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Foreign welcome to the first episode of How Tax Works. I'm Matt Forbey. In this episode I will discuss entity selection, which is perhaps the most important decision a business owner will make. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape business and financial decisions that we all make. On the page for this podcast is a handout which I'm going to reference repeatedly as I go through this. It's intended to facilitate my discussion. It is nowhere near every single consideration, but I think it does a fairly good job. I admit I'm biased of going over a lot of the main points that I'm going to cover and some of the most important ones. Generally speaking, when you're deciding what entity to be, there are two countervailing considerations. There are legal considerations, often referred to as corporate, and there's tax considerations. From a corporate perspective, you want as much protection as possible, but from a tax perspective, you actually want, instead of worrying about how much protection you have, you actually want to lower your taxes. Right? That's the standard complaint. And so as a result, you know, different entities and things have changed over time. The laws change to try to marry those two concepts. They don't always work together and they're often, as I said earlier, countervailing. One goes up, one's better, one's worse and you try to get to the right area, the right mix between. Basically I'm going to go from the top left to the bottom right, except for when I talk about it. So from the first start, you know, first beginning, we're going to talk about C Corporations, right? Various characteristics of C Corporations, right? Corporations, generally CNS from a non tax perspective are really the exact same thing. Limited liability free transferability of ownership, centralized management, continuity of life. The continuity of knife life is really interesting. So you know, I'll kind of go bottom up here. But continuity of life initially a lot of entities had to be basically in the beginning, renewed every year. Which sounds very weird to anyone today, right? Most entities are forever. So that obviously went away the way of the dodo, unfortunately. And so it has that corporations have central management, right? They have boards, they have CEOs, things like that. You can transfer shares, own, you know, anyone can own them. And there's generally limited liability, some states, and depending on the entity, the federal government may limit that liability of specific instances. But that all depends how things go. Then there are partnerships and unincorporated entities. Unincorporated entities that fit into this are really just any, any business that does not have an entity itself. You know, sole proprietorships are the main, main thing. But really anything that's what's called unincorporated really means anything that's any sort of partnership or a limited liability company, anything that's not a corporation for the GP, LP, LLP, etc. You know, general partnerships tend not to have entities. Or you can form a general partnership, joint and several liability. Everyone's liable for everything. The owners and the people operated are really agents for the partnership and have a management role. For limited partnerships, limited liability partnerships, things like that, it limits the liability. More significantly, there's no direct management role except for, you know, from the partner side, except for what they're allowed to do as basically officers of the partnership. The llc, of course, that's the unincorporated entity that most entities these days are right. Has limited liability. Limited protection, sorry, liability protection. You know, they're going to be managed by a board, by the people who run it, by the managers. There's a lot of different terms. They're not incorporated per se and they're not, you know, I hear this from time to time. What's called a limited liability corporation that does not exist in any meaningful sense. Corporations are corporations. Limited liability companies are a separate thing. They're a product. They've only been around for 35, 40 years, which in the scheme of things is pretty short, believe it or not. And they're really going to talk about, when you think about LLCs, is they have a lot of the protections from a liability perspective that corporations have, but they have passed through taxation. And I'm skipping ahead a moment here, but I think it's really important to note that they're sort of a hybrid, right, between corporations and partnerships. The biggest, you know, thing, the biggest thing for LLC was there was a whole question, what are LLC from a tax perspective? Prior to what's called the check the box regulations, there was a four factor test that determined what they were. And the IRS came out and determined that LLC are partnerships. And that really allowed LLCs to just explode. After that, every state made sure they had them. They became by far the most formed entity, except for certain circumstances where you want something else. Now go through the tax considerations. This is a tax podcast, after all, so I think it's important to discuss. I'm going to go C Corporations, then into partnerships and then back to S. Corporations. I think that's the most logical order to do it. You know, C. Corporations, right. Tax at the entity level. There is a 21% tax, it's a flat tax. You make $100, you pay $21 a tax. That's it. Plus state taxes. They generally are between 4, 6, 8% depending upon the state and that's taxed at the entity level. No matter what. Distributions are generally taxed upon receipt. There's exceptions to that. And there is no deduction again generally for any distributions. So you pay the 20% tax and any distributions are going to be. The taxes on that are