Jaconetta, Burnham & Wimer, LLC

This document was last revised on July 1, 2002 and does not reflect changes in the law that have occurred since that date. The purpose of this outline is to provide an overview of concepts germane to the subject. None of the information contained herein should be relied upon without careful analysis of the changes to the applicable laws and regulations since the revision date.

I. C CORPORATIONS

A. Formation. The contribution of appreciated property to a C corporation in exchange for its stock is not taxable as long as the shareholders contributing the property are in “control” (generally 80% of value and voting rights) of the corporation immediately after the transfer.

B. Taxation of Earnings.

1. Generally, subject to two (2) levels of taxation, once at the corporate level and again as dollars are distributed to shareholders.

2. Closely held C corporations avoid double taxation by paying out earnings as compensation to key employees/shareholders.

(a) Internal Revenue Service will disallow deductions taken by corporation for salary paid to key employee/shareholders when salary is deemed to be “unreasonable compensation,” thereby producing a tax at the corporate level.

(b) C corporations are often forced to change choice of entity when earnings exceed amount that can be paid to key employees/shareholders as reasonable compensation.

C. Taxation on Liquidation. Since the repeal of General Utilities by the Tax Reform Act of 1986, C corporations are now subject to two (2) levels of taxation on liquidating distributions to shareholders. Corporate level tax is also recognized on current distributions of appreciated assets to shareholders.

D. Limited Liability. C corporations offer all shareholders limited liability; that is, a shareholder’s liability for debts, liabilities and other obligations of the corporation is limited to the amount the shareholder has contributed to the capital of the corporation. Therefore, the shareholders’ personal assets are generally protected from the claims of creditors of the corporation.

E. Other Factors.

1. C corporations must pay State of Connecticut minimum tax.

2. Key employee/shareholders must pay State of Connecticut unemployment tax on first $15,000.00 of wages each year.

3. Full deductibility of health insurance premiums for key employee/ shareholders.

4. Only C corporations can sponsor incentive stock option plans.

II. S CORPORATIONS

A. Definition. An S corporation is a “small business corporation” for which an election under Code Section 1362(a) is in effect.

1. A corporation can make an S election only if it is a domestic corporation; that is, a corporation organized under the laws of the United States or of any state.

2. An S corporation cannot have more than 75 shareholders (NOTE: Prior to 1997, an S corporation could only have 35 shareholders).

3. An S corporation cannot be an ineligible corporation; that is, a corporation which is:

(a) A member of an affiliated group (NOTE: Beginning in 1997, an S corporation may now be a member of an affiliated group and thereby own subsidiary corporations; including qualified subchapter S subsidiaries);

(b) Financial institutions using a reserve method of accounting;

(d) A DISC or former DISC; or

(e) A possessions corporation.

4. An S corporation can only have one class of stock.

(a) Care must be exercised to insure that certain relationships between shareholders do not create a second class of stock.

(b) An S corporation can have more than one class of stock if the only difference between the classes is voting rights.

5. An S corporation cannot have non-resident alien shareholders.

6. Only eligible shareholders can own S corporation stock. Generally partnerships, limited liability companies and corporations cannot own S corporation stock, and only certain types of trusts and estates qualify. The following is a list of eligible shareholders:

(a) Individuals who are not non-resident aliens.

(b) Certain trusts.

(1) Grantor trusts;

(2) Testamentary trusts (but only for 60 days from the date of receipt of the stock);

(3) Voting trusts;

(4) Qualified Subchapter S Trusts (QSST); and

(5) Electing Small Business Trusts.

(d) Single Member LLCs. The IRS has recently ruled that a single member limited liability company’s ownership of S corporation stock will not preclude S corporation status. PLR 9745017

B. Formation. The contribution of appreciated property to an S corporation in exchange for its stock is not taxable as long as the shareholders contributing the property are in “control” (generally 80% of value and voting rights) of the corporation immediately after the transfer.

