Day 1 February 19, 2013:

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1 S CORP BUSINESS PLANNING & STOCKHOLDER AGREEMENTS, PART 1 & PART 2 First Run Broadcast: February 19 & 20, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) S Corps have always been a popular choice of entity for closely held businesses because of certain tax advantages they have over LLCs. The new 3.8% Medicare tax, which applies differently to S Corps than to LLCs/partnerships, will increase the appeal of S Corps. But S Corps are still fragile entities, with limitations on the number and type of shareholders they may have and restrictions on the type of equity and debt they may issue. Drafting the S Corp stockholders agreement is a careful balance of maximizing tax benefits, preventing the loss of the preferred tax status through inadvertently disqualifying corporate actions, and maximizing organizational flexibility in other areas. This program will discuss essential components of an S Corp stockholders agreement, including restrictions on capital structure and voting, transferability issues, equity and incentive compensation, and tax allocations and property distributions. Day 1 February 19, 2013: Business planning with S Corps and drafting stockholders agreements Counseling clients on choice of entity considerations of S Corps v. LLCs/partnerships Capital structure issues in stockholders agreements restrictions on types of debt and equity Transferability of interests and restrictions to preserve S Corp status Planning for the merger or sale of an S Corp Day 2 February 20, 2013: Overview of new tax advantages of using an S Corp over an LLC after the new Medicare tax Understanding the tax advantages/disadvantages of withdrawing money as salary or distributions Incentive compensation issues, including fringe benefits and restrictions on deductibility Planning for and drafting for distributions and allocations Speakers: Alson R. Martin is a partner in the Overland Park, Kansas office of Lathrop and Gage, LLP, where he has a national practice focusing on business law, taxation, health care, and retirement plans. He is a Fellow of the American College of Tax Counsel and the American College of Employee Benefits Counsel. Mr. Martin is the author of "Limited Liability Companies and Partnerships" and the co-author of "Kansas Corporation Law & Practice (Including Tax Aspects)." He is the president and a director of the Small Business Council of America. Mr. Martin received his B.A., with highest distinction, from the University of Kansas, and his J.D. and LL.M. from New York University School of Law.

2 PROFESSIONAL EDUCATION BROADCAST NETWORK Speaker Contact Information S CORP BUSINESS PLANNING & STOCKHOLDER AGREEMENTS, PART 1 & PART 2 Ronald A. Levitt Sirote & Permutt, PC Birmingham, AL (o) (205) rlevitt@sirote.com Alson R. Martin Lathrop & Gage, LLP - Overland Park, Kansas (o) (913) amartin@lathropgage.com

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: Middle Initial: Last Name: Firm/Organization: Address: City: State: ZIP Code: Phone #: Fax #: Address: I will be attending: S Corp Business Planning & Stockholder Agreements, Part 1 Teleseminar February 19, 2013 Early Registration Discount By 02/12/2013 Registrations Received After 02/12/2013 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER February 12, 2013 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association): $ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # Exp. Date Cardholder:

4 Vermont Bar Association ATTORNEY CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: February 19, 2013 Seminar Title: S Corp Business Planning & Stockholder Agreements, Part 1 Location: Credits: Teleseminar 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

5 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: Middle Initial: Last Name: Firm/Organization: Address: City: State: ZIP Code: Phone #: Fax #: Address: I will be attending: S Corp Business Planning & Stockholder Agreements, Part 2 Teleseminar February 20, 2013 Early Registration Discount By 02/13/2013 Registrations Received After 02/13/2013 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER February 13, 2013 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association): $ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # Exp. Date Cardholder:

6 Vermont Bar Association ATTORNEY CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: February 20, 2013 Seminar Title: S Corp Business Planning & Stockholder Agreements, Part 2 Location: Credits: Teleseminar 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

7 CHAPTER 17 Choice of Entity Tax and Business Strategies SYNOPSIS Introduction [1] General Partnership [2] Limited Liability Partnership [3] Limited Partnership [4] Limited Liability Limited Partnership [5] Limited Liability Company [6] Limited Partnership Association [7] C Corporation [8] S Corporation [9] Sole Proprietorship Reasons for Choosing a Pass Through Entity Over a C Corporation [1] No Double Tax on Business Earnings [2] No C Corporation Penalty Taxes [3] No Corporate Alternative Minimum Tax [4] Pass Through of Losses [5] Avoiding Thin Capitalization Problems [6] Passive Activity Losses [7] No Double Tax on Liquidation of a Business [8] Avoiding Reasonable Compensation Problems [9] Accounting Methods [10] NOL Carryovers [11] Family Income Splitting [12] Special Tax Treatment for Capital Gains and Losses [13] Golden Parachute Payments [14] Self-Employment Income [15] Charitable Contributions [16] Distributions of Appreciated Property [17] Estimated Tax Payments [18] Liabilities and Basis [19] Investment Interest Deduction Limitations [20] Equity for Services Reasons For Choosing a C Corporation Over a Pass-Through Entity [1] Lower C Corporation Tax Rates [2] Passive Loss Rules [3] Statutory Fringe Benefits [4] Choice of Taxable Year [5] Depleting the Corporation s Capital [6] Availability of Certain Deductions [7] Alternative Minimum Tax Rates [8] Qualified Small Business Stock Tax Characteristics Common to Partnerships and S Corporations [1] Conduit Theory [2] Limitations on Losses Inclusion of Liabilities in Basis [3] Choice of Taxable Year [4] Taxation of Cash Distributions [5] At-Risk Rules [6] Deduction Limitations of IRC Section 267(e) [7] Limitations on Tax-Free Formation of Investment Companies [8] Limitations on Passive Activity Losses [9] Two Percent Limitation for Certain Itemized Deductions