generally, it's generally taxed even though it's an ordinary, you know, dividend. They're taxed at the capital gains rate. So that's generally 23.8% is the highest rate. It's graduated. So it depends on your income level plus whatever the state has. So that can be anywhere from zero for someone who lives in Nevada or I think New Jersey has the highest, but I'm not sure, you know, New Jersey, New York, California, there's a few others that kind of stick in there. The main exceptions to this are REITs, Ricks and a few others. They exist for very, very, very specific purposes, right? Investment companies, real estate, etc, and they often require other certifications or licenses to exist. So unless you're doing what they are, they don't really make sense. And the truth is a lot of times those entities just fall into LLCs. They become pass throughs otherwise, so there's no really reason to do it. A lot of those entities have required distributions and they're actually taxed at the entity level, generally speaking. And then they get a deduction for any dividends they pay. So it's an exception to the general C corporation rule. But as I said, they have other requirements that are really important to make sure to follow. So if you don't want to be a REIT or a ric, don't. There's other, you know, similarly tax efficient ways to do it. You'll notice that, you know, the, the two columns for all the partnerships and unincorporated unincorporated entities are pretty similar. Kind of talk about them in parallel. But basically there's no tax at the entity level. That's. In general, there are exceptions to that. A number of states, cities have entity level taxes, generally referred to as a ubt, unincorporated business tax, again, unincorporation, unincorporated entity, anything other than a corporation. New York City's is probably the most famous 4%. A number of other states have it. You know, Connecticut, New Hampshire, a few Others have implemented it. I'll talk about pass through any taxes in a moment. There is, is, you know, basically even if there is no distribution, if the owners do not get anything right. There is a tax at I use the word shareholder. It's really member or partner level people who own right part of the entity. And I think that's important. People always say, look, I didn't get any money, I didn't make any money, how can I owe taxes? And the answer is, you know, the trade off is right. If you go back to C corporations, 21 +state and then 23.8+state. Right. Much higher tax rates. All the partnerships are basically 37% it's graduated plus the state rate. So what happens essentially is in exchange for lower taxation, you have to deal with the fact that you are taxed even if you don't distribute, you know, all the money or even any of the money. Right. I always point out, and I think this is a really important point, that if you're never going to pay a distribution right or anything like that, you want to keep maximally reinvesting. You want to lower your tax rate. It's actually lower to be a C corporation because it's 21% rate plus state as opposed to 37.37% plus state for any partnerships. Right. And as corporations would be the same. We'll get there in a second. So for some businesses, being a C corporation can actually lower your taxes. There's other reasons, other considerations. Any partnership or LLCs, right. Owners cannot receive W2s and the distributions are generally subject to payroll taxes. Except for limited partners, payroll taxes are 15.3% up to a little less than $170,000. And then at $170,000, what happens is only the employer side pays 7.65, so basically half, which of course is deductible. The rate isn't really 15.3 because it's deductible on the employer side. So the rate a little bit lower than that, usually somewhere around 11 or 12. This ends up with the effective rate is even if you're self employed. The limited partner exception, which exists for LPs only is the basic premise is that a limited partner in a limited partnership does not have to pay payroll taxes. Right. It's just, just how, how it works. There's an exception in the rule. There is a recent case, Sorbonne Capital Partners, it's a New York City based fund. I think they're technically venture capital or private equity, I never really remember. And basically what they had was a number of partners in that operated the business and their investments, their actual dollar investments were as limited partners. What the tax court said was that simply having the name you're being a limited partner did not mean you were actually a limited partner for tax purposes. So even though you're called a limited partner, if you're active in the business, you may still be subject to payroll taxes. Llc, is everyone subject to payroll taxes? So that's not really an issue. As I say, right. Partnership for tax but says ctp, check the box. The US is really interesting, one of the only countries that has anything like this. There's a couple countries that have elective regimes for a couple entities. But the US really allows you to elect and I'll get this into S Corporations, but basically each entity type, Inc. Corporation, llc, et cetera, et cetera, has a default tax type right, disregarded entity, partnership, corporation, what have you. And then you can usually check the box depending on your owners, the type of entity, and a few other factors. For example, you can be an LLC and check the box and be an S corporation or a C corporation. You can be a corporation, check the box, be an S corporation, you can be a trust and check the box as a C corporation and so on and so forth. There are tax reasons for doing it. There are tax reasons for not doing it. And I really, really cannot stress this enough. You know, talk to a tax advisor and think about the consequences because it's really important pass through entity