Business Entities

Sole proprietorships are the easiest to begin and end. No legal filings are required unless it operates under a fictitious name. Advantages include less administration, lower fees and sole control of the business by the owner. Some disadvantages include self-employment taxes and personal liability.

Partnerships begin when two or more people agree to enter into a business. There may be “silent” partners, and some partners may have less invested than others. Although partnerships don't need formal documents for implementation, all parties should write and sign a partnership agreement.

The advantages of partnerships include no double taxation of profits or capital gains, losses are passed through to the partners, distribution of responsibilities, and pooling of risk. The disadvantages include unlimited liability; taxation of earnings, even if not distributed; and control of the business shared among the partners. General partners are also subject to self-employment tax.

Family Limited Partnerships
The term “Family Limited Partnership” (FLP) is a slang term used by planners. There is no statute anywhere that uses the term, nor does the Internal Revenue Code use it. What “Family Limited Partnership” refers to is a limited partnership formed to hold the family business or investments, with the idea that the parents will make gifts of their limited partnership interests to their children.

Because the limited partnership interests are illiquid, so the theory goes, they should be subject to substantial discounts for federal gift and estate tax planning purposes. Family Limited Partnerships also have some attraction as asset protection vehicles, primarily because the limited partnership interests may be subject to “charging order protection in some states.

Because of the potential federal gift and estate tax benefits and potential asset protection benefits, FLPs are widely marketed by a variety of attorneys, CPAs, CFPs, and other planners. Unfortunately, FLPs are also marketed by numerous promoters who shamelessly sell one-size-fits-all cookie-cutter FLP structures and even sometimes also sell kits allowing clients to engage in do-it-yourself FLP planning.

When utilized correctly, FLPs can be very powerful estate planning and asset protection planning tools. The problem is: FLPs are almost never correctly utilized, and because of this they often fail to produce their promised benefits.

C-corporations are traditionally used for larger businesses. The corporation is a separate legal entity that incurs all liability and continues until dissolved.

The advantages of C-corporations include potentially lower taxes on (retained) earnings; limited liability to shareholders, directors and officers; the ability to set their own accounting year; and simplified division of income between family members.

Two major disadvantages of the C-corporation include double taxation (taxes are paid by the corporation on earnings and by stockholders on distributions), and a requirement for formal stockholder meetings that must include minutes. Disadvantages may also include high dissolution and liquidation costs.

In some states, corporations tend to be more expensive to organize because of stock requirements, whereas other entities don't require stock.

S-corporations are similar to C-corporations in that they share many of the same tax characteristics and are more like partnerships for tax purposes. An "S-Corporation" is a regular corporation that has between 1 and 100 shareholders and that passes-through net income or losses to shareholders under in accordance with Internal Revenue Code, Chapter 1, Subchapter S. Corporations must meet specific eligibility criteria, and they must notify the IRS of their choice to be taxed as an S-Corporation within a certain period of time.


Taxation of S-Corporations

An S-Corporation is not subject to corporate tax rates. "Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income," according to the Internal Revenue Service.

Instead, an S-Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the corporation's profits are only taxed once – at the shareholder level. The IRS explains it this way: "On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss."

Limited liability companies (LLCs) are one of the newest business structures available. An LLC may have only one member and can elect to be taxed at the partnership or corporate level. Advantages of an LLC include limited owner liability to the amount of the investment, ease of establishment, and no double taxation.

Some disadvantages of LLCs are varying setup requirements by states and differing state tax treatment from federal tax treatment. The business structure is best decided by the owner with advice from the business team. Another disadvantage is that, given LLCs' newness, much of LLC law is yet to be clarified and firmed up by the judicial system.


Discounting business interests

When the owner of interests in a closely held (family) partnership, corporation, LLC or limited liability partnership dies, the value of the interests owned by the decedent are included in the estate.

One of the common objectives in estate planning is to value these closely held interests in the business at a lower value than one would get if one simply divided the fair market value of the business assets by the number of business interests outstanding.

You're usually more likely to obtain a discount on the business value when the owner of the business interests doesn't own a majority or controlling interest of the business. There are a number of different discounting techniques, but the most common are discounts for lack of marketability, for lack of control, and for built-in gains in a corporation.

The fair market value of any interest of a decedent in a business is the net amount that a willing purchaser would pay for the interest to a willing seller. This is true when neither is under any compulsion to buy or to sell, and both have reasonable knowledge of “relevant” facts.

Because of the limited market for interests in closely held businesses, the value of the interests frequently qualify for discounts of 20-30% or more. The valuation is often affected by whether the decedent had a “controlling interest” at the time of death and by the existence of restrictive agreements as to transfer.

Although dependent on an appraisal, combined discounts for both lack of marketability and lack of control may commonly total 35%. Because corporations don't get a step-up in basis for assets owned by the corporation on the death of a shareholder, there are usually built-in capital gains due to appreciation in value or tax depreciation.

The taxes on these built-in gains will be incurred whenever there's a liquidation, so a buyer isn't willing to pay as much for the corporation as for the same assets outside of the corporation. Therefore, corporations may end up with greater discounts because of the greater tax costs on liquidation.

Considerable effort and ingenuity are frequently used to make sure the interests qualify for such substantial discounts. Moore says the IRS continues to develop arguments to limit the discounts, to disallow the gifts for the annual exclusion, and to pull gifts back into the taxable estate.

The business and its owners can establish a discount rate in the business organization documents. However, the IRS isn't bound to any self-determined discount rates and has the ultimate say on what the discount rate is on any business.

Mark Tippins
Attorney at Law
118 N. Ross Street #6 • Auburn AL, 36830
Phone: (334) 821-3670 • Fax: (334) 821-3671
E-Mail: mtippins@bellsouth.net

Real Estate  :: Estate Planning :: Business Entities

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