8 [10] Investment Interest Deduction Limitations [11] Reallocations of Income Tax Characteristics of S Corporations That Are More Advantageous Than Those of Partnerships [1] Formation [2] Continuity of Life [3] Tax-Free Reorganizations [4] Liability Relief Discharge of Indebtedness [5] No Constructive Termination [6] IRC Section 751 Hot Assets and Installment Sales [7] Self-Employment Taxes [8] Sales of Property To The Entity [9] IRC Sections 704(c) and 724 Do Not Apply Tax Characteristics of Partnerships That Are More Advantageous Than Those of S Corporations [1] Transfers of Appreciated Property [2] Basis [3] Eligible Owners [4] One Class of Stock [5] Basis Adjustments [6] Assumption of Debt and Transfer of Encumbered Property [7] Revocation or Termination of Status [8] Corporate-Level Penalty Taxes [9] Cash Distributions Excluding Redemptions in Liquidation [10] Distributions in Redemption of Stock [11] Distributions of Appreciated Property [12] State Tax Treatment [13] Special Allocations and Preferential Distributions Tax Planning Strategies: Combining Partnerships and S Corporations [1] Introduction [2] Special Allocations, Preference Distributions, and Ineligible Shareholders [3] Passive Loss Limitation Strategies [4] Dividing a Corporate Business Without Satisfying the Requirements of IRC Section 355 [5] Reducing Tax Problems When an Ownership Interest Is Received in Exchange for Services [6] Dividing A Business [7] Protecting Assets From Liabilities of the Business Appendix: Table for Comparison of Partnerships, Limited Liability Companies, C Corporations, and S Corporations Introduction Choosing the best vehicle for conducting a client s business is a difficult and everevolving task. It requires identifying the client s business and tax goals with respect to the formation, operation, and disposition of the business. Estate planning considerations are also an important factor since certain entities may be more suitable for reducing estate taxes. The number of possible business entities has increased dramatically since the Service officially recognized that limited liability companies could be taxed as partnerships for federal income tax purposes in Revenue Ruling Since then, all 50 states have passed legislation authorizing the formation of a wide variety of unincorporated entities that will provide both limited liability protection for owners, and pass-through tax treatment. 2 Depending on applicable state law, business owners can elect to carry on a businesses as a sole proprietorship, general CB See Chapter 22.

9 partnership, limited liability partnership, limited partnership, limited liability limited partnership, limited liability company, limited partnership association, S corporation, or C corporation. A brief summary of the operating features of each of these entities is set forth below. [1] General Partnership A general partnership requires two or more partners who carry on a financial, business, or investment activity as co-owners. A general partnership will be taxed as a pass-through entity for federal income tax purposes, unless the owners elect to tax it a as a corporation. 3 All partners can participate in the partnership s management, and each has the legal right to enter into contracts on behalf of the partnership. A general partnership will dissolve on the death, bankruptcy, or withdrawal of any partner unless the remaining partners elect to continue the business. All partners in a general partnership are jointly and severally liable for partnership debts. Although general partners can transfer their partnership interest under state law, an assignee gets only an interest and cannot become a substitute partner without the consent of the other partners. [2] Limited Liability Partnership A limited liability partnership (LLP) is a general partnership with limited liability protection for all of the partners. In an LLP, the partners are usually given the same limited liability protection for the partnership debts that is afforded to the shareholders of a corporation. An LLP is created by registering a general partnership with the appropriate state authority. It is generally taxed as a partnership unless the partners elect corporate tax treatment. 4 All partners can participate in management and enter into contracts on behalf of the partnership. The death, bankruptcy, or withdrawal of any partner in an LLP dissolves the entity, unless the remaining partners elect to continue the business. The assignee of a partner cannot become a substitute partner without the consent of the other partners. [3] Limited Partnership In a limited partnership, the general partner has management rights and liability for partnership debts, while the limited partners are protected against liability and cannot participate in management. A limited partnership must have at least one limited partner and one general partner. A limited partnership is taxed as a partnership for federal income tax purposes unless the partners elect corporate tax treatment. 5 A limited partnership dissolves upon the death, bankruptcy, or withdrawal of a general partner, unless the remaining general partner elects to continue or, if there is no remaining general partner, all of the remaining partners to elect to continue the partnership business. The death or bankruptcy of a limited partner does not dissolve the partnership. The assignee of either a general partner or a limited partner cannot become a substitute partner without the consent of the other partners. [4] Limited Liability Limited Partnership A limited liability limited partnership (LLLP) is a limited partnership that provides limited liability to the general partner as well as the limited partners. It is recognized in a limited number of states and is created by registering a limited partnership with the appropriate state authority. The entity name must have the initials LLLP or RLLLP after its name. An LLLP is generally 3 Treas Reg (a). 4 Id. 5 Id.

