Michael Shaff joined the firm in 2011 as Of Counsel. He is the chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. He has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chairof the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.
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Exit strategy, the plan for monetizing or disposing of a business, may seem remote and speculative when organizing a new business. But it is important to know what exit strategies are available and how those strategies are likely to be taxed depending on the form of entity through which the start up does business.
- Sole Proprietorship. If a single entrepreneur does nothing more, he will be doing business as a sole proprietorship. This is true even when the entrepreneur has adopted a trade name through which he does business, often referred to as a “D/B/A”. The advantages for doing business as a sole proprietorship include not having to pay taxes and file tax returns for a separate entity and being able to include the results of the sole proprietorship on the entrepreneur’s own tax return. The only exit strategy, if nothing more is done to transfer the entrepreneur’s business to an entity, would be the sale of the business’s assets. If the business has inventory and accounts receivable the amount of the purchase price allocated to the inventory and receivables would be ordinary income for the selling entrepreneur. The purchase price allocated to the intellectual property, going concern value and goodwill would be taxed as long term capital gain for the selling entrepreneur—provided the entrepreneur has conducted the business being sold for at least a year. The obvious down side to operating as a sole proprietorship is the principal’s personal liability for all of the debts and liabilities of the business.
- General Partnership. If two or more participants conduct a business together and they do not form an entity, the result is generally going to be a general partnership. For example, Charlie agrees to back Delta’s start up business. Delta does most of the work and agrees that when the business starts to make money, it will repay Charlie’s investment then split the business’s profits on an agreed percentage. Charlie and Delta may not even realize it, but they have formed a general partnership. Each partner is responsible personally for the debts and obligations of the general partnership[1]. While it is at least theoretically possible that a buyer would purchase Charlie and Delta’s general partnership interests, the realistic exit strategy, without their doing more, is the sale of the assets of the business. As in the sole proprietorship, the purchase price of a business sold must be allocated among the business’s various assets. Both buyer and the sellers are expected to agree on the allocation of the purchase price among those assets[2].
- Limited Partnership. A limited partnership is an entity that the participants must affirmatively elect to adopt[3]. Like a sole proprietorship and a general partnership, a limited partnership is a pass-through entity—it does not pay income tax but instead passes its income or losses through to its partners in accordance with the terms of its limited partnership agreement and the terms of federal income tax law. The general partners of a limited partnership are subject to personal liability for the debts of the limited partnership as would the partners of a general partnership[4]. The limited partners are afforded limited liability. Like the sole proprietorship and the general partnership, the likely exit strategy is the sale of the business’s assets. Also, like the sole proprietorship and the general partnership, a limited partnership (or a limited liability company) may contribute its assets or its partners may contribute their limited partnership interests to a corporation generally on a tax-free basis. [5]
- Limited Liability Company. A limited liability company (LLC) also is taxed as a partnership, meaning that the deductions from starting up and operating the business may be passed through to the investors who funded them. A limited liability company affords limited liability to all of its members (except for those who signed personal guaranties of loans, leases or other obligations of the limited liability company). LLCs and limited partnerships have the flexibility to issue a variety of classes of equity, including series of preferred having convertibility features, put rights in sum, having as wide a variety of terms as an investor and the principals of the business may negotiate. LLCs and limited partnerships also have the ability to issue profits interests. Profits interests are a way to give service providers (both employees and consultants) a stake in the appreciation of the company with no tax due on grant, no exercise price and capital gains to the extent realized on exit. A profits interest is defined as a partnership interest that would yield no distribution if the partnership’s assets were sold at their fair market value immediately after the grant of the partnership interest[6]. Any type of investor may invest in an LLC without adversely affecting the LLC’s status[7] If a potential buyer of the business buys some or all of the LLC interests, the sellers at least in part must allocate a portion of the sales price to inventory and unrealized receivables taxable as ordinary income. As previously noted, an LLC may convert to a corporation on a tax-free basis (in most cases) if possible buyers would be likely to prefer to use stock as the acquisition consideration. [8]
- Summary of Partnership Entities. The general partnership, limited partnership and limited liability company are generally treated as partnerships for tax purposes, meaning that they pass through the taxable income or loss to their equity owners. The tax benefits of net losses passed through to the partners are subject to (a) the partner having sufficient basis in the partner’s interest in the partnership (or LLC), (b) the partner being “at risk” for his or her share of the entity’s liabilities and (c) the partner being actively involved in the partnership’s business in order to claim net deductions[9]. In many cases, conducting the business through an LLC is sufficient—it provides (i) a single level of tax, (ii) limited liability and (iii) the ability to grant key employees and consultants incentive compensation without incurring tax for the recipient or the partnership.
