CLOSELY HELD BUSINESS
FORMATION/ENTITY SELECTION
Article authored by Don Chaney,
Attorney/CPA
S vs. C vs. LLC vs. Sole
Proprietorship
Emphasis on Tax and Liability Considerations
The author arbitrarily defines a closely held business to
have five or fewer owners, but with no limit as to gross or net income. Oftentimes a
closely held business has only one owner in which category the author includes a husband
and wife upon which the S Corporation one class of stock rules have no negative impact
(see below). Business clients are interested in liability/personal asset protection as
well as tax savings of both payroll and income tax.
Business Owner Personal
Liability/Personal Asset Protection Issues
Emphasizing Business Insurance Considerations
Clients wishing to establish a business tend to have
several misconceptions. One is that a corporation or limited liability company (LLC)
protects the personal assets of the business owner for all purposes. A business owner is
liable for his/her own negligence in all events and even if the business is incorporated
or uses the LLC format; in other words, a business owner may not protect personal assets
against his/her own negligence. See 19 CJS Corporations, §544. The same personal
liability of an individual based upon his/her own negligence, gross negligence as well as
an intentional act or omission including a criminal act applies to an LLC member and any
employee (whether a business owner or not). THAT LAW APPLIES IN THE SAME MANNER TO
A SHAREHOLDER OF A PROFESSIONAL CORPORATION AND MEMBER OF A PROFESSIONAL LIMITED LIABILITY
COMPANY, AS IT DOES TO A SHAREHOLDER OR MEMBER OF ANY OTHER NON-PROFESSIONAL TYPE OF
BUSINESS; IN OTHER WORDS, THE NEGLIGENCE, GROSS NEGLIGENCE AND INTENTIONAL ACTS OR
OMISSIONS OF ANY CORPORATE SHAREHOLDER AND ANY LLC MEMBER SUBJECT THAT BUSINESSOWNER TO
PERSONAL LIABILITY, SUBJECTING PERSONAL ASSETS TO RISK, EXCEPT THOSE EXEMPT IN A
BANKRUPTCY PROCEEDING. Correspondingly an entity, corporation or LLC, is fully
liable for improper acts and omissions of its owners as well as employees when done within
the scope of authority and/or employment. 19 Am Jur 2d, Corporations, §699. Thus another
business owner general misconception is that the entity (corporation or LLC) should be
funded with all operating assets including a business building owned by the shareholders
or LLC members (see below). However, an entity, corporation or LLC, does protect owner
personal assets from the following:
1. Negligence of other owners (unless the owners are both/all involved
in the loop of liability).
2. Products liability (sale of a defective product).
3. Negligence of employees (unless the owner is also involved such as
negligent supervision).
4. Business creditors, which have not been guaranteed by the owner (such
as general trade creditors as opposed to a line of credit the owners have guaranteed). As
a general rule, shareholders and LLC members as well as other entity agents such as
employees are not personally liable on corporate contracts - see 19 CJS Corporations,
§537 and §538.
OBSERVATION: Many business owners will not believe
that operating as a corporation or limited liability company does not protect them and
their personal assets from their own negligence. The following may be useful examples to
help business owners believe that they have personal responsibility for their own business
decisions (actions or omissions). It is true, officers as well as directors of large
corporations are sued personally by shareholders and other third parties for their own
negligence or intentional acts and oftentimes must pay damages from personal assets, if
the corporation is insolvent and no insurance coverage exists. Another example that at
least makes business owners "stop and think" involves an attorney that
carelessly drafts a defective contract that later is shown to have substantial monetary
detriment to the business owner client, followed by the attorney alleging no exposure
because he or she operates through a professional corporation (business owner clients
almost always admit it seems that should not be allowed, even if they continue to cling to
their belief they and their personal assets are protected by simply incorporating or
forming an LLC). PRACTICE TIP: At least the attorney should convince the
business owner clients to pursue various types of business insurance (see the discussion
below).
Business owners and agents of a corporation or LLC must exercise ordinary care and
generally must act in good faith in managing entity (corporate or LLC) affairs. 19 CJS
Corporations, §483. As above, business owners and entity agents such as employees are
personally liable for wrongful/tortuous acts in which he/she participates or directs. 19
CJS Corporations, §549. If multiple owners or employees are involved, such owners,
employees and other agents are not liable for the negligence/torts of the corporation or
other owners, employees or agents, if he/she has not participated, authorized or directed
a wrongful/damaging act. 19 CJS Corporations, §544. See the loop of liability example
just below.
As an example of the protection provided by Item 1, a CPA firm with an audit partner and a
tax partner would allow the two CPA's to have personal asset protection from the
negligence of the other CPA assuming both were not involved in the loop of liability such
as reviewing each other's work. Business owners oftentimes are required to personally
guarantee business obligations such as a premise lease or line of credit, and thus those
creditors would have access to personal assets of the business owner guarantor(s) in the
event of a default by the business (corporation or LLC) on the main obligation such as a
lease or line of credit. Another helpful illustration would involve a contractor
installing a water heater followed by the structure being destroyed. If it can be proven
the contractor installed the water heater improperly, the contractor's personal assets are
at risk; on the other hand, if the contractor utilized an entity, a corporation or LLC,
and if the contract with the building owner was with the entity rather than the contractor
himself/herself (which it always should be), and if it could be proven the water heater
itself was defective, the personal assets of the contractor would not be at risk (Item 2
above).