10 taxed as a partnership unless the partners elect to be taxed as a corporation. 6 The general partner has all of the management rights and responsibility. The death or bankruptcy of a general partner, but not a limited partner, dissolves the partnership unless the remaining general partner elects to continue or, if no remaining general partner, the limited partners elect to continue the partnership. [5] Limited Liability Company A limited liability company (LLC) is a hybrid of a corporation and a partnership. The owners of the LLC are referred to as members. An LLC will be taxed as a pass-through entity, unless its members elect to be taxed as a corporation. 7 An LLC provides some liability protection for its members similar to that provided by a corporation. Generally, an LLC dissolves upon the death, bankruptcy, or withdrawal of a member, unless the Operating Agreement provides otherwise. A member can transfer his or her interest, but an assignee cannot become a substitute member without the other members consent. Management of an LLC is vested in either the members or managers who are elected by the members. [6] Limited Partnership Association A Limited Partnership Association (LPA) is recognized in only a few states. 8 The owners, who are called members, elect the partnership s managers. An LPA will be taxed as a partnership unless its members elect corporate tax treatment. 9 LPA members are not liable for company debts. In contrast to the LLC, the death, bankruptcy or resignation of an LPA member does not result in dissolution of the LPA. It only dissolves upon a vote of its members, or the expiration of a term specified by the Bylaws. The owner of an LPA interest can transfer the interest, but the assignee cannot become substitute member without the consent of the other members. [7] C Corporation A C corporation is a traditional corporation established under state law. Owners are called shareholders and the corporation is managed by a board of directors. For federal tax purposes, a C corporation is a separate taxpayer which is required to file a return and pay taxes on its income. 10 C corporations provide shareholders with limited liability protection from corporate debts. It does not dissolve except upon vote of the shareholders or expiration of a specified term as established in its articles of incorporation. The shares of a C corporation are transferable and the transferee generally becomes a shareholder unless the corporation s governing documents contain transfer restrictions. [8] S Corporation An S corporation has the same characteristics as a C corporation, except it is a passthrough entity, rather than a separate taxpayer for federal income tax purposes. 11 [9] Sole Proprietorship 6 Id. 7 Id. 8 Colorado and Ohio recognize LPAs. 9 Treas Reg (a). 10 IRC IRC 1363.

11 A sole proprietorship is a business carried on by a single individual which is not a separate entity. The proprietor is owner and manager. All of the proprietorship s income and expenses are reported on the owner s federal tax return, Schedule C. The owner is liable for business debts, and the business terminates when the owner dies. The owner can transfer the business at any time. This chapter will examine the tax considerations that should be taken into account when choosing one entity over another. For purposes of this discussion, the term pass-through entity will refer to any business entity whose income and loss is reported on the owner s federal income tax return that is not a separate taxpaying entity. Thus, it will refer to sole proprietorships, general partnerships, limited liability partnerships, limited partnerships, limited liability limited partnerships, limited liability companies, limited partnership associations, and S corporations as pass-through entities, unless the context provides otherwise Reasons for Choosing a Pass Through Entity Over a C Corporation [1] No Double Tax on Business Earnings The principle advantages of a pass-through entity over a C corporation are (1) a passthrough entity is not a separate taxpayer and does not pay federal income taxes on its earnings; and (2) the business earnings, which are distributed to the owners, are generally taxed once and not subject to the corporate double tax. 12 The pass-through entity s earnings are taxed on the owners tax returns and increases the basis for their ownership interests. 13 This basis increase permits the earnings to be withdrawn from the business without subjecting them to another tax. 14 In a C corporation, the corporation s earnings are taxed at the corporate level. 15 If the earnings are subsequently withdrawn as a dividend, they are taxed again at the shareholder level. 16 Example (1): Frank Co., Inc. is a calendar-year corporation. Frank owns 100% of Frank Co. s stock. During 2010, Frank Co. reported $100,000 of taxable income, and distributed $66,000 to Frank. If Frank Co. was a C corporation during 2010, it would have paid $34,000 of federal taxes on its $100,000 taxable income (assuming a 34 percent federal tax bracket). 17 In addition, Frank would have paid $9,900 of federal taxes (assuming a 15 percent bracket) with respect to the dividend distribution for a total tax liability of $43,900. Example (2): Same facts as Example (1), except Frank Co. is an S corporation during 2011 and Frank is in the 35 percent federal tax income tax bracket. Frank Co. would not pay any federal income 12 IRC 11, 301, 302, 331, 702, 705, 731, 1363, 1367, and However, if an S corporation s earnings are subject to the built-in gains penalty tax (IRC 1374), or the passive investment income penalty tax, a double tax may be applied. 13 IRC 705 and IRC 731 and IRC IRC 301, 302, IRC 11(b). A 5-percent surtax is imposed on corporate income over $100,000 to phase out the 15- and 25-percent brackets. The marginal rate is 39 percent for corporate income between $100,000 and $339,000. $0 - $50,000, 15%; $50,001 to $75,000, 25%; $75,001 to $100,000, 34%; $100,001 to $335,000, 39%; $335,001 to $10,000,000, 34%; $10,000,000 to $15,000,000, 35%; $15,000,001 to $18,300,000, 38%; over $18,300,000, 35%.

