CHOICE OF ENTITY TAX CONSIDERATIONS by Curtis L. Harrington HARRINGTON & HARRINGTON 6300 State University Drive, Suite 250 Long Beach, CA 90815 (562) 594-9784, Fax: (562) 594-4414 http:/www.patentax.com E-mail: curt@patentax.com PATEN TAX® A PATEN TAX® PRESENTATION Disclaimer: Educational Only: This outline is Educational Only and no part of this presentation can be considered as federal or state tax advice, opinion, or position and is not intended or written to be used, and may not be used, for the purpose of (I) avoiding tax-related penalties under the internal revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein, nor (iii) constituting guidance on any tax or intellectual property matter. I. The Table of Contents Description II. Why a Table of Contents? III. Objectives desired for Entities A. Ownership of Assets, Rights & Profits B. Carrying on a Business C. Insulation from Creditor Liability D. Insulation from Personal Liability E. Separation of for-profit from nonprofit activities F. Tax Minimization 1. Configuring to meet Congressional Intent 2. Avoiding Double Taxation 3. Use of entity relationships to construct a tax minimizing configuration IV. Types of business Entities A. Aspects of Relationship B. Sole Proprietorship C. Co-Tenancy D. Partnership E. Limited Partnership F. Limited Liability Partnership G. S Corporation H. LLC (Limited Liability Company) I. C Corporation J. Unincorporated Association V. Other Considerations (beyond the scope of this outline) A. Mergers & Acquisitions, Splitoffs, and their taxation. B. Effects of sale of ownership shares or assets C. Nonprofit Corporations in California D. Reorganization E. Poison Pill and resisting takeover F. Dissolution and final distribution of assets. II. Why a Table of Contents? A. It enables Preview, Interview, Post View 1. By reviewing all of the categories, you will be able to see what is coming in the presentation, and when it will be presented. It will help to mark your questions at coming categories, the questions to be asked if they were not already answered in advance in that category. 2. The Table of Contents enables a quicker find, based upon the location in various aspects of the reasons for and possibilities with each entity. B. It helps to organize a body of materials which are generally disjointed, in some logical way. III. Objectives desired for Entities A. Ownership of Assets, Rights & Profits 1. Individual Ownership is the starting point. All entities either emulate or make some modification to individual ownership. Because they own property, entities are treated like persons for some purposes (e.g. liability for ownership of the asset) and not a person for other purposes (entities cannot generally invoke the 5th amendment, for example). 2. The rights to the use of Assets, Rights & Profits can controlled by agreements and by entity formation documents, as well as by laws which permit different types of actions for different types of entities. Specific entities carry generalized templates for affecting what owners can and cannot do. For example, a shareholder in a corporation generally has no right to "borrow" corporate assets unilaterally. Likewise, a trustee owner cannot use assets which were intended for the use of a beneficiary. 3. Contractual provisions can be used between entities and between individuals and entities to set their rights, liabilities, and participation. There are many cases in which an erroneous belief exists that the formation of an entity is necessary to achieve a result, when the same result can be obtained even more directly, and some times more succinctly by contract formation. A good example is the formation of a mechanism whereby some individuals are to be paid at the expense of others until some payback or time threshold is met. 4. Contracts are sometimes defeated by entity relationships. A contract purporting to create arms' length relationships and the resulting arms' length tax treatment can be defeated, even by unintended organizational relationships. Related taxpayers are limited in the deductions they can claims when they do business with each other. A corporate officer who knows of a business opportunity may be barred from taking advantage of it where the opportunity might have been related to the business in which his corporation is engaged. 5. The law puts limits upon rights, liabilities, and participation both with respect to taxation, transfer, and succession of entity rights. For example, an inheritor of a partnership interest has no right to be partner with the others in the partnership. Conversely, an inheritor in shares has the same voting right as the person who left the shares. In another example, it is generally illegal to pass personal property owned by an individual other than by will, yet the family limited partnership is used to circumvent the will restrictions. 