- Corporations. Corporations are taxed under a completely different set of rules from those affecting partnerships. Corporations are eligible for tax-free acquisitions when properly structured as (a) a statutory merger, (b) an exchange of stock of the target corporation for voting stock of the acquiring corporation or (c) the acquisition of substantially all of the assets of the target corporation for voting stock of the acquiring corporation[10] Being able to receive the acquiring corporation’s stock tax-free in an acquisition if the acquiring corporation’s payment in its own stock were taxable, is a very helpful feature, especially when a lockup agreement is in place or the acquiring corporation itself is not publicly traded or is thinly traded—if the acquiring corporation’s payment in its own stock were taxable, the target corporation’s shareholders would be taxed on the value of the acquiring corporation’s stock but would have no way to raise the funds to pay the tax. When sold, corporate stock yields capital gain or loss unless the seller is a securities dealer[11] Conversion of a partnership or LLC to a corporation is easy and generally can be accomplished tax free[12]. There are two relevant types of corporations from a tax standpoint, C corporations and S corporations.
- C Corporations. C corporations are separate legal and tax entities from their shareholders. C corporations pay tax at the corporate level and do not pass through any taxable income or loss. Shareholders are only taxed to the extent that the C corporation pays a dividend distributions out of current or accumulated net earnings. With certain exceptions[13], the dividends of a C corporation are not taxable when received by a tax-exempt entity and are subject to reduced US income tax withholding when paid to a foreign investor from a country with an income tax treaty with the US[14]. The insulation of shareholders, especially foreign investors and retirement plans, from the tax liability of the C corporation and the C corporation’s ease in being able to issue various classes of preferred stock make C corporations most attractive for important types of investors. As previously discussed, sales of corporate shares almost always give rise to capital gain or loss and the selling shareholder does not have to allocate the sales price between an ordinary and capital portion. Corporations are eligible for the tax-free reorganizations described generally in paragraph 6 above. However, if a C corporation sells its assets to the acquiring corporation, the tax cost can be quite high: 35% federal corporate income tax and 9.84% California state corporate income tax with the net amount subject to tax when distributed to individual shareholders at up to 23.8% at the federal level and up to 13.3% in California. A shareholder in a C corporation that sells its assets may only net about 40% of the total sales proceeds.
- S Corporations. S corporations are in many ways a hybrid cross of C corporations and LLCs. Net income and net loss of an S corporation is passed through to the shareholders, so in that sense S corporations resemble LLCs as pass-through entities. S corporations, like any other corporation, offer limited liability for all shareholders. But S corporations may have only one class of stock[15] The inability to issue preferred stock or convertible debt is a significant disincentive on the use of an S corporation—the issuance of such a class of securities would result in the automatic conversion of the S corporation to a C corporation. The hardest restriction on the use of an S corporation is the exclusion of all non-US individuals as eligible shareholders[16] and the limitation of no more than 100 US resident individual shareholders. As a corporation, an S corporation is eligible for use of the corporate reorganization rules. Like C corporation stock, the stock of an S corporation generates capital gain or loss when sold.
For more information about Tax & Estate Planning Practice, please contact Michael Shaff at (818) 444-4522 or .
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[1] Cal. Corp. Code §16306(a).
[2] Internal Revenue Code (“IRC”) §1060(b).
[3] Cal. Corp. Code §15902.01(a).
[4] Cal. Corp. Code §15904.04(a).
[5] IRC §351.
[6] Rev. Proc. 93-27, 1993-2 C.B. 343.
[7] Some entities like pension plans and IRAs may have to pay tax on the net income allocated to them from an LLC or other partnership that is engaged in an active business. (IRC §512.) LLCs and other partnership entities present similar issues for foreign investors.
[8] IRC §751(a).
[9] Generally, suspended losses may be claimed as the partnership generates net income or when it is ultimately disposed of.
[10] IRC §368(a)(1).
[11] E.g., Biefeldt v. Commissioner (7th Cir. 1998) 231 F.3d 1035.
[12] IRC §351. Care must be taken to convert to corporate form before undertaking acquisition negotiations.
[13] Voluntary employee benefit associations, supplemental unemployment compensations plans, social clubs and other exempt organizations that have borrowed to purchase the shares. (IRC §512(a)(3).)
[14] See, e.g., United States—Peoples Republic of China Income Tax Treaty (1984), Article 9, Section 2, reducing the withholding on dividends paid by a corporation from one country to a resident of the other from the general 30% withholding rate to 10%.
[15] Differences in, or even a complete absence of, voting rights are permitted. (IRC §§1361(b)(1)(D) and (c)(4).)
[16] IRC §1361(a).