12 taxes, because all of the $100,000 of earnings is reported on Frank s returns, increasing Frank s personal tax liability by $35,000. Frank Co. s taxable income increases Frank s stock basis by $100,000. Since the $66,000 distribution is not in excess of Frank s stock basis, no gain is recognized upon the distribution, and his stock basis is reduced by $66,000. Total federal taxes paid with respect to the $100,000 is 35 percent instead of the 43.9 percent paid as a C corporation. Note: If the $100,000 recognized by Frank Co. as an S corporation had been taxable at capital gains tax rates, Frank s tax liability would have been only $15, These tax rate changes complicate the decision as to whether corporate earnings should be reported on a C corporation return or a pass-through entity. To the extent that the shareholder s individual tax bracket is higher than the corporation s tax bracket, it may be beneficial to operate as a C corporation. However, if the C corporation tax bracket would be higher than or equivalent to the shareholder s bracket, then a pass-through entity may be more beneficial. Further consideration must also be given to whether money will be withdrawn from the corporation as a taxable dividend, as a liquidating distribution, or retained in the corporation until the shareholder s death. [2] No C Corporation Penalty Taxes The undistributed earnings of a C corporation, but not a pass-through entity, may be subject to the personal holding company penalty tax 19 and the accumulated earnings penalty tax. For example, an S election avoids the risk of the subjecting corporation to the personal holding company penalty tax for the year that the S election is made and all subsequent years. However, an existing C corporation cannot avoid liability for prior years by making the election. As a practical matter, it is less likely that future audits will raise the problem for prior years. 20 Once the three-year statute of limitation expires, these taxes cannot be assessed for the previous years. [3] No Corporate Alternative Minimum Tax The corporate alternative minimum tax is not applicable to a pass-through entity. 21 Any items of income and deduction that constitute individual preference items pass through as preference items on the owners returns. 22 For a C corporation, the corporate alternative minimum tax can result in unexpected consequences. Excess current earnings, attributable to life insurance proceeds 23 and tax-exempt interest, 24 that do not constitute taxable income may, nevertheless, create an alternative minimum tax liability for the corporation. However, a corporation can eliminate liability for the tax by making an S election, under which there is no liability for the corporate alternative minimum 18 The 35% maximum individual rule and 15% rate for qualified dividends and capital gain is scheduled to expire January 1, IRC 541 imposes a penalty on the undistributed personal holding company income of a corporation. 20 IRC 531 imposes a penalty tax on the accumulated taxable income of a corporation. 21 IRC 1363(a). 22 Because IRC 1363(b) provides that the taxable income of an S corporation is computed in the same manner as that of an individual, it is not subject to the corporate alternative minimum tax. 23 IRC 101 and 56(g). 24 IRC 103 and 56(g).

13 tax. 25 Further, the Section 59A environmental tax, based on alternative minimum taxable income, also does not apply to S corporations. This tax is computed at 0.12 percent of the excess of modified alternative minimum taxable income over $2 million. [4] Pass Through of Losses C corporations are taxable entities and corporate deductions and losses cannot be used to reduce taxes on the shareholder s individual tax returns. Pass-through entities, on the other hand, are frequently used to allow start-up businesses to pass their initial losses and credits through to their shareholders to be used against other income. However, existing C corporations that are anticipating operating losses can also gain this benefit from an S election. In addition, the benefits to the owners can still be significant, despite being subject to a variety of limitations including basis, 26 at-risk rules 27 and passive activity loss rules. 28 [5] Avoiding Thin Capitalization Problems A shareholder who lends money to a C corporation runs the risk that the Service may recharacterize the loan as a disguised equity contribution. 29 In that event, the Service would recharacterize both interest and principal repayment as dividend distributions. Although IRC Section 385, enacted in 1969, directed the Service to issue regulations to establish guidelines for recharacterization, no final regulations are in place. 30 For a pass-through entity, recharacterization is not a risk because whether a payment to the owner is interest, principal repayment, or a distribution, the tax treatment is not materially affected. In the case of an S corporation, the rules create a safe harbor for shareholder loans. 31 If the shareholder loans constitute straight-debt, they are not treated as a second class of stock IRC 1366(b) provides that the tax character of items are retained when they pass through to shareholders. 26 IRC 705 and 1366(d). 27 IRC 465. One major advantage of avoiding the corporate alternative minimum tax is that it avoids the excess current earnings preference item that is applicable to C corporations. For tax years beginning in 1990 and thereafter, the preference item is 75 percent of the excess of current earnings over alternative minimum taxable income. 28 IRC If a loan is recharacterized as equity, interest payments are treated as dividends and no interest deduction is allowed to the corporation. 30 IRC 385 established five factors to be taken into account: (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money s worth and to pay a fixed rate of interest; (2) whether there is subordination to or preference over any indebtedness of the corporation; (3) the ratio of debt to equity of the corporation; (4) whether there is convertibility into stock of the corporation; and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question. 31 IRC 1361(c)(5). 32 IRC 1361(b)(1)(D). There is nothing in the statute to prohibit the Service from taking the position that the straight debt, while not a second class of stock, nonetheless represents equity of the same classes outstanding. However, in the case of an S corporation, this recharacterization does not produce a detrimental result. The recharacterization of interest to a distribution does not result in a double tax on the earnings because of the pass through rules for S corporations.