6. Ownership and transfer of fractional interests in property, or in the entity owning the property permits the use of "discounts" on the value transferred. Entity ownership facilitates fractionalization, and the ability to subdivide transfers can reduce taxes (both realized profit and estate taxes) on the transfer. An asset worth $1,000,000 can be transferred as if it were worth $500,000. Discounts may be taken as to fractional interest and "control". B. Carrying on a Business 1. Entity formation helps to encapsulate an ongoing business into a separate "bundle". This has a number of advantages: (a) An entities' separate character helps to better measure the business' performance. (b) An entities' separate character enables it to succeed through many generations, not being tied directly to the mortality or health of its members. (c) An entity with greater longevity is more likely to have a generally more formal defined command and control structure which facilitates the ability of the organization to flourish in the more complex business environment of today. (d) entities structure enables a change in ownership of proportional ownership and thus enable a facilitated supply and demand function of the entity's value. In the long run this helps efficient, profitable entities to attract new capital. C. Insulation from Creditor Liability (a) Just as trusts can separate ownership of a property from its benefits, most business entities provide for insulation from creditor liability. In the case where a sole owner forms a business entity, the liabilities that the business entity create may be limited to the total capitalization of the entity. (b) Preservation of insulation from the liabilities to creditors is dependent upon the owners and operators of the business keeping it separate from their own affairs. (c) Insulation and relatedness are referred to as "entity" theory where the organization is treated as a single entity, and "aggregate" theory where the entity is treated as a collection of individual owners. D. Insulation from Personal Liability (a) In addition to creditor liability insulation, personal acts of an individual acting within the entity are protected within a band of activity which is not extremely negligent nor extremely willful. An act which is criminally negligent can result in personal criminal liability while an intentional criminal act can also result in personal criminal liability. Certain strict liability crimes can, by statute, result in liability of the organizational officers who ordered the actions constituting the crime. (b) The principle of acting "ultra vires", that is, outside the scope of permitted activity of the organization, can affect personal liability. An organization will be limited by its stated filing papers or its internal policies and procedures, as well as the formal parliamentary acts of the governing board. (c) Where dual liability exists, or where individual officer or entity head becomes embroiled in an issue which might result in some personal liability for an individual officer or entity head, the responsibility of the entity to either pay for civil liability or defense of civil liability will depend upon the contract with its members and its entity internal policies. (d) Several statutes provide tax liability to organization members. Briefly these include §6672 (liability for responsible persons who willfully fail to pay tax), §3505 (any third party who is responsible for directly paying the tax on wages of employees), §3713 (failure of a third party to remit monies owed to the federal government over others), §6901 (third party transferee liability where the transferor owed taxes), as well as state provisions. E. Separation of benefits, activities, and functions. 1. Entities can be used to separate benefits to different classes of individuals or other organizations. Examples include payment of different amounts to different classes stock, or the requirement for some partners in a partnership to contribute working capital while others do not. 2. The ability to separate activities can be advantageous. Separation can prevent a high risk business from causing losses in a lower risk business. Separation can help to sell one business while keeping another, without simply creating a sale of assets. 3. To the extent that some benefits, activities, and functions are not desired to be separated, contracts and insurance can fill the gap to complete the control desired. F. Tax Minimization 1. Configuring to meet Congressional Intent. It is well established that exclusions from income and allowability of deductions is at the whim of Congress, and of the state and local taxing agencies. Where Congress gives certain benefits to certain entities and withholds them from others, there may be no logic in the legislation. Often picking the best entity for a given business is difficult. Even where all of the factors are considered in depth in selecting an entity, conditions may change to make the entity non-optimum. Even if business conditions do not change, congressional action can "change the rules" such that a selection of one entity may be non-optimum after new legislation is passed. 