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Entity Choice in Light of Revised Estate and Gift Tax Rules

What advisors need to know about corporations, partnerships and other structures under which their clients do business

By Blake Christian, CPA/MBT

Key Takeaways:

  • When taxpayers and/or their heirs expect to be at or near the maximum income tax rates, they will generally want to leave appreciated and appreciating assets in the taxable estate, rather than transfer them prior to death.
  • The legal structure of a taxpayer ’s business operations can have a significant annual income tax impact, as well as a longer-term impact on their estate and the net amount ultimately realized by their heirs.
  • Below are six widely used business operating structures, and the pros and cons of each type with respect to an owner ’s income and estate planning options.

As many advisors have learned, the 2013 increase in personal federal income tax rates — up to 39.6 percent, plus a potential 3.8 percent federal tax on Net Investment Income (NII) — combined with a drop in the maximum estate and gift tax rate to 40 percent (only on net assets of $5.34 million per spouse), significantly changes estate tax planning for most taxpayers. It ’s especially important for your successful business owner clients.

One of the most common questions I get from clients and friends is about which legal structure they should opt for to run their new or existing business. My standard answer is, “Well, it depends. ”

There are a multitude of legal, tax and operating issues to consider, and one size certainly does not fit all. The general choices for operating a business include the following:

  1. Sole Proprietorship – Schedule C
  2. Limited Liability Company (LLC)
  3. Limited Partnership
  4. General Partnership
  5. Subchapter S Corporation
  6. Subchapter C Corporation

There are also other legal entities that may be worth investigating for certain operations, including trusts, cooperatives and joint ventures in unincorporated form.

Following is a general summary of the pros and cons of the most common forms of operations and how structure may impact income and estate planning.

1) Sole Proprietorship

This is by far the simplest form of doing business and requires very little in the way of startup costs. While legal liability exposure is highest in this form, owners can still have employees and pay themselves a W-2 and fund various benefits in a Schedule C business.

Estate and Gift Tax – Upon the death of the owner(s), the legal entities ’ business and personal assets will transfer to trusts or heirs as outlined in the taxpayer ’s trust and estate documents. Various minority and marketability discounts available to other legal structures are not available in a sole proprietorship.

2) Limited Liability Company (LLC)

LLCs are by far the most popular form of doing business for a variety of reasons, including limited legal liability for other members ’ bad behavior. There are various federal elections available to treat the entity as different entity types. The remaining discussion assumes a partnership election is made.

Taxable income and losses flow through to LLC members (and retain their “ordinary ” or “capital ” character) and member tax basis is adjusted. In addition, both partner and third-party loans can increase member tax basis. Also, moving assets and members in and out of the LLC is generally easier from a tax perspective than it is for a corporation.

Estate and Gift Tax – The most significant estate tax advantage associated with operating as an LLC that ’s taxed as a partnership is that upon the death of an LLC member, both the “outside ” tax basis in the LLC units inherited and the tax basis in the assets held by the LLC on the date of death will be revalued to the fair market value. This offers a very significant advantage to heirs when the LLC has increased in value during the lifetime of the decedent.

3) Limited Partnership

A Limited Partnership must still have a General Partner (GP). LPs are generally not subject to self-employment tax on their K-1 income as is the case with most GP and LLC members.

Estate and Gift Tax – The value of the units will vary much more than the LLC, based on the specific partnership terms.

4) General Partnership

The rules are similar to LLCs and Limited Partnerships discussed above, except that the partners have more liability exposure.

The partners are subject to self-employment taxes on most of their allocable K-1 income other than certain passive/investment/portfolio income.

Estate and Gift Tax – See Limited Partnership discussion above.

5) S Corporation

An S Corp is generally the least costly and easiest type of entity to set up and operate. Like an LLC, income and losses flow to shareholders, and tax is generally paid at the owner level rather than at the entity level.

One of the biggest tax breaks in this type of structure is that the S Corp shareholders can take a portion of the profits as distributions rather than as W-2 income, and payroll tax savings ranging from a minimum of 2.9 percent to 15.3 percent can be achieved.

Company-level debt does not factor into member tax basis here. Distributions must parallel the S Corp ’s stock ownership. Shares can only be owned by U.S. resident individuals and certain trusts.

Estate and Gift Tax – Unlike in an LLC, when a shareholder dies in an S Corp, the heirs will only receive a revaluation in the “outside ” basis in their corporate shares – not the underlying S Corp assets. This can create significant income tax problems for the heirs. Furthermore, complexities of retaining S Corp status can occur if an ineligible owner comes into the mix – e.g., an ineligible trust or nonresident alien.

6) C Corporation

C Corps are similar to S Corps with respect to the reasonable cost of formation and operation. The big difference between S Corps and C Corps is that C Corps pay tax at the entity level; however, C Corps pay a blended rate of only 22.5 percent on the first $100,000 of taxable income. C Corp shareholders will still pay taxes on W-2 earnings and certain dividends and other distributions – making them vulnerable to possible “double taxation. ”

An unlimited number of shareholders are allowed and the C Corp can generally choose any tax year-end. Most other entities are generally limited to calendar year-ends.

Estate and Gift Tax – A similar negative to S Corps is that upon the death of an owner, there is a revaluation of only the stock, not the underlying assets. Lack of restrictions on ownership make C Corps more flexible from an inheritance standpoint.

Summary

In summary, an LLC or Limited Partnership provides the most flexible lifetime and post-mortem planning opportunities for your clients, but each taxpayer must fully evaluate their options based on the type of business operations and their overall estate plan.

About the Author

Blake Christian, CPA/ MBT is a Tax Partner in the Long Beach office of California-based Top 50 CPA firm HCVT LLP. Blake has over three decades of experience and specializes in corporate and high net-worth individual income, estate and gift tax planning. Blake is a frequent speaker and author and is a thought leader in best practices for professional service firms.