14 [6] Passive Activity Losses Certain closely held C corporations are subject to the passive activity loss limitations. These suspended losses cannot be used against the shareholder s income because the corporation is a separate taxpaying entity. 33 In a pass-through entity, an owner that does not materially participate in the business will incur passive activity income from his or her distributive share. 34 An S election may be a method of unlocking business income of a C corporation and converting it into passive income that can then be offset by passive losses from other business activities. The characterization as passive activity income under IRC Section 469 depends on whether shareholders materially participate in the activities of the corporation. 35 Example: Alan and Ben are equal shareholders in Inc., a C corporation. Alan materially participates, but Ben does not. Inc. is a profitable corporation and pays a $50,000 dividend to Alan and Ben. If Ben has passive activity losses, he will not be able to deduct them against the dividends. However, if Inc. makes an S election, Ben s share of the income will be passive activity income that can be offset against the losses. [7] No Double Tax on Liquidation of a Business The Tax Reform Act of 1986 (TRA 1986) drastically revised the tax consequences of distributions of appreciated property upon liquidation of a corporation. Subject to certain transition rules, IRC Sections 336, 337, and 338 require gain to be recognized to a corporation whenever the corporation makes a liquidating distribution of appreciated property to its shareholders. Thus, an asset sale by a C corporation followed by a liquidation, results in a double tax of the sales proceeds. A pass-through entity generally avoids these results. Any gain recognized to the entity from a sale of its assets passes through to the owners and increases the tax basis for their ownership interest in the corporation, thus reducing the owners gain upon receipt of the liquidating distribution. 36 Note, however, in the case of an S corporation, the builtin gains penalty tax may be applicable. Example (1): Benco, Inc. is a calendar-year C corporation, all of the stock of which is owned by Ben. On January 10, 2011, when Benco s sole asset is a parcel of real estate with a fair market value of $1 million, and a tax basis of $200,000, Benco sold the real estate for $1 million and liquidated. Ben s tax basis for his Benco stock is $10,000. Benco s $800,000 gain on the sale is taxed at 34 percent. The shareholder gain on the liquidating distribution is taxed at 15 percent. 33 IRC IRC IRC 469 defines material participation as regular, continuous, and substantial involvement in the operations of an activity. See IRC 469(h)(1). Note: The determination of material participation is more favorable for S shareholders than for limited partners or members of a limited liability company. See Temp Treas Reg T(a) and Temp Treas Reg T(e)(3)(I)(B). 36 IRC 705, 731, 1367 and This approach works best under the following circumstances: (1) the shareholder s stock basis is less than the corporation s basis for its assets; or (2) the corporation has only capital assets. To the extent that ordinary income is recognized (producing a basis in excess of the liquidation proceeds), an offsetting capital loss will not completely eliminate the ordinary income. However, if the basis increase equals the amount of the liquidation proceeds and the tax rate for capital gains and ordinary income remains at 28 percent, there is an offsetting deduction.

15 #Table Corporate tax ($800, percent) = $272,000 Shareholder tax ($1,000,000 $272,000 $10,000 15%) = $107,700 Total tax $379,700 Net to shareholder $620,300 #Table Example (2): Same facts as Example (1), except Benco is an S corporation and is not subject to the built-in gains penalty tax. #Table Corporate tax $ 0 Shareholder tax ($1mm 10,000 15%) $148,500 Total tax $148,500 Net to shareholder $851,500 #Table [8] Avoiding Reasonable Compensation Problems Generally, C corporations can deduct salaries and other compensation to its owners to the extent that it is a reasonable value for the services rendered. Excessive compensation can be recharacterized as dividends by the Service. 37 However, it usually makes little difference for a pass-through whether earnings are paid out to the owners as distributions or salary. 38 [9] Accounting Methods Certain C corporations are not permitted to use the cash method of accounting. 39 The cash method of accounting is permissible for pass-through entities even if gross receipts exceed $5 million. 40 However, may not be permitted to use the cash method of accounting if it meets the definition of a tax shelter. For these purposes, a tax shelter is a pass-through entity in which more than 35 percent of its losses would be allocated to owners who did not actively participate 37 IRC 162; Treas Reg There are cases in which the characterization of an item as a dividend distribution can make a difference for contributions to retirement plans, creation of a second class of stock, distributions out of earnings and profits and, in the past, for determining whether or not the earnings were subject to the 50 percent maximum tax on personal service income.. 39 IRC 448(a)(1). 40 IRC 448(a)(1).