The author firmly believes the best liability/personal asset protection of a business
owner is in the form of obtaining adequate business insurance such as liability, products
liability, malpractice, vehicular, etc., but obviously insurance protection will exist
only if it is affordable. The business client should be advised to shop around for the
highest limits, least amount of deductible, lowest premium and fewest exclusions from
coverage. The author cautions business clients not to wait until a claim is made to see
whether it is covered or excluded; rather during the insurance coverage review, the
business client should have a "laundry list" of specific items insurance should
cover. If the selling agent states certain coverage is available, that should be confirmed
in writing, such as providing a letter upon payment of the first insurance premium to the
agent and insurance company itself itemizing specific promised coverages. Under Arizona
law, reasonable expectations of a contracting party are to be enforced even if the written
contract, such as an insurance policy/contract, is to the contrary under the Darner
decision/doctrine - 682 P.2d 388 (Ariz., 1984); the Darner decision related to oral
promises which the author advises absolutely must be substantiated/confirmed in writing
(the letter to the agent and insurance company). If certain desired items are not covered
(such as the negligence of the owner himself/herself or negligence of employees), the
business owner should ask the cost of a "rider"; as an example, it is becoming
popular for businesses with a number of employees to obtain insurance coverage for sexual
harassment which is considered an intentional act and otherwise excluded from coverage.
The following is a laundry list of the type of problems a business who operates a licensed
elder care facility should confirm in writing are covered:
1. Food poisoning.
2. Improper medicine dosage.
3. Negligence, gross negligence and intentional acts of employees and
contractors as well as the business owner himself/herself.
4. Injuries caused by the elder residents to themselves, to other elder
residents, to employees and contractors as well as the owners or third parties entering
upon the premises (such as a person making a delivery or a repair).
5. Injuries caused by uninvited third parties on the premises (such as a
burglar).
6. Injuries to property or person caused by weather, defects in the
house (such as a broken pipe causing flooding) or other acts of God.
7. Any other concern of the client as to possible injury or damage to
property or any person.
Because proper insurance coverage is so important, the author needs to point out the
following in addition:
1. Coverage for gross negligence, recklessness and intentional acts
generally is not available, but the author would suggest attempting to obtain such
coverage for acts and omissions of third parties (generally other than the business owner
and any employee) such as a landlord obtaining insurance covering other tenants against
recklessness and/or intentional acts or omissions of a tenant.
2. Business vehicle insurance should be verified to cover driving under
the influence of alcohol and/or drugs, and any vehicle, especially if taken home by an
employee, should be covered for authorized or unauthorized personal driving, such as a
vehicle driven by a child of an employee with or without permission. Vehicle insurance
generally should have extremely high liability limits such as $500,000/$1,000,000 along
with as much medical payment coverage as the carrier will allow (medical payment coverage
covers medical expenses for those in the insured vehicle no matter the cause/fault of the
injuries).
3. Switching business insurance must be done cautiously as most policies
are "claims made" which means coverage is only for any claim made during the
period of coverage. If that is the case, "tail" insurance coverage needs to be
obtained from the carrier being dropped.
4. So many businesses are being operated out of a home office, and the
owner of such a business needs to be informed personal insurance does not cover business
usage. Thus the insurance agent/carrier needs to be informed when purchasing business
insurance of business usage of the home so that liability, fire and casualty and other
insurance is binding. As an example, a typical homeowners insurance would not cover an
injury to a visiting business client. HOME OFFICE §280A, IRC DEDUCTION CAUTIONARY
NOTE: It is the position of the IRS under §121, IRC, that any portion of a home
not used for personal purposes at least 2 out of the last 5 years before sale will cause
that business portion of any gain on sale of the home to be taxable. Thus if the home is
appreciated, perhaps home office deductions should not be taken. In all events, any
previous depreciation taken reduces the §121, IRC exclusion and causes gain recognition
to the extent of the depreciation taken. §121(d)(6), IRC; see the 1998 IRS Publication
523 - Selling Your Home.
5. Employees need to be covered by workers compensation insurance to
avoid the business owner from being personally liable for on-the-job injuries; it is to be
noted in Arizona generally a business owner is also liable for injuries to subcontractors
and employees of subcontractors not covered by any other workers compensation insurance
notwithstanding the Vicarious Liability Doctrine which states generally independent
contractors are liable for their own negligence. Thus proof of workers compensation
insurance should always be had when dealing with independent contractors.
6. Many contracts require specific insurance (such as a commercial lease
requiring a tenant to obtain certain liability insurance), and the particular
clause/requirement should be given to insurance agents bidding for coverage with a
follow-up letter with the contract provision attached again to the agent and insurance
company confirming coverage was represented to exist and specifically not excluded.
