Module 4:Choice of Entity Challenge

Module 4:Choice of Entity Challenge

Part 1: Classifying the Client

Client Goals

Advisors role-Find out and prioritize Client’s Objectives

- Ask smart, open-ended questions with goal in mind.

- Flush out key facts

- Facilitate more precise definition of what client wants.

-Prioritize conflicting interests?

Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com

Private Business Owner Classifications

• Soloist- one person in business.

• Toilers-owners who work in the business.

• Golfers-investors with other interests.

• Hybrid-toilers and golfers.

• Big Fish-a majority owner and other minority owners.

• Family Affair-family-run business.

• Personal Service Organization-type of toilers where service business.

• Emerging Public Company- Focus is to go public.


Problem 1:Facts

• Joyce, owner, wants to provide star manager Jim an equity-based incentive to ensure loyalty and dedication, and prevent going to a competitor.

• She wants him to have common stock but not pay anything for it, No tax liability except for capital gains when he sells stock to co or Joyce; Forfeiture of rights in stock if employment is terminated within 8 years for any reason.

What additional questions should be asked?

Joyce’s Goal: Equity Incentive for Jim

Advisor queries:

• Does Jim get existing value (stock) or just interest in future value growth (profits)? Profits

• Does Jim pay anything for his equity interest? No

• Are tax consequences to Jim a concern? Yes

• What if Jim flakes out and does not do job? Forfeit


Joyce’s Priorities

• Since corporation, then Joyce can offer future right to profits since corporate structure requires consideration for stock.

• Stock could be bonus compensation, but taxable on it when receive it.

• If other entity, then either is okay. If stock right, then have to include buy-sell provisions, forfeiture of rights because stock is generally freely transferable.

• Bottom line: May not be able to get all of what want at the same time.

Problem 2: Brand Products Inc.

FFour year old company that is in the business of providing branded our year old company that is in the business of providing branded promotional products to large companies. promotional products to large companies.

Four owners, Pete, Sue, Rick and James, recently developed a Four owners, Pete, Sue, Rick and James, recently developed a business plan for the next seven years that is based on an business plan for the next seven years that is based on an average annual growth rate of 12 percent.average annual growth rate of 12 percent.

The company will soon develop the power to accelerate its growth The company will soon develop the power to accelerate its growth at a rate faster than that reflected in the business plan. at a rate faster than that reflected in the business plan.

Faster growth >>> potential for higher profits & more visible Faster growth >>> potential for higher profits & more visible industry position, industry position,

But, requires more equity capital or more shareholder-guaranteed But, requires more equity capital or more shareholder-guaranteed debt and accelerated hiring and training programs. debt and accelerated hiring and training programs.

Plus, increased risk of program failures, which will be very Plus, increased risk of program failures, which will be very expensive, hurt the company's reputation, and make it harder expensive, hurt the company's reputation, and make it harder to attract profitable brands.to attract profitable brands.

Copyright 2005 Dwight Drake. All Rights Reserved.Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held EnterprisesBusiness Planning: Closely Held Enterpriseswww. drake-business-planning.comwww. drake-business-planning.com

Scenario

Pete and Sue are unrelated golfers who each own 40 percent of the business, but do not work in the business. They put up cash for their equity and arranged for the bank financing.

Rick and James, also unrelated parties, manage the business on a full-time basis. Each was granted 10 percent of the outstanding stock of the company as part of his compensation package.

You represent the entity. What type of owner approval should be required to authorize a faster growth rate?

Growth Rate Fears

Advisor potential queries:

• What are specific risks of faster growth?

• What factors contribute to faster growth?

• Does each growth factor pose the same risks?

• Are some owners more risk-adverse than

others?


Growth Factors for Brand Products

1. Accelerate growth of existing programs. No serious risks.

2. Obtain new proven program from competition. Plum opportunity requiring capital and people but no serious failure risks.

3. Obtain new unproven programs. All growth risks in spades.


Solutions: Pete, Sue/Rick, James

Resolution for Accelerated Growth

Accelerate existing programs full throttle

New Proven programs accepted if Company profitable (last year and current year) and debt/equity ratio not over amount, e.g., 5-to-1 Otherwise, majority rules with 3 votes.

New Unproven programs require consent of three of four if existing bank lines will handle. Otherwise, all four must consent.


Module 4: Choice of Entity Challenge

Part 2: Non-Tax Considerations

Non-Tax Variables

• Liability protection- Personal vs limited

• Control- Voting, veto, mgmt. participation

• Transferability- Buy-sell, first refusal, limited to economic interests

• Term-fixed, perpetuity

• Fringe Benefits-tax benefits if corp.

Different Ownership Interests

Challenge: Separate control, income, and equity growth.

C Corp Tools: Voting and nonvoting stock, preferred stock, hybrids, shareholder debt, employment contracts.

S Corp Tools: No preferred or second class of stock. Only voting differences. Least flexible.

Partnerships and LLCs: Only limitation is “substantial economic effects” limits of 704. The most flexible option.