16 in the corporation s management. 41 [10] NOL Carryovers IRC Sections 382, 383, and 384 provide annual limitations on a C corporation s NOL carrybacks and carryforwards when there has been a more than 50 percent stock ownership change during any three-year period. 42 These limitations are not applicable to pass-through entities. Rather, in a pass-through entity, any losses that flowed to the owner can be carried forward or back on their returns without regard to any change of ownership in the entity. However, if the owner of a pass-through entity does not have sufficient basis to use a loss and later sells his ownership interest before acquiring additional bases to use the loss, the use of the loss is forfeited. The loss is effectively waived because the owner does not accede to it. 43 [11] Family Income Splitting Despite the kiddie tax, 44 a pass-through entity can be used to split income among family members. If the children are owners, income can be taxed at their brackets rather than at those of the parents (provided the children are age 14 and older) without incurring a gift tax by the parents. Also, reasonable compensation must be paid to family members for services rendered and use of capital. 45 [12] Special Tax Treatment for Capital Gains and Losses The capital gains recognized by a pass-through entity are taxed at a maximum rate of 15 percent on an individual return, 46 versus 34 percent on a C corporation return (35 percent for large corporations and personal service companies). 47 Capital losses passed through to the owner of a pass-through entity can be applied against non-business capital gains, subject to the passive activity loss limitations of IRC Section 469. In addition, capital losses, in excess of capital gains, can be deducted up to $3,000 per year with no limit on the number of years the loss can be carried forward. 48 C corporation returns make no provision for the deduction of excess capital losses and allow a carryforward of capital losses as an offset against capital gains for a five-year period only. 49 [13] Golden Parachute Payments Compensation paid to an executive of a pass-through entity under a golden parachute 41 See IRC 448(a)(3), 448(d)(3), 461(I)(3), 464(e)(2), 1256(e)(3)(B). 42 IRC 382, 1363(c).IRC 382 limits the use of pre-stock ownership change NOLs against postownership change income. Note, however, that NOL carryovers can be used to reduce the built-in gains penalty tax. See IRC 1374(b)(2). To that extent, the IRC 382 limitations can apply to S corporations. 43 IRC 705 and 1366(d)(2) limits the carryover of a suspended loss to the partner or shareholder who was originally allocated the loss. 44 IRC 1(g). 45 IRC 704(c) and 1366(e). 46 IRC 1(h). Some capital gains are taxed at 25% and 28%. 47 IRC 11(b). 48 IRC 1212(b). 49 IRC 1212(a).

17 agreement is not disallowed, as it would be for a C corporation. 50 For example, if the S corporation anticipates a sale to another corporation, and a golden parachute agreement is in effect, retaining the S corporation format would be advantageous. [14] Self-Employment Income Distributions of earnings of a C corporation are subject to a double tax, therefore, most payments to shareholder-employees will take the form of compensation and be subject to both FICA and Medicare taxes. An S corporation s distributions are not currently subject to the employment taxes when the IRS can recharacterize a distribution as wages. For pass-through entities other than S corporations, all of the business earnings are treated as net earnings from self-employment and subject to self-employment taxes, unless the owner is treated as a limited partner. [15] Charitable Contributions C corporations are allowed a deduction for charitable contributions, but not in excess of 10 percent of taxable income. 51 Charitable contributions by a pass-through entity are reported by the entity s owners and not subject to the 10 percent limitation. The pass-through of charitable contributions from S corporations allows individual taxpayers to deduct such contributions up to a maximum of 50 percent of adjusted gross income. 52 [16] Distributions of Appreciated Property Distributions of appreciated property from a C corporation to its shareholders as a dividend, redemption, or liquidating distribution, causes the corporation to recognize a gain equal to the difference between the fair market value and the corporation s tax basis for the property. 53 For pass-through entities, other than S corporations, pro rata distributions of appreciated property are generally not a taxable event. 54 S corporation distributions of appreciated property, however, causes gain to be recognized by the corporation. 55 [17] Estimated Tax Payments C corporations must make estimated tax payments. 56 A C corporation with $1 million or more in taxable income in one of its three preceding tax years, must pay in 100 percent of its computed estimate of income tax liability or it will be subject to estimated tax penalties. 57 For the owners of pass-through entities, in taxable years beginning in 1994, 110 percent of their prior year s tax can be used as a safe harbor. 58 Further, pass-through entity owners may also pay in 90 percent of the current year s tax liability and avoid the estimated tax penalties. 59 Additionally, 50 IRC 280G(b)(5)(A)(I), 280G(a). 51 IRC 170(b)(2). 52 IRC 170(b)(1). 53 IRC 311 and IRC 731 and IRC 331 and IRC 6655(d)(1)(B)(2). 57 IRC 6654(d)(1)(C). 58 IRC 6654(d)(1)(B)(I). 59 Id.

