business entities chapter 22 tools & techniques of financial planning copyright 2007, the...

Business Entities Chapter 22Tools & Techniques of

Financial Planning

Copyright 2007, The National Underwriter Company 1

What is a Business Entity?

• A “business entity” is simply an organization that operates a business in some way.

• Business entities run the gamut from the one-person sole proprietorship to corporations with thousands of employees.

• Choosing a business entity has a major impact on the business because different entities have different rules on how they may be formed and governed as well as different tax consequences.


Financial Planning


Types of Business Entities

• Sole Proprietorships.

• Partnerships.

• Limited Liability Companies.

• C Corporations.

• S Corporations.

• Professional Corporations.

• Associations.

• Trusts.


Financial Planning


Selecting The Entity

• When the owners choose the business form, they are not stuck with that form.

• The form of the business entity is important because:– It will affect the costs to start up the business.– How the entity will be governed on a day-to-day basis.– What the personal liability of the owners will be.

• As we explore the different entities, think about the circumstances that would make a particular type advantageous.


Financial Planning


Sole Proprietorships

• A Sole Proprietorship is an unincorporated, one-person business, entirely owned and directed by a single person.

• Simplest form of business as it may be started with a minimum of legal formality.

• The sole proprietor and the business are one, and the assets of the business are, at the same time, a part of the proprietor’s personal estate.

• All assets of the business, both tangible and intangible, belong to the sole proprietor.

• All profits are his or her personal property and flow through to his or her personal income tax return.

• The life cycle of the business is dependent to the sole proprietorship’s ability and personality.


Financial Planning


Advantages of a Sole Proprietorship

• You can be your own boss.• You can make decisions for the business without having

to ask anyone else.• You keep the profits of the business.• Easy to start.• Although you need to keep separate account records for

the business, you only need to file one tax return.• Business losses may offset income from other sources

for tax purposes.


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Disadvantages of a Sole Proprietorship

• The owner is personally responsible for all aspects of the business.

• If the business is sued, so is the business owner.• If the business owes money, the business owner is

responsible for the debt, and the owner may have to use personal assets to pay it.

• If the owner cannot pay the debts of the business, he or she may have to claim personal bankruptcy.

• The only way to transfer ownership of a sole proprietorship is to sell the entire business to someone else .

• The life of the business ends when the sole proprietor dies.


Financial Planning


Partnerships

• A partnership is an association of two or more persons to carry on as co-owners of a business for profit. There are several types of partnerships:– General Partnerships. – Limited Partnerships.– Family Limited Partnerships.– Limited Liability Partnerships (LLP).

• Partnerships can generally be formed on a tax-free basis. Neither the partnership nor its partners will recognize any gain (or loss) when the partnership receives money or property in exchange for partnership interest.


Financial Planning


General Partnerships

• Each partner is a principal.• Each are fully active in the business with a voice in its

management.• Each is an agent of the other with authority to act for the

firm within the scope of its business.• Each shares in the profits.• The income or losses flow through to the principal’s

personal income tax.• Each partner is fully liable for firm debts.


Financial Planning


Limited Partnerships

• Limited Partnerships – are defined as partnerships formed by two or more persons having as members one or more general partners and one or more limited partners.

• The limited partner’s financial ability is limited to his or her investment in the firm.

• Note that a limited partnership must have at least one general partner with full liability.


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Family Limited Partnership

• Family Limited Partnership – A limited partnership that exists between members of a family.

• If a partnership among family members is a genuine partnership, it will be treated tax-wise the same as any other partnership and the same rules will apply.

• The family limited partnership is a technique frequently used as a means of shifting the income tax burden from parents to children or other family members.


Financial Planning


Limited Liability Partnerships (LLP)

• A limited liability partnership is a general partnership that is typically available to only certain professions such as accountants, doctors, and lawyers.

• The main distinguishing feature of an LLP is that the partners are not liable for the professional malpractice of another partner.


Financial Planning


Limited Liability Companies (LLC)

• A limited liability company (LLC) is a hybrid business entity created under state law. It typically combines the limited liability normally associated with a corporation and the pass-through tax treatment accorded to a partnership. The requirements, operating rules, and tax treatment vary widely among the states.

• Members of LLCs can choose to be treated, for federal income tax purposes, as either a C Corporation or a partnership.

• LLCs may be appropriate when the owners of a business require flexibility in ownership structure.


Financial Planning


C Corporations

• A corporation is a business entity that limits the liability of its owners. Legally, a corporation is a separate entity from its owners and employees. A corporation can own property in its own name, enter into contracts in its own name, and can sue and be sued in its own name.

• Business owners who are also employees of the corporation cannot limit their negligence liability for actions that they themselves commit.

• An owner of a closely-held or family-owned corporation is often required to personally co-sign, with the corporation, for loans, and thus, may be unable to limit his liability completely.