2. Avoiding Double Taxation. Some entities attract tax at the entity level and then provide for tax to individuals receiving profits from the entity. Other entities attract no tax at the entity level. 3. Use of entity relationships to construct a tax minimizing configuration. American tax law has long established the right of taxpayers to arrange their affairs so as to minimize taxation. However, the creation of entities and entity relationships to take advantage of form over substance tax advantage may be nullified under a theory requiring "economic substance". The bright line for economic substance generally doesn't exist and can vary based upon the transaction. Probability and statistics can come into play where a required element of risk is required. For example: Samueli 32 TC No. 4 ; Docket Nos. 13953-06, 14147-06. (3/16/2009) involved an agreement in an underlying securities transaction which statistically reduced an opportunity for gain (by limiting the ability for transfer of securities to only three (specific) days out of a 450 day transaction period. Code Sec. 1058(b)(3) requires no reduction on the lender's gain opportunity. Although there was no limitation on gain for the 3 days in which the securities could have been returned, given the statistical restriction that 3 days represented out of 450 days, the court held that there was an effective bar on the lender's opportunity for gain. Thus, if one party's opportunity is severely restricted (statistically minimized), it exposes the transaction as form over economic substance. IV. Types of business Entities A. Aspects of Relationship 1. Ownership of Property. This includes legal title and beneficial ownership. Basis of property passing into and out of the entity. Tax effects resulting from moving property into and out of the entity. 2. Extent of Liability. Liability to co-participants. Liability to outsiders/creditors. 3. Extent of taxation for normal business income activity. Extent of taxation for sale of assets. 4. Merger and acquisition of one entity by another, both for same and different business entities. Splitoff and dissolution. B. Sole Proprietorship 1. Base Case and for providing comparison for other entities. 2. Single owner will typically own both their own personal assets as well as the business assets. Difference between personal ownership and business ownership of assets is extreme. Business asset ownership is shown by "reasonable and necessary" as in IRC §167, by keeping a listing of business assets and depreciation schedule, and by insuring that they are segregated. 3. Business name can be in accord with the name of the owner, or a DBA (a listing that helps plaintiff's sue the correct entity) or a name associated with a formal state filing of an entity. 4. Owner is always liable personally. The only method to reduce exposure is by the purchase of insurance or the provision of indemnity in contracts with others. 5. Tax filing for business is via Schedule C, as an adjunct to the 1040 tax return for the individual. Previous inability to deduct health insurance premiums was phased in several years ago. Business use of vehicle is typically on a mileage basis. 6. Basis of assets converted to business use is the lesser of the FMV of the asset or the adjusted basis of the asset at the time of transfer. 7. General Characteristics: (a) very informal, (b) the only additional tax filing is the schedule C, (c) no additional franchise tax or costs for tax compliance, & (d) asset ownership either continues or is part of the owners asset base. C. Co-Tenancy. 1. Main characteristic is Co-ownership and usually with land. Two or more people have common ownership of an asset and cooperate with each other to preserve and/or benefit from property. Usually all owners have rights in all of the assets. Generally includes a right of partition where practical. Co-tenants are said to serve personal interests rather than a joint profitability. Strangely, patent rights are personal property and co-inventors who did not plan to go into business or envision common profit. Where one inventor invents chocolate and the other invents peanut butter and they bump into each other, they invent the Reese's cup with no intention to go into business together. They may plan to go into business together, but they would be partners. Without such plans for joint profit, and stopping at the time of the joint invention, they are co-tenants. Much like the house inherited from the parents, either can destroy the invention by allowing others to use it for free. To preserve the property they need only agree to deal jointly. 