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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.
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