Financial Planning


C Corporations (cont’d)

• Some states may require a corporate charter and corporate bylaws to be filed.

• A corporation generally must have a shareholder meeting once a year and periodic meetings of the board of directors.

• There generally must be formal elections of directors.• A corporation is a separate taxable entity from its owners

and pays federal income tax at its own income tax rates. • Employee benefits are generally deductible to the

corporation.


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• When the corporation distributes its profits as dividends to its shareholders, the shareholders are taxed, but the corporation is not allowed a deduction for dividends that are distributed. This is what causes the so-called “double tax’ on corporate income. Income is taxed first at the corporate level and then again when profits are distributed to shareholders as dividends.

• Corporations can generally be formed on a tax-free basis. The corporation will not recognize any gain (or loss) when it receives money or property in exchange for its own stock, whether the stock is newly issued or treasury stock.


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• Generally upon the complete liquidation of a corporation, the shareholders will receive money or property from the corporation in exchange for the stock that they own.

• If they receive more than the basis they have in their stock, they will have a capital gain. If they receive less than the basis in their stock, they will incur a loss.


Financial Planning


S Corporations

• An “S” corporation is a corporation that has elected to have its income, deductions, capital gains and losses, charitable contributions, and credits passed through to its shareholders. For federal income tax purposes, an S corporation is treated much like a partnership. For almost all other purposes, an S corporation is treated as a “regular,” or “C” corporation.


Financial Planning


S Corporations (cont’d)

• An S Corporation may be appropriate when the owners of the business entity would like the limited liability that is available with a corporation, but also desire pass-through treatment for federal income tax purposes.

• Some corporations are formed as S corporations to take advantage of the owners’ ability to deduct losses in the early years, and then when the company becomes profitable, the S election is terminated.


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• Much like a partnership, an S corporation is generally not subject to tax at the entity level.

• Whether the S corporation’s profits are distributed to them or not, S corporation shareholders are taxed on the S corporation’s taxable income.

• Shareholders take into account their shares of income, loss, deductions, and credit on a per-share, per-day basis.


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• S corporation income that could directly affect the tax liability of the shareholder is passed directly through the corporation to the shareholder.

• Any loss or deduction that the S corporation takes that could directly affect the liability of the shareholder is also passed directly through to the shareholder.


Financial Planning


Professional Corporations

A professional corporation is simply a C corporation or S corporation in which all the shareholders are members of a profession such as doctors, lawyers, or accountants. A group of professionals might form a corporation so that the owners can take advantage of certain fringe benefits that are available only to employees of C corporations.


Financial Planning


Associations

• An association is not really a “business” entity, but is generally a voluntary organization of people under a common name to accomplish some purpose.

• Associations are generally unincorporated, but they usually will have articles of association or a charter or bylaws for a governing document.


Financial Planning


Trusts

• A trust is an entity established either through a will or during an individual’s life. In creating a trust, assets are placed in the trust by the grantor. These assets, call the corpus of the trust, are then managed by the trustee for the beneficiaries.

• The beneficiaries may receive either the income from the trust or the remainder of the trust, which is the corpus at the time the trust ends, or both. The trustee manages and holds legal title to the property while the beneficiaries hold beneficial title.


Financial Planning


Trusts (cont’d)

• Trusts are required to file a federal income tax return if the trust has any taxable income, or if it has gross income of $600 or more for the year.

• Trusts are modified conduit entities because they receive a deduction for income that is distributed from the trust and are taxed on income that is retained by the trust.


Financial Planning


Trusts (cont’d)

• Trust tax rates are very compact.– Trusts are taxed at the 35% marginal tax rate when taxable

income exceeds $10,450 (in 2007).– Individuals are not taxed at the 35% rate until their taxable

income exceeds $349,700 (in 2007).– Corporations are not taxed at the 39% rate until taxable

income exceeds $100,000.– Over $335,000, the marginal corporate tax rate starts to

decline again.– The beneficiary that receives the income from the trust is liable

for the tax on the income.


Financial Planning


Revocable Trusts

• A revocable trust avoids probate and can serve as a will substitute by governing the distribution of the grantor’s property.

• Because the grantor has not parted with control of the property, the grantor incurs no gift tax when the trust is set up;

• the grantor is responsible for the income tax on the income from the trust property;

• the trust property is included in the grantor’s estate for estate tax purposes when he or she dies.


Financial Planning


Irrevocable Trusts

• The grantor will relinquish the rights to the property in exchange for a trustee’s management expertise and objectivity and the transfer is subject to a gift tax.

• The income from the trust property is paid either by the trustee for the trust or by the beneficiaries; and the property is not pulled back into the grantor’s estate.

business entities chapter 22 tools & techniques of financial planning copyright 2007, the...

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