2. Other cotenancy examples includes sharing an office, but keeping separate practices at the office location. Sharing an investment such as co-ownership in a REIT. Sharing ownership passively in an asset. 3. Where the property makes a distributed profit, each co-tenant reports and pays tax on their separate share. Schedule C (non passive) or E (passive) is used depending upon the character of the income produced. Unlike a partnership, the other co-tenants cannot object to a new and different cotenant resulting from sale of a cotenant's interest. 4. The base relationship of co-tenancy may have no, or very little cross agency. The cross agency necessary to preserve the assets represents a move toward a threshold beyond which the relationship will be held to be a partnership. Right of survivorship is the first threshold in the direction of partnership, but joint survivorship requires unity of time, title, interest and possession. As a result, and unless a property was left to someone under conditions of joint tenancy with right of survivorship, the state must be created by re-conveyance, or by cross conveyance of remainder interests. 5. The patent case demonstrates a cross agency which is necessary to preserve the property. Because of the negative nature of the patent asset, the fact that all interest holders must join and assent to the enforcement of the patent, one single owner, no matter how small, can license others and effectively destroy the patent. Where the co-inventors agree to only license to one agreed licensee, there is no clause causing equal terms and no partnership results. D. Partnership 1. The members go beyond the threshold of agreeing to preserve assets, (and perhaps in the patent case of agreeing to preserve each others exclusive position) but beyond this to empower each other to actively operate the business on each other's behalf. 2. Each partner is considered as active as every other partner in running the business, with any restrictions on the partners by their agreement. Any partner can bind the partnership. All partners are personally liable for partnership debts, although there is an organizational respect between the partnership as a single entity versus its aggregative nature. A judgement against a partnership does not per se create a judgement in favor of the partners CA Corporations code §16307(c). A creditor of a partner may not obtain judgement against or attach the assets of the partnership. 3. Partnerships formed for holding intellectual property maintain the individual "holder" status of the partners. It is unsettled whether this can be done with other pass-through entities. Since the liability involved in holding patent-type intellectual property is slight to zero, a partnership for holding intellectual property is optimum where it is desired to reap the "instant capital gains of IRC § 1235. 4. A partnership can elect to be taxed as a corporation, or as a pass through entity. The remainder of the discussion for a partnership will assume pass-thru rather than corporate characteristics. 5. A partnership as a pass-through entity can agree upon a formula for partners interests, liabilities to the other partners, participation in profits, requirement to contribute capital, requirement to cover losses, and more. Partnerships may have a more limited life as generally the remaining partners need not accept a substituted partner into the group, such as may occur upon death of a partner. The formulas for partner interests and liability should be clear and unambiguous as they may be needed to support that partner's tax position if questioned. 6. Partnerships use a more complex basis system, including an outside basis for property before it entered the business (also known as "basis of partners interest") and an inside basis of the property as it enters and is depreciated by the partnership (also known as "basis of partnership assets). A short list is as follows: (a) Property owned by a partner and then transferred into the partnership has an outside bases equivalent to the adjusted basis of the asset in the hand of the partner when transferred (increased by any gain at the time of transfer) (IRC §723). However, non-business assets (such an automobile) are limited to the lesser of adjusted basis or fair market value (similar to that for sole proprietorship property) Reg. § 1.167(g)-1 (b) No gain or loss occurs upon contribution of property to a partnership (IRC §721), except for "investment company partnerships"(IRC §721(b)) . There is no restriction as to the size of the partnership interest similar to the "control" requirement when forming a corporation. (c) Transfer of encumbered property results in "gain" to the extent that the partnership assumes the liability. (d) Holding periods are "tacked" from the holding period of the contributor of the partnership property.