18 pass-through entity owners should take into account the entity s income on a quarterly basis for purposes of computing the quarterly estimated taxes due. [18] Liabilities and Basis A C corporation owner cannot include any corporate liabilities in calculating the tax basis of their stock in the corporation. The same is true of an S shareholder. 60 An S shareholder s basis is limited to stock basis and basis in debt owed to him by the corporation. 61 Further, basis is not increased by any third-party loan to the corporation even if the shareholder guaranteed the debt. 62 S shareholder payments on guarantees of corporate debt is required in order to create basis. 63 Additionally, delivery of a shareholder s note to third-party creditors is not sufficient unless the corporation is relieved of liability. 64 To achieve leveraged deductions, S shareholders must borrow directly and then contribute, or loan, to the corporation. 65 In contrast, the basis rules for partnerships and LLCs allow both recourse and nonrecourse liabilities to increase a partner s tax basis for purposes of deducting losses and determining the tax liability of distributions. 66 [19] Investment Interest Deduction Limitations IRC Section 163(d) limits deductions for investment interest expense to the owner s investment income. Interest paid on a debt incurred by a shareholder to buy stock in a C corporation is treated as investment interest and subject to the IRC Section 163(d) limitation. Interest paid by a C corporation, however, is not subject to the investment interest limitation. 67 Pass-through entities must separately determine investment income, investment expense, and investment interest at the entity level. 68 These amounts are then combined with the owner s other investment items to calculate the limitation on deductions of investment interest. Interest paid on debt incurred to purchase an interest in a pass-through entity will not be subject to the investment interest limitation, except to the extent the debt is allocable to the investment, as opposed to business activities of the pass-through entity. 69 [20] Equity for Services If an employee of a C corporation or S corporation receives stock as compensation for services, income is recognized based on the fair market value of the stock received. 70 However, 60 IRC IRC 1366 and See Chapter Id. 64 Id. 65 Id. 66 IRC 752(a). 67 IRC 1363(d). 68 IRC Notice 89-23, C.B Id. 70 IRC 83.

19 an employee of an LLC or a partnership can receive a profits interest as compensation for services without any tax consequences Reasons For Choosing a C Corporation Over a Pass- Through Entity Although pass-through entities generally enjoy more favorable tax treatment than C corporations, there are a number of situations in which a C corporation may be more advantageous. [1] Lower C Corporation Tax Rates With the passage of the 2003 Tax Act, the highest marginal individual income tax rate equals the highest marginal corporate rate (35 percent versus 35 percent). 72 C corporations retain the benefit of graduated income tax rates. Taxable income up to $50,000 is taxed at 15 percent. Thus, earnings not distributed to shareholders that are used to purchase wasting assets, or to pay debt or redeem stock can be subject to a much lower tax rate. The retention of earnings in the corporation will produce a lower overall tax than if the S election were made only for taxable income of $100,000 or less. 73 The following chart illustrates the tax savings available to a corporation over an S corporation, assuming a 35 percent ordinary income rate and 15 percent capital gains rate for the shareholders. This chart also takes into account the impact of the double tax associated with distributions of corporate earnings. #Table C Corporations $50,000. $75,000. $100,000. $400,000. Taxable income: Corporate Tax ( 7,500.) (13,750.) ( 22,250.) (136,000) Shareholder tax (6,375.) (9,187.) (11,663.) (39,600.) Net $36,125. $52,003. $66,087. $225,000. Total Tax $13,875. $22,937. $33,913. $175,000. Effective Tax Rate 27.75% 30.5% 33.91% 43.9% S Corporations $50,000. $75,000. $100,000. $400,000. Taxable income: Corporate Tax Shareholder tax (17,500.) (26,250.) (35,000.) (140,000.) Net $32,500. $48,750. $65,000. $260, Rev Proc 93-27, C.B IRC 1(a), (b), (c), (d), and 11(b). 73 But the double tax on distributions of corporate earnings will generally outweigh the benefits of the lower C corporation tax rate.

20 Total Tax $17,500. $26,250. $35,000. $140,000. Effective Tax Rate 35.% 35.% 35.% 35.% #Table [2] Passive Loss Rules A pass-through entity engaged in multiple activities within the meaning of IRC Section 469, some of which are passive and others of which are nonpassive, cannot use passive losses to offset nonpassive income. 74 Under IRC Section 469, passive activity losses can be used to offset operating income of a C corporation, but not an S corporation. 75 An S corporation shareholder who does not materially participate in the corporation s activities may not be able to use the losses. By retaining C corporation status, these losses may provide some current benefit by reducing the C corporation s tax liability or by offsetting all corporate losses against the income. 76 [3] Statutory Fringe Benefits Certain statutory fringe benefits, such as accident and health insurance, group term life insurance, and the exclusion for meals and lodging, are not generally available to owners of passthrough entities. 77 (See discussion in Chapter 10.) The shareholder-employees of a C corporation are not subject to these limitations. The corporation can deduct the cost of fringe benefits paid on behalf of its shareholder-employees, and the employee can exclude the value of the fringe benefit from his income. [4] Choice of Taxable Year A pass-through entity s taxable year is generally required to be a calendar year unless a business purpose year can be established or the pass-through entity makes a valid Section 444 election. (See Chapter 2.) The loss of a fiscal year can restrict the corporation s ability to shift income between taxable years of the shareholder. For example, if a C corporation has a January 31 fiscal year, bonuses can be paid out in either December or January and still be deductible in the C corporation s January 31 fiscal year return. This planning is not available to S corporations that are required to use a calendar year. [5] Depleting the Corporation s Capital Some lenders perceive a pass-through entity to be a higher credit risk than a C corporation. The conduit nature of a pass-through entity causes lenders to be concerned that owners can drain all of its capital, leaving a shell corporation. Although state law requirements 74 IRC 469(a)(2); Temp Treas Reg T(g). 75 IRC 469(e)(2) allows passive losses in closely held C corporations to offset active business income but not portfolio income. 76 Id. 77 The statute does not specifically deny any deduction to the corporation or to the shareholders. IRC 1372 treats an S shareholder who owns 2% or more of the stock as a partner and the S corporation as a partnership for purposes of fringe benefits. Thus, deductions or tax benefits for fringe benefits that are available to partners are also available to S shareholders. See IRC 162(l)(6), which allows S shareholders a 25% deduction for health insurance premiums paid in tax years beginning before January 1, 1994.