WORSE CASE SCENARIO: In the event a business owner is faced with a claim
in excess of any insurance coverage, and if bankruptcy is necessary, under Arizona law
only the following are exempt assets, which the debtor/business owner may keep. Up to
$100,000 of equity in a principal residence may be kept (33 ARS 1101). Arizona statutes
that follow contain several other important exemptions including qualified plan and IRA
accounts as well as cash value and life insurance policies. However, it appears as if a
closely held business qualified plan account on behalf of the owner who is also the plan
administrator may not be exempt - see the 1992 U.S. Supreme Court decision in Patterson
vs. Shumate, 112 S.Ct. 2242. Other Arizona bankruptcy exemptions are extremely limited and
include $1,000 of a vehicle and only $2,500 of value of business tools and equipment. Thus
if bankruptcy is necessary, personal investments, a business building, a vacation home and
other assets would not be exempt and would be subject to claims of creditors of the
business owner; however, one strategy would be to liquidate non-exempt assets before
filing bankruptcy and utilize the cash to obtain home equity up to the $100,000 allowable
limit. Under federal bankruptcy rules, either federal exemptions apply or particular state
exemptions apply such as in Arizona. LEGISLATIVE ALERT: Congress is in the process of
reconsidering bankruptcy exemption allowances. OBSERVATION: Bankruptcy exemptions are
extremely limited, and so the author once again emphasizes the need to pursue and obtain
affordable business insurance of all types including liability, products liability,
vehicular, workers compensation as well as other types that might be appropriate to the
business, such as coverage for sexual harassment claims especially if a number of
non-owner employees are involved.
The following are further musts for business owners that utilize a corporation or LLC
format:
1. Utilize the "Inc.", "LLC" or other entity
designation on everything including checks, invoices, contracts, brochures, vehicles, etc.
In other words, "blare to the world" it (meaning customers/clients/patients) is
dealing with the entity and not the business owner personally.
2. Do not co-mingle entity assets including cash with personal assets as
that is generally what allows, "piercing the entity veil".
Before turning to tax and other business formation considerations, it is important to note
a corporation as well as an LLC provide the same liability/personal asset protection
subject to the above issues and suggestions.
Business Formation Payroll and
Income Tax Issues
Turning to tax issues, again both payroll tax and income
tax savings need to be addressed. Regarding payroll tax savings, S Corporation
shareholders as well as passive LLC members are afforded minimization and avoidance of
payroll tax respectively. A business that has net income generated from the sale of
inventory, utilization of expensive equipment or other assets and/or key non-owner
employees may utilize an S Corporation to avoid some, and in certain cases, a substantial
amount of payroll/FICA tax. This is pursuant to IRS Rev. Rul. 74-44, which seemingly
requires S shareholders to be paid replacement wages with the remainder of net profit
subject to distribution without any payroll tax. As an example, assume a business is owned
by one individual who manages the business that is operated as an S Corporation and is a
retail sales business with several key non-owner employees. Assume a tax year net income
of $65,000 - about the social security tax maximum. Under those circumstances, especially
if the managing shareholder does not work full time, it would seem reasonable the facts
would indicate net profit is derived in three equal shares - from efforts of the managing
shareholder and non-owner employees as well as the sale of inventory. Thus 2/3's of
$65,000 would not be subject to payroll tax (more than $43,000), and the savings as
opposed to operating as an LLC in which all of the $65,000 of flow through income would be
subject to 13.2% self-employment tax would be about $5,700 (13.2% of $43,000; about 9% of
the net income). A business, which derives all income basically from the services of S
shareholders, is not allowed any payroll tax savings and all net income is subject to W-2
wages and FICA tax. Again see Rev. Rul. 74-44 as well as Spicer Accounting, 91-1 USTC,
50,103. For a decision which makes clear significant services of non-shareholder employees
allows distributions to be paid to S shareholder employees without being subject to FICA
tax, see Migliore, TC Memo 1977-247.
Under revised proposed IRS regulations (Prop. Reg. §1.402(a)-2(d) through -2(j)) relating
to partnership/LLC flow through income and the application of self-employment tax, a
non-managing LLC member of a manager managed LLC (as opposed to a member managed LLC) may
avoid self-employment tax if the member is not a manager and if the member provides
services less than 500 hours to the LLC (presently spousal attribution is not applied as
it is with §469 passive activity rules to determine 500 hours of participation). The
revised proposed regulations also provide the member must not be subject to claims of
general creditors, and that is automatically the case under Arizona LLC law, and
self-employment tax may be avoided if other tests are met (providing less than 500 hours
of service to the LLC by a member who is not a manager) even if the non-managing member
guarantees LLC debt. The LLC must be manager managed, and any manager would be subject to
self-employment tax automatically under the revised proposed regulations as a manager, and
only a manager, may contract on behalf of the LLC (29 ARS 654); however, under the
proposed regulations, a non-managing member may exclude net flow through income from
self-employment tax if the other tests are met, even if that non-managing member is
involved in LLC voting/management decisions to any extent (which generally would be
desirable in a closely held LLC with only several members which would include the managing
member(s) and investing/passive member(s)). CAUTIONARY NOTE: The above
proposed IRS regulations and commentary are based upon Arizona limited liability company
statutory law which may not be the same in any particular state.