(IRC 1223(1)). Where property contributed is not capital gain property in the hands of the contributor, the IRS take the position that the holding period of the shares are split in proportion to the fair market value of the contributed assets Rev. Rul 85-164. (e) "Partnership share in exchange for services". The value of the partnership interest is considered "ordinary income" under IRC § 61. A partnership share received can be a "capital interest" or a "future profits interest". Either interest will increase the new partner's capital account, but a "future profits interest" has no immediate effect depending upon how it is drafted. A "capital interest" is measured as if the partnership dissolved the same day and would have resulted in a payment to the new partner. (f) Outside basis: + rises with capital contributions by the partner + rises with the increase of his distributive share of income ( ) decreases with distributions to that partner ( ) decreases as to the amount of partnership losses ( ) decreases with nondeductible, non capital amounts ( ) decreases as to the amount of capital depreciation (g) Organization expenses may be amortized over a 60 month period (IRC § 709(b)) (h) Partner's losses generated by the partnership are limited to that partner's outside basis (IRC § 704(d) & IRC §705(a)2). (I) Partnership interests subject to at-risk and passive loss limitations at the partner level. (IRC §465 & IRC §469(a) ) (j) Active partner income is subject to self employment tax. Losses and gains flow through to the partner as an individual tax filer. 7. Many of the corporation deductions for benefits, such as qualified retirement plans, life insurance, accident insurance, cafeteria plans, incentive share offerings, etc., are unavailable. 8. Generally Stated Advantages of Partnerships: (a) Preserves inventors "holder rights" under IRC § 1235. (b) Generally, the partnership does not incur tax on profits at the partnership level. (c) No state filings are required. (d) Partners are personally liable for debts the partnership incurs. (e) Partners are implied agents for the partnership and an expelled partner can generally still bind the partnership absent some action of the partnership to publicly communicate that the former partner is no longer involved with the partnership. (f) Partnership can convert to into corp or LLC tax free. (g) When one partner leaves, dies or is expelled, the partnership may become dissolved. (h) Wide variations on partner duties, participation, control and much much more can be had by a partnership agreement. Buy out provisions are prevalent due to the danger of dissolution if one partner leaves. (I) The degree of "entity level" integration can be controlled with the partnership owning a lot of assets and becoming the central entity, versus a low level of control where each partner operates essentially as a sole practitioner. (j) Where partnership agreement is silent on some issues, the default is the California RUPA (Revised Uniform Partnership Act) (k) California utilizes a Secretary of State form GP-1 whereby a partnership may make a Statement of Partnership Authority. This form ensures real estate transfers, causes banks to be more willing to lend money, etc. (l) If the partnership operates under a name that is different from its partner's names, it must file a DBA for the partnership. (m) California's adoption of the Uniform Partnership Act of 1994 made a switch to a preference for partnership being an entity rather than an aggregation of individuals. This has helped preserve the barrier between liability of the partnership as an entity, versus the individual liabilities of the partners as an aggregate. See California Corporations code § 16201. Also, for transferring property, any partner can transfer or assign property unless a signed, filed and recorded Statement of Partnership Authority limits such authority §16303. (n) The main problem with partnerships is to draft a partnership agreement which lists all of the negative consequences of what can go wrong. Where dissention rises to the level of litigation, the partners will have effectively lost control of the partnership. (o) Unlike co-tenants, partners owe each other a duty of loyalty (no taking partnership opportunities to one's self, no competition against the partnerships etc) E. Limited Partnership 1. California adopted the Uniform Limited Partnership act of 2008 (effective January 1, 2008) which created a dual threshold of January 1, 2008 for newly formed Limited Partnerships, and a threshold of January 1, 2010 as the forced date of effectiveness for old limited partnerships. 2. A limited partnership requires at least one general partner and at least one limited partner. The limited partners, providing that they do not affirmatively act in a way as a general partner would, even in one aspect, enjoy limited liability. The position of limited partners is similar to that of shareholders, in terms of liability to third parties. CA Corporations code §15903.03. 