Ownership Issues

• Type and amount of contribution: Cash, property, debt, services

• Treatment of debt-equity contribution: Ratios, disposition

• Equity interest for contribution: %, Valuation• Bailout of earnings: Deductible vs. nondeductible by

corp.; accumulated (retained) vs caps (penalty) • Treatment of profits and losses: Tax rate and offsets• Basis upon Disposition: Stepped up vs. rolled over• Employee Fringe Benefits: Availability of tax

shelters-employee benefits, deductible

Earnings Bailout of $100k Income

C corp C corp P or LLC S Corp Dividend Compensation Distribution Distribution

Corp Inc. Tax 22,250 0 0 0 Owner Inc. tax 11,662 28,000 28,000 28,000

Total Income Tax 33,912 28,000 28,000 28,000

Double vs. Pass-thru Taxation

* Assumes 15% dividend rate and 28% marginal ordinary rate.


Conversion Flexibility From C corp to

- Partnership or LLC: Killer double tax

- S corp: Doable but serious traps

From S corp to

- Partnership or LLC: Painful single tax

- C corp: Piece of cake

From LLC or Partnership to

- C corp: Doable with minor traps

- S corp: Doable if qualify

- LLC or Partnership: Doable Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com

Control

• Voting rights

• Veto power

• Classes of interests

• Buy-sell agreements

• Restrictions on transferability

Fringe Benefits

• Medical, health, life, disability, dependent or family care

• Better in C-corporation because deductible by corporation.

• Can include as part of compensation package.

• Use pre-tax dollars.

Self-Employment Taxes (SET)

• Bail out of earnings in unincorporated entity subject to SET.

• N/A to Corp. dividends, or profits from a LLC

Passive Activity Rules

• Closely-held corp. (not PSC) can offset active income with passive losses (via portfolio income). But, when distributed to shareholders, income taxed as active income.

• Material participation-income is considered passive or active based upon level of participation in the business.

• Bottom line: Cannot shelter passive losses through corporate structure.

Problem 1: Roger’s Machine Shop

Roger plans on opening a specialized machine shop. He will put up 55 percent of the capital, receive 55 percent of the equity interests in the business, work full time as CEO of the business, and draw a salary and a bonus based on performance. Three other individuals have committed to fund the balance of the needed capital in equal shares, and they will each receive 15 percent of the equity of the business. The business will have minimal debt and is expected to be profitable by year two. Roger wants a structure that assures, to the maximum extent possible, freedom from minority owner hassles and contractual negotiations and dealings with minority owners. He wants total control. He wants to insure that his investors do not have to pay self-employment taxes on any income they receive from the business. You represent Roger.

Recommendation:

Problem 3-C: Roger Specialized Shop

Driving factors for Roger:

• Maximum control (Board control) - no hassles from minority owners

• Income bailout to minority owners - no double income taxes or self-employment taxes

• Protected compensation contract and bonus program

• Limited liability - machines, employees and contracts

• Passive income to minority owners


Recommendation: S Corp

Key Lessons

1) Figure out the parties’ unique goals that will narrow the options to 1-2.

2) Go through the requirements of each to see if narrow to preferred option.

OR1) Start with a corporation to see if you can

achieve goals. Can’t be overkill. 2) If cannot, then consider each of the other

alternatives.

Module 4: Choice of Entity Module 4: Choice of Entity ChallengeChallenge

Part 3: Entity conversionsPart 3: Entity conversions

From Partnership to Corp: Option 1


Corp

Stock

Tax Impacts:• No gain or loss recognized

• Partnership’s asset basis transfers to C corp

• Partnership terminated

• Owner’s stock basis equals basis in partnership interest (adjusted for debt transfers to corp)

• Owners not original issuees – 1244 impact and potential S election impact in year 1

Owners

Partnership

Assets & liabilities

Stock inliquidation



Corp

Stock

Tax Impacts:• No gain or loss to Partnership or Corp


• No gain or loss to owners unless money in excess of basis is distributed

• Owners’ basis in assets equal basis in partnership interests, which carries over to Corp and determines Owners’ basis in stock

• Owners original issuees of stock

Owners

Partnership

Assets & liabilities

Assets and liabilities in liquidation



Corp

Stock

Tax Impacts:• No gain or loss to Partnership or Owners


• No gain or loss to Corp unless money in excess of basis is distributed

• Owners’ basis in stock equals basis in partnership interests, which carries over to Corp and determines Corp’s basis in assets

• Owners original issuees of stock

Owners

Partnership

Partnership Interests

Assets and liabilities in liquidation

Check The Box

• No need to form corp or transfer assets and liabilities

• Entity remains the same – only tax status changes

• Reduces paperwork and third party hassles

• Tax consequences same as option 1- Partnership contribution followed by Partnership liquidation

• No corporate “trappings” benefits

• No S status payroll tax benefits

• No tax-preferred employee benefits to owner/employees



Piece of Cake

• No entity change nor need to transfer assets and liabilities

• Entity remains the same – only tax status changes

• Revoke S election (takes majority) or cease to qualify as S

• Specify effective date to ease accounting and tax hassles. Default date is first day of next taxable year unless revocation before 15th day of 3rd month of current year

• Mid-year effective date creates short S year and short C year – allocation options

• No election back into S status for 5 yrs

• Bailout S earnings that have already been taxed to shareholders – 1371(e) one year bailout period


From S status to C status

Module 4:Choice of Entity Challenge

Documents

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