Keep in mind income (distributions to an S shareholder and flow through income not subject
to self-employment tax to an LLC member - see the discussions above) not subject to
payroll tax does not build social security credit and is not available for a qualified
plan type contribution calculation (see Rev. Rul. 59-221 and Ltr. 8716060 indicating S
Corporation flow through income to an S shareholder may not be utilized in a pension type
calculation with the same tax logic applying to partnership/LLC flow through income not
subject to self-employment tax). However, a business with a number of eligible employees,
such as the retail business example above, may not want to afford a qualified plan in any
event because of the cost involved with covering non-owner employees (the S shareholder
with W-2 income and his/her spouse could nonetheless then make a deductible IRA
contribution assuming participation in no other qualified employer plan). Regarding social
security, if the business owner has 40 quarters of high earnings, high social security
payments are fixed and the payroll tax savings by an S shareholder or passive LLC member
would be most desirable.
Turning to income tax issues, C corporations vs. S Corporations vs. LLC's vs. sole
proprietorships involve different income tax advantages and disadvantages. As an important
example, a C corporation is subject to double tax (oftentimes a very severe penalty) upon
the sale of C corporation assets when the business is sold; the C corporation
asset/business sale double tax may result in 20% or more total tax upon a business sale
than if only one level of income tax were paid which would be the case if the business
sale was by an S Corporation, LLC or sole proprietorship. The gain/income on the sale of C
corporation assets such as allocated to equipment, customer/client information, covenant
not to compete and goodwill is taxable at the C corporation level at a minimum of 15%
federal income tax and 9% Arizona corporate income tax with the net amount to C
shareholders being taxable on the personal return of the C shareholder net of the basis in
the stock which is generally very low. If the sales price of the C corporation assets is
substantial, the extra tax caused by the C corporation format could be a large amount
(obviously an extra 20% of a $500,000 sales price is $100,000). C corporation shareholders
could avoid the problem by selling stock which would create desirable long term capital
gain treatment, but almost always the buyer of a closely held business will only wish to
purchase assets and not stock or an LLC interest to obtain write-off in the assets
purchased and avoid any existing liability problems such as a potential and unknown
products liability or malpractice claim. C corporation shareholders may mitigate the
double tax by allocating a portion of the purchase price under the required price
allocation rules of §1060, IRC to shareholders personally for covenant not to compete
assuming the allocation has economic reality (meaning the selling C corporation
shareholder is not moving, has not died and actually retains the ability to compete). See
the September 1994 article by the author entitled Buying, Selling A Business: What to
Consider.
HIDDEN C CORPORATION TAX: Especially a personal service corporation
subject to high flat federal and Arizona corporate income tax rates would generally pay
enough shareholder wages to clean out C corporation net income and reduce it to just below
zero and avoid any corporate tax. The cost to the shareholders up to the social security
limitation ($68,400 in 1998 and $72,600 in 1999) is 15.3% vs. 13.2% self-employment tax
applied to net self-employment income of a sole proprietor and net flow through income to
an active participant LLC member. That higher payroll cost of 2.1% on more than $70,000 is
about $1,500. That is another reason the author is not a fan of C corporations. While S
Corporation shareholders pay the same payroll tax rate, W-2 income may be minimized
utilizing Rev. Rul. 74-44, but if the individual S shareholder reasonable wages approach
the FICA level ($72,600 in 1999), the S Corporation also incurs additional payroll tax
over utilizing a sole proprietor or LLC arrangement if co-owners are involved.
Additionally, a C corporation, especially a personal service corporation subject to flat
high corporate income tax rates (35% federal and 9% in Arizona), needs to clean out
corporate taxable income (generally by way of increased shareholder final/additional
salaries and any qualified plan contributions if such a fringe benefit has been
instituted) at the end of each tax year; this is once again to avoid a double tax on the
income at the C corporation level and then at the C corporation shareholder personal level
when net funds are later distributed. On the other hand, a C corporation allows C
shareholders to write-off health and disability insurance (C shareholders may cover only
themselves as well as any selected key non-owner employees under the rules of §105, IRC)
through the C corporation and take qualified plan loans (but no interest deduction is
allowed). Generally the author would not consider those enough benefit to suggest the
institution of a C corporation - suffice to say the author is not a fan of C corporations.
Even though in general other business owners (S shareholders, LLC members and sole
proprietors) may not write-off through the business health and disability insurance,
§162(l), IRC allows the write-off of a percentage of health, but not disability,
insurance on the owner personal return before adjusted gross income if other coverage does
not exist - the percentage is 45% before adjusted gross income (not subject to the 7.5%
limit) in 1998. Assume a business owner client has family health insurance of $3,000 a
year and personal disability insurance of $1,500 per year; utilization of a C corporation
would allow a full $4,500 write-off, and any other business format would allow a $1,350
write-off in 1998 before adjusted gross income on the personal return of the business
owner with the remainder subject to the 7.5% of adjusted gross income and so probably of
no tax benefit. Under the example, the C corporation allows $3,150 of additional
write-off, and if personal federal and state income tax of 33% plus 15.3% FICA/payroll tax
is saved by the extra write-off, the tax savings in 1998 would be about $1,500. However,
because of C corporation problems set forth in this outline and the increase/phase-in to
100% of health insurance premiums (and not disability insurance premiums) write-off by
other business owners, the author generally will not favor utilization of a C corporation.
Keep in mind even service providing professionals utilizing key non-owner employees may
institute an S Corporation format to save payroll tax especially if the net income per
professional does not greatly exceed the annual social security tax maximum which is
$68,400 in 1998 (if S Corporation shareholder wages are at least the social security
level, the only tax savings would be the 2.9% Medicare tax for the S shareholders).