3. Unlike a general partnership, a limited partnership requires a more formal filing (in California, the LP-1 form). The filing identifies the general partners and the voting required of the limited partners for amendments, dissolution, and other extraordinary permissions. A limited partnership needs an agreement which formalizes these aspects as well as other aspects not needed on the LP-1 form. 4. In California, Limited Partnerships are not allowed to be used for banking, trusts or insurance business operations. Further, record keeping and rights supplied under the new act are extensive. Therefore, one of the enhanced negatives for limited partnerships are the record keeping and formality requirements which are now greater than that required for C corporations. 5. Limited Partnership partners are taxed in the same manner as partnerships. Limited partners are subject to the passive loss rules (500-hour, 5 tax years out of 10, or 3 year personal service activity test). 6. Limited partners have the right to the general partnership agreement records (CA Corporations Code §15901.11), but the general partners have some rights of confidentiality as to day-to-day operations (CA Corporations Code §15903.04) 7. Distinguish "Master Limited Partnerships (MLP) or "Publicly Traded Partnerships" (PTP) from Limited Partnerships. Master Limited Partnerships have shares and are traded on established markets. MLP's and PTP's are taxed as corporations. If greater than 90% of PTP income is passive source income, it is not subject to corporate taxation. F. Limited Liability Partnership 1. A Limited Liability Partnership (LLP)An LLP is a form of ownership in which partners receive limited liability protection. This is a professional type of partnership (for law firms, accountancy firms, etc) where all members have an active role. 2. Every partnership that engages in a trade or business in California or earns income from California sources and every LLP that registers with the California Secretary of State is required to file California Form 565 which is the state equivalent to the federal form 1065. 3. Limited liability is generally as to ordinary torts and not professional negligence. Taxation to partners is the same as for a general partnership. The LLP pays an annual minimum franchise tax of $800. G. S Corporation 1. 1.5% California Entity Level Tax; minimum annual franchise tax is $800. Profits and losses flow from the S corporation to each shareholder through the Schedule K-1. Each shareholder is responsible for paying taxes on their distributive share. 2. 100 shareholders, all must be U.S. residents. Transfer of share to non-resident alien can destroy "S" status. Only one class or participation level of stock is possible. S Corporations cannot be used for entity types described in IRC § 1361(b)(2); (financial institutions, insurance companies, corporations electing under §936 for income from U.S. Possessions, & former or current domestic international sales corporations. 3. Terminating events which lead to termination of the S status can include (1) affirmative revocation, (2) any disqualification (such as an interest passing to an ineligible foreign person), & (3) too much passive investment income. Some relief from inadvertent termination is found in IRC § 1362(f). 4. S Corporations are incorporated in the same manner as a C Corporation, followed by an "S Election" form 2553 filed with the IRS. The election is supposed to be filed by the 15th day of the 3rd month in the year of formation or later year, although the IRS has been lax in recent years about either not accepting the election or invoking a penalty. (Rev. Proc 2003-43 & Rev. Proc 2007-62 & Rev. Proc 97-48). 5. S Corporations require the same level of corporate upkeep as a C corporation, including an annual meeting, formal minutes, and recordation of board decisions. Failure to keep up with corporate formalities can result in piercing of the corporate veil, and personal liability for the owners. 6. S Corporations have a closer focus on the entity level. Unlike a pure partnership where nearly all effects on the entity flow divisibly through to the partners interest, much more focus is on the entity (no adjustment of internal basis of shares, and therefore an S corporation can't dissolve tax free). 7. Owners of the S corporation are not liable for the losses of the business beyond their investment and creditors may only look to the corporation and their business assets for payment. 8. A tax return (1120S) must be filed each year regardless of the amount of income or loss. Capital gains and losses passed straight through to shareholders. 