C. Taxation of Earnings. Generally, an S corporation is a pass-thru entity; that is, earnings pass-thru to the shareholders where said earnings are taxed at each shareholder’s personal income tax rates.

1. Generally, there is no corporate level income tax on earnings of S corporations. However, there are exceptions for earnings of S corporations that were formerly C corporations and then converted to S corporation status:

(a) Income tax is imposed on an S corporation that has earnings and profits from prior years of operation as a C corporation and gross receipts more than 25% of which is derived from passive investment activities.

(b) C corporations with LIFO inventory as of the date of conversion to S corporation status must pay recapture income on the difference between the inventory’s LIFO basis and its “as if” FIFO basis.

2. Losses of an S corporation pass through to its shareholders where, subject to certain limitations, such losses can be used to offset income from other sources. Corporate level debt does not increase a shareholder’s stock basis for loss pass-through purposes. However, S corporation shareholders do have debt basis equal to the amount the shareholder has loaned to the corporation.

3. Historically, the State of Connecticut taxed the earnings of S corporations. Effective July 1, 2001, the corporate level tax on S corporations has been eliminated.

D. Taxation on Liquidation. Generally, only one level of tax (at the shareholder level) is recognized on the liquidation of an S corporation. However, please note as follows:

1. Unlike a partnership, the distribution of appreciated assets triggers gain recognition.

2. Built-in gains tax must be paid at the corporate level for S corporations that were formerly C corporations and sell certain assets within 10 years of the conversion.

E. Termination. An S corporation is terminated upon the occurrence of any one of the following:

1. Revocation by shareholders holding more than one-half of the stock of the corporation.

2. The corporation ceases to qualify as a small business corporation.

3. The S corporation has passive investment income which exceeds 25% of its gross receipts for three (3) consecutive years and has accumulated earnings and profits from prior years of operation as a C corporation.

F. Other Factors.

1. Health Insurance. Health insurance premiums paid in consideration of services on behalf of a shareholder who owns more than 2% of the corporation are deductible by S corporation and includable as income by the shareholder-employee. The shareholder-employee may claim the deduction for health insurance costs of self-employed individuals or, to the extent that deduction is not available, as an itemized deduction on Schedule A.

2. Self Employment Taxes. Since dividends payable to S corporation shareholders are not subject to self employment taxes, planning opportunities may exist for shareholder/employees who wish to avoid employment taxes on income that is otherwise deemed to be self employment income.

III. General Partnerships.

A. Formation. The contribution of appreciated property to a general partnership in exchange for a partnership interest is not taxable even where the contributing partners are not in “control”.

B. Taxation of Earnings. All earnings and separately stated items pass-through to the partners where they are taxed once at each partner’s personal income tax rates.

1. Tax must be paid on profits even where no distributions of cash are made to partners.

2. Subject to certain restrictions, losses pass-through and can be used to offset a partner’s income from other sources. A partner’s share of partnership level debt increases the partner’s outside basis for purposes of utilizing pass-through losses.

3. Partners are generally treated as being self-employed and therefore must make estimated tax payments and pay self-employment tax on earnings.

4. Partners’ wages are not subject to state unemployment tax.

C. Taxation on Liquidation. Although there are exceptions (for substantially appreciated inventory and unrealized receivables), there is no tax imposed on current and liquidating distributions of appreciated assets. Thus, a partnership can generally be liquidated without substantial tax costs.

D. Unlimited Liability. The most significant disadvantage of the general partnership is that all partners, even passive or silent partner/investors, are fully liable for all the debts, liabilities and obligations of the Partnership.

E. Other Factors.

1. There are no restrictions on who can be a partner in a general partnership.

2. Partnerships can create preferences on distributions and special allocations of profits and losses.

3. Deductibility of health insurance premiums of partners is limited to 70% for 2002; 100% deductible beginning in 2003.

IV. Limited Partnerships. A partnership with two classes of partners; (1) General Partners who manage the partnership and have unlimited liability the same as in a general partnership, and (2) Limited Partners who have limited liability (the same as a shareholder of a corporation) but cannot participate in the management of the partnership. LPS are taxed the same as general partnerships.

