CHOOSING A BUSINESS ENTITY
Everyone starting a for-profit business is faced with the issue of what type of entity to use for the business. There are numerous possibilities, and the distinctions among the various types of entities can be confusing. The principal choices to do business include a sole proprietorship, a general partnership, a limited partnership, a limited liability company, and a corporation. Despite this menu of choices, choosing the right entity for a business is primarily a function of how best to limit liability and limit taxes.
Limiting Liability. Limiting liability is the much simpler issue. If a person does business as a sole proprietor, there is no legal distinction between the business assets and the personal assets. Thus, all of a person’s personal assets are at risk for liabilities incurred by the business, and all of the business assets are at risk for liabilities incurred by the person personally. For this reason, a business should be formed as some type of entity that limits liability, as these are legal entities separate and distinct from their owners.
The limitation of liability is not absolute. Under certain limited circumstances a person with a claim against the entity is able to impose personal liability on its owners. In corporate law, this is known as "piercing the corporate veil." The basic elements are an undercapitalized company which engages in a financial transaction which is deemed to be a fraud on creditors.
Limiting Taxes. Tax issues can be extremely complex. Thus, it is imperative to engage a competent tax adviser for the business. For income tax purposes, however, there are basically three types of entities: "C" corporations, "S" corporations, and partnerships - all classifications created under the Internal Revenue Code. The following is a short synopsis of the tax implications and characteristics of these tax entities:
"C" Corporations. Subchapter “C” corporations are taxable entities, and the corporation itself is responsible for paying Federal income tax on its taxable income. C corporations may have multiple classes of stock, and there is no limitation on either the number or type of shareholders that a C corporation may have. Dividends paid by a C corporation to its shareholders are paid with after-tax dollars. If
it pays dividends to its shareholders with the after-tax profits, the shareholders will pay an additional tax on the dividend (the so-called “double taxation”).
"S" Corporations. Subchapter “S” corporations do not pay tax at the corporate level. Instead, items of income, gain, deduction, and loss pass-through to the corporation=s shareholders, and the shareholders pay tax on this income at their applicable personal income tax rates. The shareholders must pay this tax whether or not they receive any cash distributions from the corporation. There are, however, certain limitations that apply to S corporations that do not apply to C corporations or to entities taxable as partnerships. For example, S corporations may not have more than 100 shareholders or more than one class of stock.
Partnerships. Like S corporations, partnerships and limited liability companies electing to be taxed as partnerships do not pay tax at the entity level. Entities taxed as partnerships, however, are not subject to many of the limitations applicable to S corporations. Instead, they may have an unlimited number of owners as well as multiple classes of equity. In addition, they may be owned by other entities as well as by individuals and foreign persons. As a consequence, entities taxed as partnerships provide pass-through tax treatment as well as flexibility to meet a wide variety of business, management, and financial needs.
Disregarded Entities. A limited liability company with multiple owners will typically elect to be treated as a partnership for Federal income tax purposes. But if the limited liability company has only one owner, then it is a so-called “disregarded entity” for Federal income tax purposes. For example, if there is a single individual owner, the owner would report the company’s income on Schedule C of Form 1040.
Which is the Right Entity for Your Business? Today, more limited liability companies are formed than any other type of entity. But, that does not mean that a limited liability company is necessarily the best choice of entity for every business. Deciding on the choice of entity requires a careful evaluation of the specific facts and circumstances surrounding the proposed business and its owners.
By Leonard J. Gambino
ESTATE PLANNING AFTER THE TAX REFORM ACT
For 2013 and beyond, estate planners and their clients have a new favorable tax planning environment. For the last decade, estate planning attorneys have been attempting to address their clients’ goals while hedging against the uncertainty of the federal estate tax. The estate tax was originally scheduled to revert to a maximum 55% rate with a non-indexed exemption of $1 million in 2013. However, this changed on January 1, 2013.
ATRA. The resolution to the “fiscal cliff” saga of late 2012 was achieved through passage of the American Taxpayer Relief Act (“ATRA”) on January 1, 2013. Under ATRA, the top tax rate for estates, gifts and generation-skipping transfers is 40%. This rate is not currently subject to change and is coupled with the indexing for inflation of the estate and gift tax exemption amount (untaxed inheritances) and therefore provides both an opportunity and a need to revisit every estate plan. For 2013, the exemption is $5.25 million for combined lifetime gifts and transfers at death. The federal exemption for 2014 will be $5.34 million.
