How to structure your enterprise
How you structure, buy and sell business interests has never been more important. There are many tax considerations that can cost or save you money. The most important factor may be the structure you choose for your company.
Tax treatment of business structures
Business structures generally fall into two categories: C corporations and pass-through entities. C corporations are taxed as separate entities from their shareholders and offer shareholders limited liability protection. (See chart 5 for corporate income tax rates.)
Pass-through entities effectively “pass through” taxation to individual owners, so the business income is taxed at the individual level. (Read more on individual taxes and the individual rate schedule.) Some pass-through entities, such as sole proprietorships and general partnerships, don’t provide limited liability protection, while other pass-through entities, such as S corporations, limited partnerships, limited liability partnerships and limited liability companies, can.
Because some pass-through entities can offer the same limited liability protection as a C corporation, tax treatment should be a major consideration when deciding between the two structures. (See chart 6 for an overview of key differences.) The biggest difference is that C corporations endure two levels of taxation. First, a C corporation’s income is taxed at the corporate level. Then the income is taxed again at the individual level when it is distributed to shareholders as dividends. The income from pass-through entities is generally only taxed at the individual owner level, not at the business level.
Although this benefit is significant, it is not the only consideration. There are many other important differences in the tax rules, deductions and credits for each business structure that also need to be considered. You always want to assess the impact of state and local taxes where your company does business, and owners who are also employees have several other unique considerations. Also, the choice of business structure can affect the ability to finance the business and may determine which exit strategies will be available. Each structure has its own pluses and minuses, and you should examine carefully how each will affect you. Call a Grant Thornton advisor to discuss your individual situation in more detail.
If you work in a business in which you have an ownership interest, you need to think about employment taxes. Generally all trade or business income that flows through to you from a partnership or limited liability company is subject to self-employment tax — even if the income isn’t actually distributed to you. But if you’re an S corporation or C corporation employee-owner, only income you receive as salary is subject to employment taxes. How much of your income from a corporation comes from salary can have a big impact on how much tax you pay. (See Tax planning opportunity 9 for more information.)
Don’t wait to develop an exit strategy
Many business owners have most of their money tied up in their business, making retirement a challenge. Others want to make sure their business — or at least the bulk of its value — will be passed to their family members without a significant loss to estate taxes. If you’re facing either situation, now is the time to start developing an exit strategy that will minimize the tax bite.
An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money. To pass on your business within the family, you can give away or sell interests. But be sure to consider the gift, estate and generation-skipping tax consequences. (Read more on estate planning.)
A buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Buy-sell agreements are complicated by the need to provide the buyer with a means of funding the purchase. Life or disability insurance can often help and can also give rise to several tax and nontax issues and opportunities.
One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions to this, however, so be sure to consult a Grant Thornton tax advisor.
You may also want to consider a management buyout or an employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan created primarily so employees can purchase your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or supplementing an employee benefit program, an ESOP can offer you many advantages.
Assess tax consequences when buying or selling
When you do decide to sell your business — or are acquiring another business — the tax consequences can have a major impact on your transaction’s success or failure.
The first consideration should be whether to structure your transaction as an asset sale or a stock sale. If it’s a C corporation, the seller will typically prefer a stock sale for the capital gains treatment and to avoid double taxation. The buyer will generally want an asset sale to maximize future depreciation write-offs. Sellers should also consider whether they prefer a taxable sale or a tax-deferred transfer. The transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization, but the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are advantages to performing a taxable sale:
- Tax rates are scheduled to increase in 2011.
- The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred sale.
- The buyer benefits by receiving a stepped-up basis in the acquisition’s assets and does not have to deal with the seller as a continuing equity owner, as would be the case in a tax-deferred transfer.
- The parties don’t have to meet the stringent technical requirements of a tax-deferred transaction.
A taxable sale may be structured as an installment sale if the buyer lacks sufficient cash or the seller wants to spread the gain over a number of years. Contingent sales prices that allow the seller to continue to benefit from the success of the business are common. But be careful, the installment sale rules create a trap for sellers if the contingency is unlikely to be fulfilled. Also, installment sales may not make as much sense in the current environment because tax rates are scheduled to go up. (Read more on installment sale considerations when tax rates have the potential to increase.)
Careful planning while the sale is still being negotiated is essential. Grant Thornton can help you see any trap and find the exit strategy that best suits your needs.