V. Limited Liability Companies Taxed as Partnerships. Limited liability companies are entities which are owned by “members” and are either managed by the same members or by a separate group known as “managers.” An LLC with more than one (1) member is generally taxed as a partnership.

A. Formation. The contribution of appreciated property to an LLC in exchange for an LLC interest is not taxable even where the contributing members are not “in control”.

B. Taxation of Earnings. All earnings and separately stated items pass-through to the members where they are taxed once at the member’s personal income tax rates.

1. Tax must be paid on profits even where no distributions of cash are made to members.

2. Subject to certain restrictions, losses pass-through and can be used to offset a member’s income from other sources. A member’s share of company level debt increases the member’s outside basis for purposes of utilizing pass-through losses.

3. Members are generally treated as being self-employed and therefore must make estimated tax payments and pay self-employment tax on earnings.

4. Members’ wages are not subject to state unemployment tax.

C. Taxation on Liquidation. Although there are exceptions (for substantially appreciated inventory and unrealized receivables), there is no tax imposed on current and liquidating distributions of appreciated assets. Thus, an LLC can be liquidated without substantial tax costs.

D. Limited Liability. As with corporations, members are generally not liable for the debts, liabilities and obligations of the Company. Unlike a limited partnership, no member has unlimited liability, and all members can fully participate in the management of the Company.

1. Flexibility afforded LLCs can be a double-edged sword if operating agreement is not carefully drafted.

2. Lack of case law precedent creates uncertainty in many areas; including the question of when creditors will be allowed to pierce the “LLC veil.”

E. Other Factors.

1. There are no restrictions on who can be a member of an LLC.

2. LLCs can create preferences on distributions and special allocations of profits and losses.

3. Deductibility of health insurance premiums of members is limited to 70% for 2002; 100% deductible beginning in 2003.

4. LLCs can always convert to a corporation at generally no tax cost.

NOTE: THE LLC IS THE ONLY BUSINESS ENTITY THAT OFFERS LIMITED LIABILITY TO ALL ITS OWNERS WHILE NEVER BEING SUBJECT TO TWO (2) LEVELS OF TAXATION!!!

VI. Limited Liability Partnerships. A partnership that achieves limited liability by filing a Certificate of Limited Liability with the Secretary of State without having to change the entity’s status as a partnership.

A. Existing partnership agreement among the partners still governs following conversion.

B. It is uncertain whether protection from liability is the same as that afforded by LLCs.

VII. Single Member Limited Liability Companies. In Connecticut, sole proprietors can form an LLC and achieve limited liability the same as an LLC with more than one member. A single member LLC is generally treated as a “disregarded entity” for income tax purposes. The single member is treated as being self-employed resulting in one level of taxation on earnings and liquidating distributions. Thus, all earnings are reported on Schedule C of the member’s individual income tax return.

CONCLUSIONS

LLCs have become the entity of choice as a business planning and estate planning entity.

A. Repeal of conveyance tax on transfers of real property to entities by individuals who own the same share in the entity as share of real property prior to the transfer has led to the proliferation of LLCs for the “at home” business and real estate rental activities.

B. LLCs have become an excellent vehicle for protecting assets from claims of creditors (superior to the S corporation), and now is a viable option for a single owner.

C. The family limited liability company has replaced the family limited partnership as the entity of choice for family succession planning for businesses, rental real estate activities and vacation homes.

D. Family LLCs can be used effectively in Title XIX planning to protect assets from long term care expenses.

E. Reduction of Connecticut gift tax which began in 2001 (which over a period of several years will eliminate gift tax on gifts less than $1,000,000) will make estate planning strategies such as Qualified Personal Residence Trusts and Grantor Retained Annuity Trusts more attractive in Connecticut.

FINAL NOTE: A caution to the business owner attempting a “do-it-yourself” LLC.