DB#2: Form of Organization:One of the most important decisions business owners make is the
form of organization
they select for conducting business. Read the article "
forms of organization"
attached and provide your thoughts or opinions on that. This article summarizes the pros and cons of company structures. Since this decision will affect nearly every aspect of a firm’s operations, it is important that the
finance professionals
understand the tax and economic implications of the company structure. normal tying style for a regular discussion board
forms of organization.pdfbody.fm Article 1 C Corporation, LLC, or Sole Proprietorship? What Form Is Best for Your Business BY GARY M. FLEISCHMAN, CMA, CPA, AND JEFFREY J. BRYANT, CPA Choosing the optimal company structure is a difficult decision and one of the most important a business owner will ever have to make. Type of ownership, capital formation, management, myriad tax considerations—the form chosen to structure the business will affect nearly every aspect of its operations. It is important, therefore, that management accountants be familiar with the pros and cons of the various forms under which an entity might be set up. Because the choice of business structure will determine many features of its design, no one factor should dominate this decision. While tax consequences should not be considered in isolation, they are never- theless a major consideration. C corporations tradi- tionally have been viewed as the vehicle that maximizes nontax advantages, for example. Recent legislation, however, has spread many of the C corporation’s strengths to other organizational forms. Because nontax benefits are now widely available in other structures, tax variables have become a more complicated and signif- icant factor in choosing a form for a company. Selecting a suitable business form increasingly is becoming a matter of choosing among the most appropriate tax attributes. Tax and economic environment change requires that business owners not only must choose an optimum structure for their start-up, but they also must continually reassess their original choice. The appropriate choice inevi- tably will shift as the business evolves. For example, a tax conduit that passes losses directly to owners’ tax returns during the initial years of operation is often a good beginning choice. Then, as the business grows and profits increase, a C corporation that facilitates capital formation and shields owners from profit taxes may become a better alternative. The importance of reviewing structure at all stages in an organization’s life cannot be overstated. In an intensely competitive world, a wise initial selection and the diligent monitoring of that choice can significantly impact an enterprise’s long-term viability. Let’s look at the current status of four business struc- tures: sole proprietorship, partnership and LLCs, S corpo- rations, and C corporations. For the legal background of the limited liability company (LLC) and limited liability partnership (LLP), see sidebar, “The Evolution of LLCs and LLPs.” THE ART OF CHOOSING THE BEST BUSINESS STRUCTURE Selecting the most appropriate structure for an organi- zation is more an art than a science. Seldom do all factors point to an ideal form. Advantages and disadvantages often fluctuate as laws change, further complicating the decision. Several recent tax laws and IRS rulings have significantly altered the analysis. The following observa- tions incorporate these developments and provide useful guides for choosing an entity form. •SOLE PROPRIETORSHIP. As its name implies, this form is an option only for a business with one owner. For many reasons, the sole proprietorship is often maligned as having no meaningful tax planning opportunities. Recently enacted law is changing this perception. Nearly every piece of recent major tax legislation has benefited sole proprietorships. Health insurance premiums paid by proprietors and other self-employed persons, for example, are now scheduled to become fully deductible by the year 2004. The political clout from a 1 ANNUAL EDITIONS growing segment of small business lobbyists should continue this trend. Perhaps one of the most important factors to consider, given the current legislative environment, is flexibility—a strong point in favor of the sole propri- etorship. Major tax legislation has become an annual event, and nearly every notable interest group is clamoring for a tax overhaul. An organizational form— particularly for a start-up—that is easy to escape from would make a good initial choice. A proprietorship can be inexpensively switched to a different structure if future tax reform alters your tax advantage. The low cost of changing forms is unique to proprietorships. Converting an entity’s classification is not necessarily economical, even when it can be readily accomplished. Owners of entities eligible for check-the-box regulations can easily change formats at least once after their first election. Reelection is a “conversion event,” however, and that may trigger liquidation and other adverse tax consequences. The mere election of S status by a C corpo- ration can impose a heavy double-tax burden on the corporation and its shareholders. An S corporation-level tax is possible due to the built-in gains tax, the LIFO recapture tax, and the excess net passive income tax. A proprietorship, therefore, is probably the least risky business form from which to change. In an era of tax reform, this flexibility is important. •PARTNERSHIPS AND LLCS. General partnerships, LPs, LLPs, and