Portability. ATRA permanently enshrined portability into the federal tax code. In addition to the unlimited marital deduction, portability allows the representative of an estate of a decedent who is survived by a spouse to elect to allow the surviving spouse to use the decedent’s unused exemption in addition to the surviving spouse’s unused exemption amount. The portability option allows a married couple to transfer $10.5 million ($10.68 million in 2014) free of any federal estate or gift tax without having to use marital trusts or credit shelter trusts. While the use of exempt trusts still has a valid purpose for asset protection purposes and estate tax purposes, there is now more flexibility.
Illinois Estate Tax. A separate consideration is the Illinois estate tax which currently has a top rate of 16%, but which can produce a much higher effective tax rate on the portion of an estate above $4 million. Presently, the Illinois exemption amount is $4 million, effective January 1, 2013, and is not indexed for inflation and there is no current portability between spouses. Accordingly, an individual or married couple may be able to avoid any federal estate tax but still incur a substantial Illinois estate tax. A carefully drafted and updated estate plan can mitigate this potential exposure and allow a married couple to shelter a combined total of $8 million from Illinois estate tax.
Same-Sex Marriage. For the first time, the term “spouse” (in reference to married couples) includes individuals in same-sex marriages for federal law purposes. Following the Supreme Court’s recent ruling in United States v. Windsor, holding Section 3 of the federal Defense of Marriage Act to be unconstitutional, various federal agencies have been reinterpreting federal laws and regulations to more broadly encompass the term “spouse.” Same-sex couples who marry in a jurisdiction that allows such marriages, regardless of where they may currently reside (and whether their marriage is recognized in that state), now enjoy all the rights and privileges of marriage under the federal tax code. In addition to the unlimited marital deduction and portability, married same-sex couples may now select "married filing jointly" on federal tax returns for 2013 and beyond. They also can amend up to three years of prior income tax returns if advantageous for their specific tax situation. However, because Illinois law currently only allows Civil Unions and (as of this writing) same-sex marriage is still being debated and litigated, Illinois couples who are not married but are united in a Civil Union should consult a knowledgeable tax advisor to discuss their planning options.
Gifting. The exemption of $5.25 million provides an opportunity to make substantial lifetime gifts without incurring any gift tax liability. In addition, the gift tax annual exclusion was increased to $14,000 for 2013 (and 2014), allowing gifts to an unlimited number of individuals as long as the total gifted to any one person in a year does not exceed the annual exclusion. These annual exclusion gifts do not use any portion of the federal exemption and do not require the filing of a gift tax return. The exclusions for gifts made to directly to an educational institution for tuition and for payments of medical expenses not covered by insurance also do not reduce the $5.25 million federal exemption. An analysis of gifting strategies is appropriate as part of an estate plan review.
Conclusion. As a result of the permanent federal exemption of $5.25 million and portability under ATRA, the higher Illinois estate tax exemption, and the Windsor decision, there is an opportunity now to structure an estate plan which can minimize future estate taxes and, in the right circumstances, simplify the planning for married couples. Estate plans should always be reviewed periodically; now is the time to review every estate plan.
By Sanjay J. Agrawala
Practice Spotlight: Estate Planning and Probate
In addition to providing customary estate planning services, such as preparing wills, living trusts, powers of attorney, and insurance trusts, Schoenberg, Finkel, Newman & Rosenberg, LLC counsels clients in more sophisticated tax strategies, such as:
- business succession,
- estate freezes,
- shareholder agreements,
- family partnerships,
- generation-skipping transfers,
- charitable trusts,
- residence trusts,
- grantor retained annuity trusts,
- asset protection, and
- gift tax returns
The Firm’s probate and trust law practice includes decedents’ estates, guardianships, estate and trust administration, and post-mortem tax planning. It also includes the preparation of federal and state estate tax returns and fiduciary income tax returns.
Schoenberg Finkel Newman & Rosenberg, LLC (312) 648-2300
This newsletter is not intended to be legal or tax advice and is not a substitute for obtaining legal or tax advice. This Newsletter is deemed to be advertising material by the Illinois Supreme Court.