Because the C corporation does not allow any payroll tax savings opportunities, has double
tax on the sale of C corporation assets and has the need for year-end clean out, the
author prefers the S Corporation format which allows an active business owner to minimize
payroll tax if the business makes net income selling inventory and/or from the efforts of
non-S shareholder key employees even though S shareholders are unable to write-off health
and disability insurance through the S Corporation. The main disadvantage of an S
Corporation is if multiple owners (husband and wife owning 100% of an S Corporation would
be considered one owner and avoid the following problems) are involved because of the one
class of stock rules requiring proportionate to ownership distributions of cash not
subject to payroll tax and of flow through income and loss tax attributes. While an LLC
allows disproportionate distributions of cash and special allocations of deductions/tax
attributes, multiple owners having basically the same responsibilities and time spent
would want to take proportional distributions in most cases and so proportionate
allocation to ownership of flow through net income would be fair and acceptable. Thus if
the business does not involve services provided almost entirely by owners, an S
Corporation format allows managing owners/active S shareholders to minimize payroll tax
whereas managing/active LLC owners would be subject to self-employment tax on all net flow
through income.
An LLC format would probably be best if a relatively large number of owners are involved
especially if one or more of the owners are not active in the business and are investors
desiring equity in the business as well as a return on investment based upon net profits;
investor net LLC flow through income would not be subject to self-employment tax, but
investing LLC members could be involved in management decisions/voting (see the discussion
above of the revised proposed self-employment IRS regulations) and could receive special
allocations of deductions with the proviso when the LLC business is sold any negative
capital account would need to be zeroed out with an additional cash contribution. Reg.
§1.704-1(b)(2)(ii)(b). Additionally, an LLC format for a rental real estate operation
would be generally best (as opposed to a corporate format), as all flow through net income
would not be subject to self-employment tax to any owners/LLC members - see Reg.
§1.1402(a)-4.
A sole proprietorship arrangement seems to be best if the business is all service provided
by the one owner (a single or married business owner); in other words, the business does
not sell inventory and does not have any key non-owner employees and, of course, the one
owner is active in the business, meaning an S Corporation nor an LLC format would allow
any payroll tax savings. All net income of the sole proprietor would be subject to
self-employment tax, but that could be mitigated by instituting a qualified plan which
generally would be affordable because no or small cost would be involved for eligible
employees of the sole proprietor. The entity structure (corporation or LLC) would not be
necessary to protect personal assets of the sole proprietor, as the sole proprietor is
unable to protect himself/herself from his/her own negligence. Again the best personal
asset protection would be adequate business insurance. CAVEAT: However, a sole proprietor
that is using services of subcontractors (such as an engineer) might consider forming an S
corporation to protect personal assets against negligence of the subcontractor as best
possible. The S corporation might also be available to reduce payroll taxes under Rev.
Rul. 74-44 because some profit is made for the professional (such as an engineer) by the
efforts of the subcontractor (in other words, the client pays more for the services of the
subcontractor than the subcontractor is actually paid). The professional would generally
be protected by the doctrine of vicarious liability from the negligence of the
subcontractor/independent contractor, but that is no protection from the client with which
the professional has contracted.
Generally, the author for a business that sells inventory at a profit and/or makes a
profit on the efforts of non-owner employees favors the S Corporation format because
active owners may save a substantial amount of payroll tax and still have personal asset
protection to the extent allowed by law (discussed above). Again, the author is not a fan
of C corporations, but when more than two owners are involved, especially if passive
investors have equity interests, an LLC format probably would be best.
S ELECTION CAUTIONS: Although the IRS has been more flexible, Form 2553
generally must be completed correctly and filed within 2½ months (75 days) of the tax
year it is to be effective; generally the S Election would be made for the first tax year
and the 75-day period begins on the first day of corporate existence. Rev. Rul. 72-257
states the first day of the taxable year is the day the Articles of Incorporation are
filed, if state law provides corporate existence begins on that date. Arizona law does
provide corporate existence begins on filing of the Articles (the date of delivery, if the
Articles are accepted). 10 ARS 203A. The Arizona Corporation Commission stamps on the
Articles the date of filing which would be the date utilized on the S Election for
completing many blanks such as date incorporated as well as the date the corporation first
had shareholders and began doing business. Most importantly, both spouses must sign the S
Election if both spouses have an ownership interest which would be the case unless the S
Corporation stock is owned as the separate property of only one spouse. See the topic
below entitled Owner Interest Titling Cautionary Note.
TAX SAVINGS CAUTIONARY NOTE: The practitioner should inform clients that
payroll tax savings as well as income tax savings law provisions might not last forever.
It is to be noted Congress has previously considered legislation to modify somewhat Rev.
Rul. 74-44 and revised proposed LLC self-employment regulations are subject to change or
repeal. The allowance of coverage of only C corporation shareholders under health and
disability insurance reimbursement plans has also been subject to much legislative
activity - remember §89, IRC that was repealed before it became effective.