9. Reasonable Wages Issue: As a pass through, the S Corporation tries to minimize salary to its employee shareholders to avoid social security contributions and withholding obligations. (The opposite side of this controversy involves C Corporations minimizing dividends and paying an overly generous salary to avoid double taxation). The general rule for S Corporations is that "zero" is not a reasonable salary, but low salaries have been known to pass IRS muster. 10. S Corporation liabilities do not increase a shareholder's basis, unlike the case of a general partnership. 11. So long as S Corporation had no accumulated earnings and profits from its time as a C corporation (if applicable), all of the distributions are counted as return of basis for the expenditure to purchase the shareholder stock. 12. Income of the S corporation is taxed to the shareholders even if it is not distributed. Special allocations of the S corporation to individual shareholders are not allowed. H. LLC (Limited Liability Company) 1. Minimum annual franchise tax is $800. Fees are charged based upon California Source Income. Fee structure begins for income of between $250k - 500k at $900 (average .24%) and $11,790 for income over $5,000,000 (maximum is .236% and falling for higher incomes). See instructions for California form 568 for the latest fee changes. 2. The LLC basic filing is simple, but there should be an "operating agreement" which is almost exactly like a partnership agreement. The "operating agreement sets forth the operating rules, standards, complex formulas for distribution, and the like. 3. Like a partnership (assuming partnership form is elected), an LLC can make distributions based upon complex formulas and unusual considerations, and are not limited to a single class of shareholder participation. 4. The California Franchise Tax Board states: "The LLC's main advantage over a general partnership is that, like the owners (shareholders) of a corporation, the owners (members) of an LLC are generally not responsible financially for the debts and obligations incurred in the course of the LLC's business. In addition, an LLC has the (check the box) flexibility to be taxed as a partnership, sole proprietorship, or corporation. 5. Being more like a general partnership (assuming partnership form is elected), any liability taken on by the LLC increases each partners basis. AND the basis need not be evenly allocated among the partners. 6. The strict formalities present with C and S corporations are not present in LLCs. Given many taxpayers laxity on keeping up corporate formalities such as an annual meeting and keeping the corporate minutes, for those taxpayers an LLC provides a safer alternative as there are fewer formalities in which to "fail", and fewer opportunities for piercing the corporate veil (to open up shareholder liability). 7. As is the case for a general partnership (assuming partnership form is elected), many of the corporation deductions for benefits, such as qualified retirement plans, life insurance, accident insurance, cafeteria plans, incentive share offerings, etc., are unavailable. 8. Single member LLC (assuming partnership form is elected) is disregarded as an entity, and the single member owner simply files a Schedule C as if it were a sole proprietor business. 9. Assuming partnership form is elected, LLC members are assumed to be active and will generally be liable for self employment taxes, whether or not any money is actually distributed (similar to a sole proprietorship or general partnership). However the exceptions to this rule are for rents, interest, dividends, and gains and losses distributed to "limited partners" who have no authority for the LLC and do not participate more than 500 hours per year. 10. Impermissible Business Types. One major drawback for some businesses is that they are not allowed to operate under an LLC. There are specific lists, but generally they are individuals for which a professional license is required (small, non-exhaustive example: architects, contractors, locksmiths), as well as some other types of businesses: (small, non-exhaustive example: gaming clubs, ticket sellers and photogrammetry). I. C Corporation 1. Minimum annual franchise tax is $800. State and Federal Corporate Tax Rates Apply. 2. Establishment requires the filing of articles of incorporation, and should have a complete set of bylaws which set forth classes of stock, rights and duties, methods for election and more. 3. Shareholder/Investors eligible for qualified small business stock benefits. Depending upon income levels, the C corporation rate may be less than the individual federal income rate. 4. Reasonable Wages Issue: Double tax unless C Corporation can minimize dividends and paying an overly generous salary. 5. Corporation losses are not limited to basis of the shareholder interest and may be carried back and forward. 