21 for pass-through entities and C corporations are the same (both are corporations under state law), this perception does not exist for C corporations. To some extent, the solution is to educate lenders about the principles of a pass-through entity. The bank may wish to impose a restriction limiting the amount that owners may withdraw to that which is needed to pay taxes on the income passed through. [6] Availability of Certain Deductions A C corporation, unlike a pass-through entity, is allowed to deduct accrued rents, bonuses, and interest payments owed to shareholders who own 50 percent or less of the corporation, provided that such expenses are paid within two and one-half months after the end of the taxable year and are taxed on those amounts in that year. 78 In addition, the corporation is allowed the dividends received deduction, which can range from 70 percent to 100 percent of the dividend income. 79 [7] Alternative Minimum Tax Rates The Revenue Reconciliation Act of 1993 increased substantially the alternative minimum tax rates charged to individuals for tax years beginning in The alternative minimum tax rate for individuals is 26 percent for alternative minimum tax income up to $175,000, and 28 percent for alternative minimum tax income in excess of $175, The corporate alternative minimum tax rate remains at 20 percent. 81 An exemption of $40,000 is available to corporate filers, 82 while a $45,000 exemption is available to shareholders filing a joint return. 83 [8] Qualified Small Business Stock IRC Section 1202 provides for a capital gain exclusion of up to 50 percent on the sale of stock in a C corporation which meet the definition of qualified small business stock. 84 The effect of the Section 1202 deduction is to reduce the capital gain rate to 14 percent. Only stock in a C corporation will qualify for the exclusion. Pass-through entities are allowed to hold qualified small business stock and pass through the exclusion to its shareholders. 85 The stock, however, must have been held for more than five years and issued after August 10, The amount of gain that is excluded is subject to certain per-issuer limits. The stock must be owned by a corporation that conducts a qualified business and meets a gross assets test. A qualified trade or business for these purposes does not include service-oriented businesses, such as accounting, law, or architecture, where the principal asset is the reputation of 78 IRC 267(a)(1), 276(b)(2), 267(e); Treas Reg 1.404(b)-1T. 79 IRC 243, IRC 55(b)(1)(A). 81 IRC 55(b)(1)(B). 82 IRC 55(b)(1)(B). 83 IRC 55(d)(1)(A). 84 IRC 1202(a). For 2009 and certain periods in 2010, the exclusion is 75% and for certain periods in 2011, the exclusion is 100%. See 1202(a)(3) and (4) (c)(1). 86 IRC 1202(g)(1).

22 one or more employees; banking or franchising; farming; businesses extracting natural resources eligible for percentage depletion; and trades or businesses operating hotels, restaurants, or other similar ventures. 87 Prior to, and immediately after the issue date, a qualified small business corporation s gross assets cannot exceed $50 million any time after August 10, Gross assets are cash plus the aggregate adjusted bases of all other corporate property, determined as if the bases were equal to the property s fair market value immediately after the contribution. If the corporation subsequently exceeds the $50 million limit, it is not disqualified; however, the corporation can never again issue qualified stock. 88 The corporation must also meet an active business requirement Tax Characteristics Common to Partnerships and S Corporations Pass-through entities, such as an S corporations and partnerships (including LLCs taxable as partnerships), share several similar operational provisions. In fact, the Committee Reports discussing the Subchapter S Revision Act of 1982 specifically noted that the goal of the Act was to adopt the pass-through characteristics of partnerships for S corporations. 90 Thus, a number of operational rules are essentially the same for both types of entities, as set forth below. [1] Conduit Theory Both S corporations and partnerships are treated as conduits for federal income tax purposes. Neither is a separate taxable entity; income, loss, deduction and credit from each entity flows through and is reported on the shareholder s return, irrespective of whether the income is actually distributed. 91 [2] Limitations on Losses Inclusion of Liabilities in Basis Both partnerships and S corporations allow losses to pass through and be deducted on the shareholder s return, but only to the extent of basis. 92 Shareholders can deduct losses to the extent of stock and debt basis. 93 Partners, however, can only deduct losses to the extent of their basis in their partnership interest. 94 An S shareholder s basis is limited to stock basis and basis in debt owed to him by the corporation. Basis is not increased by any third-party loan to the corporation even if they are guaranteed by the shareholder. 95 Shareholder payments on guarantees of corporate debt is 87 IRC 1202(g)(3). 88 IRC 1202(c)(1) and IRC 1202(a). 89 IRC 1202(b), 1202(e)(3), 1202(d), 1202(e). 90 S Rep No 640, 97th Cong, 2d Sess (1982), reprinted in CB 718. For purposes of the following discussion, all references to partnerships should include limited liability companies to the extent they are treated as partnerships for federal income tax purposes. 91 IRC 701, 702, 703, 1363, and See, however, Chapter 7for a discussion of S corporation corporate-level penalty taxes. 92 IRC 704(d), 1366(d). 93 IRC 1366(d). 94 IRC 1366(d). 95 See Ch 9.