LLCs have many similar tax character- istics, but there are noteworthy differences in tax treat- ments as well. Although LLCs do not have to be taxed as partnerships under the check-the-box regulations, owners are likely to do so in the vast majority of cases. Partnerships and LLCs are conduit entities for U.S. tax purposes. Conduit tax treatment implies that income is taxed at only one level: As income is earned, the owners—rather than the entity—are taxed. There is generally no second taxing when income is distributed to the owners. In contrast, C corporation earnings are taxed once at the corporate level and again when distributed to owners as dividends. Net losses generated at the conduit level are passed on to owners, who may deduct these losses in the current year to offset other taxable income on their personal tax returns. Conversely, initial year losses in a C corporation can only be carried forward by the corporation to offset future corporate income. Losses do not produce an immediate tax benefit and may ultimately be wasted if the corporation never produces sufficient income. Conduit entity income and losses retain their character when passed through to owners. Therefore, capital gains realized by the entity are characterized as such on the owners’ tax returns. For high-income individual taxpayers, the Taxpayer Relief Act of 1997 (TRA 97) lowers the maximum tax rate on net capital gains to 20% when the taxpayer’s other income is taxed at a higher rate. To take advantage of this rate differential, individual owners with high marginal rates may find that a partnership or LLC is a good entity choice if the business is expected to generate capital gain income. A corporation’s capital gains, on the other hand, are taxed to the corporation at regular corporate rates and taxed again as ordinary income when distributed to individual shareholders. Most small business owners today realize that at some point they will probably transact business in the international arena. LLCs are especially useful for inter- national businesses. The LLC is relatively new in Tax Rates and Legal Liability: A Brief History •Changes in marginal tax rates. The dynamics of analyzing the best form for a business can be illustrated by considering the effects of fluctuating tax rates during the last two de- cades. For most years prior to 1981, maximum individual marginal tax rates exceeded the maximum rates for C corpo- rations, making C corporations an appealing choice from a tax standpoint. The 1981 Tax Act, however, lowered the maximum individual tax rate from 70% to 50%, while the maximum corporate rate decreased from 48% to 46%. Then, the Tax Reform Act of 1986 (TRA 86) established a maximum rate for individuals that was below the top rate for C corpo- rations. TRA 86 lowered the highest individual rate to 28% and decreased the maximum corporate rate to 34%. This in- version increased the popularity of conduit entities, such as partnerships and S corporations, vis-à-vis C corporations. Today, individual rates once again exceed corporate rates, though not at the pre-1981 magnitude. •A changing legal environment. Over the past two decades exposure to liability has exploded, and limiting this expo- sure has become a major factor in business planning. Na- tional accounting firms organized as general partnerships, for example, were devastated by their legal responsibilities for the savings and loan crisis of the 1980s. Plaintiffs attached the personal assets of partners whether those partners were directly responsible for malfeasance or not. In this environ- ment, the S corporation became popular as owners sought protection behind the corporate veil. Restraints on owner- ship and capital structure limited the S corporation’s useful- ness, however. As it became necessary to cap personal assets exposure, demand arose for an entity that could successfully meet two critical needs: more flexibility to maximize individ- ual taxpayer advantages and enhanced liability protection for owners. 2 Article 1. C Corporation, LLC, or Sole Proprietorship? America, but an equivalent has been widely used in other countries for years. Foreign investors are comfortable with LLCs, which make them popular vehicles for foreign investment in the United States. LLCs also present investors with substantial international tax planning opportunities. Though LLCs have existed on the world stage for a long time, foreign countries do not necessarily tax them in the same manner as in the United States. Typically, LLCs are classified as partnerships for U.S. tax purposes, while foreign countries often consider them taxable entities, much like C corporations. An entity that is treated as a nontaxable partnership by the United States but as a taxpaying organization by a foreign country is called a “hybrid” entity. Because of this tax dichotomy, businesses sometimes use hybrids as intermediaries to shop for countries with favorable tax treaties and to defeat U.S. income tax. Both Congress and the IRS have recently moved to stop these practices, but LLCs will likely remain a popular choice for international businesses, particularly because S corpora- tions must be domestic, and nonresident aliens cannot own S corporation stock. Tax implications of an LLC. Barbara, a U.S. citizen, and Robert, a Canadian resident, organize an LLC in Minnesota. They elect to classify the LLC as a partnership in the United States, while Canada treats this entity as a taxable corporation (a hybrid). The United States will tax Barbara directly on her share of LLC income. Canada,