a C Corporation (C Corp) is a separate legal structure formed for a business, protecting ownership and their personal assets from judgments against the company. It is a much more time consuming process to form a C Corporation, as the structure must include shareholders, officers, and directors. Often times, the drawbacks of double – taxation and administrative issues cause small business owners to seek other alternatives (4).
Part II: Make your recommendation as to what form of organization you believe will be best, and be sure to explain the reasoning for your choice. After careful consideration, it is my opinion that the best business structure for your new venture would be to form and Limited Liability Company (LLC). This structure will provide the company with adequate protection while also establishing safeguards for each member and his or her personal assets. In this arrangement, each member will be removed from the consequences that could result from another member’s misconduct or negligence. I place particular emphasis on this fact because I know that all three of you are personal friends outside of the work environment, and I do not want there to be hesitation on anyone’s part regarded the business for fear of damaging the friendship.
In addition to the advantages named above, the LLC will allow each member to have clearly defined roles and management duties, as well as clearly defined ownership stakes and shares of profits and losses. As we will discuss in the coming sections, the formation of the Operating Agreement for the LLC will help to clearly establish these roles, allowing each of you to focus solely on your aspect of the business and allowing it to run as smoothly as possible (5).
Part III: Discuss the tax consequences of contributing cash, property, and/or services to the new entity. Ordinarily, there are no tax consequences on contributions of property or services to a Limited Liability Company. Typically, members can utilize the tax treatment provided by IRC Section 721(a) when it comes to the contribution of property to an LLC. This section states that no loss or gain shall be to the partnership or any of its members in the case of contribution of property to the partnership in exchange for an interest in the partnership (6). However, there are exceptions to this rule, particularly when the contribution is an attempt to disguise the sale of property to avoid taxation. In these circumstances, the contributing member would have a taxable gain when the sale is completed (7). Cash contributions have similar treatment. They are given in exchange for ownership interest, and as a result, they are not taxable.
Part IV: Discuss, in detail, how this entity is taxed (if at all) and what filing requirements it has with the IRS. Assuming you will not be making an election to be treated as a corporation (this would require becoming an S Corp or C Corp) the Limited Liability Company will be treated as a partnership. In other words, the LLC is treated by default as a “pass through” entity, meaning each member will be responsible for his or her portion of the profits on their personal income taxes. All partnerships are required to file Form 1065 with the IRS.
This form is the U.S. Return of Partnership Income and it demonstrates the income, gains, losses, deductions, and credits from the operation of the partnership (in this case, the LLC). Each member’s share of profits will be outlined by the Operating Agreement, which we will discuss further in the next section. Should your LLC decide to split profits and losses in a manner that does not match up with each member’s percentage interest, then you will need to request a special allocation from the IRS (8).
Part V: Discuss how income and distributions may or will be allocated to Penelope, Mark, and John. Income and distributions will be allocated to each member through the Operating Agreement. In an LLC, the Operating Agreement allows its members to structure the financial and working arrangements in a way that suits the business and each member. In this agreement, the members establish each owner’s percentage ownership of the LLC, his or her share of profits and losses, the rights and responsibilities of each member, and what will happen to the business if one member decides to leave (9).
It also helps to establish the framework for providing each member with a capital account for their portion of ownership. For example, Penelope’s percentage ownership in the LLC may be defined by the percentage of capital she contributes (be it cash, property, etc.) to the business. In turn, this established ownership percentage can be used to determine what proportion of the LLC’s profits she is entitled to receive.
Part VI: Discuss, in detail, how the individuals are taxed (if at all) with respect to the net profits from this entity and what filing requirements they will each have with the IRS. As mentioned previously, a Limited Liability Company is considered a “pass through” entity unless it makes a special corporate election to be treated otherwise. By utilizing a Limited Liability Company, you are required to report your individual share of profit or loss from the business on your personal tax return. The Limited Liability Company will provide each member with a Schedule K-1, which demonstrates each member’s share of income, credits, and deductions for the partnership.
Each member is then required to report these amounts for both federal and state taxation on their individual Form 1040 and Schedule E (8). Another important note to consider when it comes to individual taxation of Limited Liability Company members is the fact that each member is considered self-employed. As a result, each member must remember to make estimated tax payments for income and self-employment taxes on a quarterly basis. Failure to do so may result in penalties on your personal income tax return (8).
Part VII: Discuss how Penelope, Mark, and John will calculate their basis in the new entity. Be sure to include the impact that debt has on basis, if any. As previously mentioned, the Operating Agreement will help to determine each member’s basis in the new Limited Liability Company. In general, the tax basis of a member with an interest in an LLC will be equal to the value of any cash or property the member contributed to the LLC. The value of these contributions is shown on the LLC’s balance sheet in the form of capital accounts for each member. IRC Section 752 describes the regulations involved in treating liabilities (debt) with regards to basis or stake in the partnership.
Using this rule, any increase in a partner’s share of the liabilities of a partnership shall be considered a contribution of money by said partner to the partnership (10). With regards to loans made by a member to the partnership, there are special circumstances to consider. While the loan itself will be treated as a contribution and effectively increase the member’s proportional share of ownership, the member will also be given the treatment of a creditor if the business were to ever be liquidated. Creditors stand a much better chance of being able to recover a portion of their investment into the LLC than the other members.
Part VIII (Limited Liability): Discuss the exposure that Penelope, Mark, and John’s personal assets will have to the debts and lawsuits of the entity you have recommended. As we have discussed throughout this memo, the formation of a Limited Liability Company limits the exposure of its members to their percentage of ownership or equity interest in the company. This protects the member’s assets in the event of a business related lawsuit or other form of legal action against the company. In other words, each member’s exposure will be limited to a fixed sum, akin to the value of the individual’s investment into the company. In addition, this means that each member will not be personally liable for the debts of the company. This is a key difference between the Limited Liability Company and other forms of General Partnerships, as members who organize their business in the structure of the latter have unlimited liability (11).
1. http://www.entrepreneur.com/encyclopedia/limited-liability-partnership# 2. http://www.sba.gov/content/limited-liability-company-llc
5. http://www.rocketlawyer.com/article/why-start-an-llc-limited-liability-company-advantages-and-disadvantages.rl 6. http://www.law.cornell.edu/uscode/text/26/721
8. http://www.sba.gov/community/blogs/6-things-you-need-know-about-your-tax-responsibilities-llc 9. https://www.nolo.com/legal-encyclopedia/llc-operating-agreement-30232.html 10. http://www.law.cornell.edu/uscode/text/26/752
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