BUSINESS OWNER PAYROLL TAX CAUTIONARY NOTES: A business owner is known as
the responsible party for making all payroll tax payments, and under §6672, IRC, if
payroll tax deposits/payments are not submitted to the IRS, the business owner is 100%
responsible for such taxes which are not dischargeable in bankruptcy. Thus the business
owner must be sure that IRS and other governmental agency payroll tax deposits and
payments are always a (and perhaps the) priority creditor. Additionally, failure to make
payroll tax deposits and payments timely results in immediate and heavy penalties - for
example, a late required IRS payroll tax deposit incurs almost immediately a 20% penalty.
Accounting Methods
Emphasizing When Accrual Method (vs. Cash Method) Is Required
The cash method of accounting is desirable, as utilization
of the accrual method requires that accounts receivable be declared as taxable income even
though cash has not been collected and ending inventory not be allowed as a deduction even
though payment may have been made. However, a business must utilize the accrual method of
accounting (which has the benefit of a write-off of accounts payable that have not been
paid) if production, purchase or sale of merchandise/inventory is an income-producing
factor. Reg. §1.446-1(a)(4)(i). Rev. Rul. 74-279 states inventories are required even if
sold at cost. It was held in Wilkinson-Beane, Inc., 420 F. 2d 352 (1970), the accrual
method of accounting was required as the cost of inventory averaged slightly more than 15%
of total cash receipts. Thus if an S Corporation is utilized to minimize S shareholder
payroll tax (see above) because inventory is sold at a profit, the accrual method of
accounting needs to be utilized. However, keep in mind Reg. §1.446-1(c)(1)(iv)(a) allows
a taxpayer required to use the accrual method of accounting to use the cash method of
accounting as to other items of income and expense except accounts receivable, accounts
payable and inventory. Numerous other accounting method requirements exist under tax law;
as an example, the rules of §263A, IRC require a manufacturer to capitalize certain
otherwise deductible expenses relating to ending inventory - a tax disadvantage because
capitalized means non-deductible. SMALL BUSINESS CASH METHOD ALLOWANCE:
Rev. Proc. 2000-22 states, the accrual method of accounting will not need to be used by
any taxpayer with average annual gross receipts of $1,000,000 or less, as long as the
taxpayer does not regularly use another method of accounting (generally the accrual method
of accounting) for books, records and reports, including financial statement reporting. An
isolated use of the accrual method of accounting, for example, on a one-time basis to
obtain a bank loan, does not violate that requirement, but keeping books regularly on the
accrual basis would. Additionally, the taxpayer using this exception is required to meet
the requirements of Reg. §1.162-3 that allows merchandise (materials and supplies) that
are not incidental to deduct only those actually consumed or used. In such a situation
(such as a retailer or contractor) that would otherwise be required to use the accrual
method of accounting, any tax year end inventory would need to be reflected as an asset
and not deducted as an expense. This exception allows the taxpayer to avoid recognition of
accounts receivable, but also denies any deduction for accounts payable. Many small
businesses keep accounting records on the accrual method, and so would be prohibited from
using this method unless that was discontinued. The revenue procedure allows changing from
the accrual method of accounting to the cash method for qualifying taxpayers under the
automatic change provisions of Rev. Proc. 99-49. The average annual gross receipts of
$1,000,000 or less applies if, for each prior tax year ending after December 16, 1998, the
taxpayer's average annual gross receipts for the three tax year period does not exceed
$1,000,000, and a taxpayer in existence for less than three years determines annual gross
receipts for the number of years of its existence with short tax years being annualized.
Gross receipts are defined in Reg. §1.448-1T(f)(2)(iv) and includes sales net of returns,
service fees, interest, dividends and rents, but does not include sales tax.
Business Formation Completion
"To Do" List
In forming a business, the professionals involved with the
business owner, generally the CPA and lawyer should be sure to do the whole job. That
would include discussing with the client whether or not the following items need to be
addressed and completed:
1. If multiple owners are involved, a corporation or LLC will be
necessary, and a co-owner agreement generally should be prepared specifying owner
contributions or availability of equipment or a building, specific responsibilities and
the method of calculation of owner W-2 and other distribution amounts, a prohibition on
owner competition during ownership and for a period of time after ownership termination,
divorce contingencies which generally would direct the court to award the business
interest to the managing spouse and other assets or payment to the non-managing spouse,
transfer restrictions in the event of the desire of an owner to sell to a third party
(such as an absolute prohibition without permission of other owners or a right of first
refusal/purchase option by other owners) as well as death and disability contingencies
which could be funded with insurance.
2. Negotiate a business owner/tenant favorable premise lease - see the
July 1998 article by the author in this publication entitled Business-Tenant Favorable
Lease Negotiations.
3. Prepare any contracts the business owner(s) will utilize on a regular
basis including a reasonably restrictive employment agreement (Arizona has what is known
as the blue pencil rule requiring non-solicitation, non-competition and other restrictions
to be reasonable in time and geographic scope and if over broad such are not enforceable
at all - see American Distribution Co. vs. Mascari, 724 P.2d 596 (App., 1986)), sales
contracts keeping in mind generally unsigned invoices and the like do not create binding
terms on the buyer (Farm & Supply vs. Phoenix Fuel Co., 442 P.2d 88 (Ariz., 1968)),
limitation of liability business owner protective agreements such as for a pest control
company, sports events provider and so on.
Going hand-in-hand with the general doctrine that a business owner is liable for his/her
own negligence and the need for affordable insurance to protect against risk inherent in
the particular business, business owners must keep in mind they have an affirmative duty
to make and keep business premises reasonably safe for customers, invitees, employees and
other third parties such as contractors. Among many other case decisions see Preuss vs.