6. Many of the corporation deductions for benefits, such as qualified retirement plans, life insurance, accident insurance, cafeteria plans, incentive share offerings, etc., are available if the corporation can afford it. 7. Corporation shares are freely transferable and the internal working of the corporation are unaffected. 8. Cannot use the cash receipts and disbursement method (IRC § 448) Generally the accrual method must be used. 9. C Corporation form is the desired form for public offerings to transition to a public corporation. 10. The current C Corporation Franchise Tax rate is 8.84% for general corporations and 10.84% for banks and financial corporations. J. Unincorporated Association 1. 7701(a)(3) defines an association by virtue of its relatedness with a corporation. The key is determining whether the association resembles a corporation in form and function and without regard to whether a state charter is present. Characterization of an entity as a corporation invokes the §11(a) corporate tax. 2. The Treasury Regulations §301.7701-1(c) sets forth factors including the associates relationships among themselves, the relationship of the associates to third parties, and the relationship to property in the association. Modern aspects such as centralized management, and non limited life are also likely to be included. 3. Morrissey v. Commissioner, 296 US 344 (1935) is the principal case which sets forth the enumerated characteristics of (1) existence of associates, (2) carrying on business, (3) indefinite continuous life, (4) central management, (5) limited shares-owner liability, (6) transferable shares, & (7) all corporate property held as title in a single entity. V. Other Considerations (beyond the scope of this outline) A. Mergers & Acquisitions, Splitoffs, and their taxation. B. Effects of sale of ownership shares or assets C. Nonprofit Corporations in California D. Reorganization E. Poison Pill and resisting takeover F. Dissolution and final distribution of assets. Curtis L. Harrington Office: Harrington & Harrington; No. 91719, 2300 Redondo Avenue, Long Beach, CA 90809-1719; Tel. (562) 594-9784; Fax (562) 594-4414 curt@patentax.com PATEN TAX® http://www.patentax.com Specialty: High Technology Patent / Trademark / Intellectual Property Law & Taxation Education: B.S. Chemistry - Auburn University (1974) M. S. Electrical Engineering - California State University Long Beach (1990) M.S. Chemical Engineering - Georgia Institute of Technology (1977) J.D. - University of Houston School of Law (1983) M.B.A. - University of Oklahoma (1985) LL.M. Taxation - University of San Diego School of Law (1997) Admitted Supreme Courts of California, Arizona, Texas, & Nevada to Practice: U.S. Supreme Court; U.S. District Court, Central District of California Internal Revenue Service U.S. Patent and Trademark Office U.S. Court of Appeals for the Federal, Fifth & Ninth Circuits California Department of Real Estate - Broker Los Angeles County California EMT-Basic U.S. Tax Court FCC-Commercial & Amateur Extra Certified by The State Bar of California Board of Legal Specialization: Taxation Languages Japanese Language Proficiency Examination, Approved by Japan Foundation, Level 4; Kanji Proficiency Exam of the Japan Kanji Aptitude Testing Foundation, passed Level 7, recognized by the Japan Ministry of Education, mastery of 640 kanji; some technical Russian reading ability. Patents Prepared and prosecuted more than 100 patents, in the electrical and Prepared chemical technologies; specialty areas include optics, fiber optics, cryogenics electromagnetics, natural gas processing and computers, & trademark and copyright preparation and prosecution. Patents include: Chemical: 4,957,634; 4,851,077; Electrical: 4,876,892; 4,833,351; 4,837,525; Mechanical: 4,879,895; 4,906,199; and Optical: 4,919,512; 4,898,468. Litigation Associate counsel in patent matters, trade secret litigation; Judge pro tem, Long Beach Municipal Court; Superior Court Mediation program, Long Beach; Attorney-Client fee Dispute Arbitrator, Long Beach Bar Association; Patent Panel, American Arbitration Association. Teaching Adjunct Law Professor, Golden Gate University School of Law, LL.M. Taxation Program; Georgia Institute of Technology - previously taught heat and mass transfer laboratories, and analog and digital computer laboratory. Member: State bars of California, Arizona, Texas and Nevada; Vice Chair of the California Board of Legal Specialization Taxation Advisory Committee (member 2006-2011). Fellow, National Tax Practice Institute; Former Memberships: Long Beach Bar Association (Board of Governors, 1994-95); Orange County Bar Association, Taxation Section, (Co-Chair Technology Law Section 1996); Orange County Chapter of California Society of Enrolled Agents - President 2003-2004; California Bar Association: CEB committee (1999-2000); Income & Other Tax subcommittee (Chair 2000-2002); Taxation Section Executive Committee (2002-2005).