Samb's of Arizona, Inc., 635 P.2d 121 (Ariz., 1981). This would particularly apply to
retailers/store locations, contractors/job sites and landlords/rental property.
COMMUNITY PROPERTY STATE OWNER INTEREST TITLING CAUTIONARY NOTE: Arizona
and 8 other states are community property jurisdictions; the following points out
community property titling as opposed to joint tenancy with right of survivorship titling
is a must for a corporate or LLC ownership interest in a successful business (value of the
business appreciates over the owner investment) located in a community property state
owned by husband and wife. If an interest in corporate stock or an LLC ownership interest
is by both husband and wife residing in a community property state, in almost all cases
the ownership should be as community property held in a revocable trust of the spouses or
as community property with right of survivorship (HOWEVER, SEE THE COMMUNITY PROPERTY WITH
RIGHT OF SURVIVORSHIP TAX BASIS CAUTIONARY NOTE BELOW) and specifically not as joint
tenants with right of survivorship. The purpose is to obtain the full step-up in basis
upon the death of the first spouse pursuant to §1014(b)(6), IRC. It is typical that a
business would be started with a small investment, and if successful, after a number of
years great appreciation takes place (in other words, the business could be sold for a
substantial amount). If the business interest (stock certificate or LLC interest) is held
in joint tenancy, the step-up in basis is only 1/2 of the appreciation. On the death of
the first spouse, under the general rule of §1014, IRC, the appreciated separate property
of the deceased's spouse receives a step-up in basis to fair market value at death and the
basis of separate property of the surviving spouse is not changed; that result takes place
because each spouse under Arizona law is deemed to own 1/2 of joint tenancy property as
separate property. Russo vs. Russo, 298 P.2d 174 (Ariz., 1956). As an example, assume
husband and wife begin an S Corporation with a $100,000 investment, and upon the death of
the first spouse, the fair market value of the business is $500,000. Upon the death of the
first spouse, if the S Corporation stock is held as community property or community
property with right of survivorship, the income tax basis for the surviving spouse is
$500,000 - the desirable result. On the other hand, if the S Corporation stock certificate
had been in joint tenancy, the step-up in basis would only be to $300,000 - in the opinion
of the author, malpractice would have been committed on the part of the attorney creating
the stock certificate. SEPARATE PROPERTY OF ONE SPOUSE CAUTION: If the
business interest is the separate property of one spouse, it should be titled as such. In
the example above, if the spouse owning the separate property business ownership interest
dies first, the basis becomes $500,000, but if the other spouse dies first, the basis
remains $100,000 in the hands of the surviving spouse owning the separate property. COMMUNITY
PROPERTY WITH RIGHT OF SURVIVORSHIP TAX BASIS STEP-UP CAUTIONARY NOTE: The
practitioner is directed to the article entitled "Community Property With Right Of
Survivorship: Uneasy Lies The Head That Wears A Crown Of Surviving Spouse For Federal
Income Tax Basis Purposes", Virginia Tax Review, Winter, 1998, page 577, which
contains an analysis of estate inclusion and tax basis of property from a decedent law.
The article concludes §2033, IRC only includes probate assets and §2040, and IRC applies
to joint tenancy with right of survivorship property and not necessarily community
property with right of survivorship property. The article also concludes that Rev. Rul.
87-98, which had been relied upon by a number of commentators to allow a full step-up in
basis upon the death of the first spouse of community property with right of survivorship
property, does not logically allow a full step-up in basis. The author of the article
reasons if the decedent's 1/2 interest in community property with right of survivorship is
not included in the estate of the first spouse to die, neither §1014(b)(6) nor (9), IRC
apply to allow a full step-up in basis. In fact, the author of the article suggests no
step-up in basis would be allowed because of no estate inclusion. The author of the
article concludes until §2040(b), IRC is amended to include as a joint interest between
husband and wife specifically community property with right of survivorship, uncertainty
exists as to the basis of community property with right of survivorship property upon the
death of the first spouse in the hands of the surviving spouse. Thus it is only prudent to
advise clients of the current issue and suggest the solution for holding and owning
appreciated property (such as a closely held business interest, real estate, investments
and so on) would be to utilize a revocable trust with assets titled in the name of the
trust specifically designated as community property (referred to as straight community
property by the author of the above referenced article to avoid the community property
with right of survivorship tax basis step-up issue). An alternative to utilizing a
revocable trust and community property trust titling would be to hold the appreciated
asset of the spouses as straight community property without a survivorship feature
subjecting the asset to probate proceedings.
Business Building and Other Business
Operating Assets
Owned By Shareholders or LLC Members
Business Creditor Protections and Related Tax Issues
As above, a typical business owner misconception is that if
an entity (corporation or LLC) format is utilized, a business building owned by one or
more of the owners and other high cost business assets such as computers or trucks need to
be placed into the entity; however, generally the author suggests just the opposite. Such
assets generally should be kept out of the entity and away from the grasp of general
creditors as well as claims not covered by insurance keeping in mind any assets owned
personally by an owner committing negligence himself/herself or who has personally
guaranteed an entity obligation would have such assets subject to those claims/creditors.
Such assets would then be rented to the entity with a requirement that rental payments to
the shareholder or LLC member be a reasonable/fair value amount. Among many decisions, see
Fagan, 81-1 USTC, 9436. However, to avoid self-employment tax on net rental income and
sales tax under Arizona law on gross rental income, the §179, IRC quick write-off
deduction would not be allowed for business personal property (equipment, computers,
trucks, etc.) rented to the entity because the rental would not be a business. Any net
rental income would not be considered passive income (see Reg. §1.469-2(f)(6)), but net
rental loss would be subject to the passive loss write-off limitation rules of §469, IRC.
Typical Business Client
Misconceptions
Especially a new business owner probably will have
preconceived notions, which are not exactly correct. The following would be examples
(NOTE: The first statement is the misconception, and the first two items relate to
multiple owner businesses - husband and wife generally are considered one owner):
1. Titles such as president are of utmost importance. However,
management control is "where the power lies". The author believes titles are
mostly for the benefit of third parties/non-owners, and businesses with multiple owners
will determine management control by way of specific co-owner agreements regarding voting
on all aspects of business operation.
2. Earnings, compensation and so tax exposure always follows ownership
percentage. While it is true that S Corporation distributions/dividends not subject to
payroll tax must be paid at the same time and in proportion to ownership, generally other
payments may be based on a number of factors not involving ownership percentage.
Compensation in various forms (such as W-2 wages, return on owner investment and LLC
distributions to owners) may be based upon hours worked, gross or net income generated,
extent of investment in the business at a specific interest factor (a loan by an S
shareholder to an S Corporation must meet certain requirements such as interest paid must
not be pegged to profits) as well as other factors not connected to ownership percentages
of the various business owners/operators.
3. The monthly overhead burden under the business premise lease is
only base rent. The business owner needs to be aware in most cases various other triple
net type charges are involved and must be paid on a monthly basis. The business owner
before signing a premise lease needs to obtain a good faith estimate of the total monthly
payment from the landlord to avoid surprise at a substantially higher monthly obligation.
Again see the premise lease tenant favorable negotiation article referenced above.
4. In general commercial contracts are non-negotiable. Especially novice
business owner will, for example, simply sign a business lease agreement for equipment or
a vehicle without negotiating the terms including price, early return penalty and so on.
The business owner needs to learn not to be timid and to be pro active in negotiating
almost any contract. The business owner needs to institute business protections such as
hiring employees only with reasonable restrictions such as non-solicitation of
customers/clients of the business in the event of employment termination, selling products
with limitation of liability contractual provisions and so on.
5. Failure to recognize the extent of overhead items. As an example, a
new business owner understands net income is subject to income tax, but fails to realize
before the first business tax return is due that substantial payroll tax also must be paid
on net income. No matter how much research goes into a business plan/budget, overhead
expenses almost always seem to exceed estimates. In that regard, the business owner must
set prices/fees that are competitive, but also allow a reasonable profit. A new business
owner needs to be prepared for the extent of payroll, sales and other taxes as well as
cost of insurance that will be due on a regular basis.
6. All business operating assets should be placed into the entity
(corporation or LLC). Especially real estate and high cost assets should not be owned by
the entity, but held outside of the entity and away from the grasp of general creditors of
the business. As above, related party tax rules apply including the requirement of fair
market value rent from the entity to the business owner. Keep in mind in the event a claim
against the entity above insurance coverage or excluded from insurance coverage is made,
entity (corporate or LLC) assets such as accounts receivable and inventory will be at
risk.
7. Any business needs to incorporate. The business client may believe
incorporation is necessary for personal asset protection, tax reasons and/or prestige.
Generally a business that is operated by only the owner and is basically a service
business need not incorporate, and the name prestige may be had by obtaining a trade name
through the Arizona Secretary Of State for a $10.00 fee (see the business name protection
topic below). Personal asset protection is not possible when the owner operates a service
business, as one cannot protect himself/herself from his/her own negligence. A service
business with all net income generated through the efforts of the owner may not save
payroll tax by utilizing an S Corporation.
Business Name Protection
A federal name registration provides a business with a
presumption of constructive use throughout the United States. 15 USC §1057. Federal law
makes clear a federal registrant has superior rights to use a name over a subsequent user
despite the fact the subsequent user has filed for a state trade name. Burger King of
Florida, Inc. vs. Hoots, 403 F.2d 904 (1968). So long as there is no federal registration,
the use of a business name locally is protected in the area of prior use. 15 USC
§1115(b)(5). In Arizona a name is protected statewide by filing as a corporation or LLC
or for a trade name. Thus when starting a business, the owners will want to be sure the
name selected is not the same or deceptively similar to a name registered locally or under
federal law. If the business intends to expand from the local area, a federal registration
should be made immediately.
Payroll Tax Payment Cautionary Note
Business owners need to understand if payroll tax is not
paid (withholding from employee paychecks including any W-2 to the owner), the business
owner will be deemed to be the responsible party under §6672 of the Internal Revenue
Code. That provision provides that the responsible party/business owner is personally
liable for 100% of the payroll tax. Additionally, failure to make payroll tax deposits
timely will result in large penalties. Thus business owners need to be cautioned to pay
payroll taxes including all required deposits on a priority basis. |