taxes. It's a bit of a misnomer. What it actually is is basically a workaround of a state and local tax cap, SALT cap. And you know, New York has the bait. Excuse me, New York has the pta, New Jersey has the bait. Every state has a, has a fun little acronym, right? And what they are is basically they, it's elective and they shift the income tax incidence to the entity and then they provide a credit to the owner, right? And so what happens is you pay the tax the entity level, it's deductible at the federal level. And then that basically means that the people who own businesses pay a lower effective tax rate because they're able to deduct their state and local taxes without a cap, right? The cap is really low, right? $10,000. I know it's indexed to inflation a little bit, but it's really pretty much $10,000 is fairly low for high, high income earners or anyone who lives in a high tax jurisdiction. So it's really important from a constitutional perspective. I'm actually not sure. And a law perspective that it's actually allowed. A lot of practitioners will admit with a bit of a cheeky grin that you know, this is not allowed because it's technically an optional tax, even though you elect into it. Electing into a tax is not permitted to create a tax that is deductible right. At the, at the entity level. But the IRS issued a notice saying it's okay. So even though it that notice has no support, I'm not sure anyone really is going to challenge it because it would simply raise taxes on people. And, and generally speaking, that's not a situation where people challenge laws. They want to keep taxes low. Right. There's a countervailing again countervailing goals with S Corporations very similar to the partnerships generally. No tax at the end level. But New York City, for example, ignores the S election entirely. Not the state, just the city, and Therefore imposes an 8.85% tax on new York City source income for S Corporations there. It's tax, you know, similar to GPs, LPs, all the partnerships, LLCs. There's a tax at shareholder level. Even if you don't distribute the income, you are required to pay reasonable compensation via W2 to any S Corporation shareholders that also work within the business, provide services, advice, what have you significant audit risk. And the IRS has signaled that they are starting to audit that. Historically what people did was they decreased the reasonable compensation below frankly reasonable levels. And as a result, you know, they maximized. You know the next point, right? Dividends are not subject to payroll taxes. So because dividends are not subject to payroll taxes, there is a benefit to not to paying yourself a lower reasonable compensation to minimize payroll taxes. So the IRS is saying, well look, you know, Social Security not that well funded these days. So we need to make sure that it's done right that reasonable compensation. There are audits, you know, recommend definitely something that people consider when choosing entity type and also talk to your advisors making sure that's correct. You know, the, the dividends in addition to not being subject to payroll taxes, also the taxes on the dividends are eligible for PTETs. Right. Which I talked about with the partnerships and LLCs. So as a result, you know that those amounts can the taxes, the effective taxes are lower because you can deduct state taxes from your federal taxes. So there is, you know, double benefit of decreasing reasonable compensation, you know, so that, that's a benefit. Right. Then moving on, you know, back to C Corporations restrictions. There's no meaningful restrictions on C Corporation ownership really. They are almost certainly the most easiest to own, most common to own, especially for foreigners. For reasons I'll get to in a moment. As corporations have by far the most restrictions on ownership. Right. Maximum 100 shareholders, used to be 10 people often say, you know, when will I have 100 shareholders? I have seen large medical practices, large law practices that have 100 shareholders and run into this issue. There are ways to get around it. It is clunky and tough. Sometimes it requires tax to do, you know, recognizing tax and paying tax to do. The shareholders cannot be non resident aliens. So basically any individual or any foreign corporation, they can't be corporations in general. The exception to that is if a s Corporation owns 100% of another S corporation that's permitted. The main, the top corporations, just an S corporation have to make an election. The lower tier corporations, what's called a Q sub qualified S corporation subsidiary and that again, 100% owns. So it's kind of pointless to have, you know, to stack them unless you have a business reason for doing it. From a tax perspective doesn't help. Most trusts cannot be shareholders. LLCs can be shareholders and S corporations, but the LLC must be what's called a disregarded entity, which is just ignored for tax purposes. Partnerships definitely cannot. I don't recommend having LLCs own. And the reason is it's very easy to mess that up. Estate planning can create a partner if you own it in a state that is not, you know, with a spouse. Right. That can be a problem. That can be problematic as well. So there's a lot of reasons. Reasons you can only have one class of stock. So all the economic rights have to be equal with every share held by every shareholder. You can have voting, non voting. But it has to be binary. Cannot be double voting or half voting or whatever. The allocations and distributions must be pro rata, which means that if the s Corporation makes $100, it has 100 shares. Each share will get $1 allocated to it. If you make a distribution, each share will get 1% of whatever the distribution is. Contrast that with any partnership, right? Whatever you want really is for the entities. You know, you can do whatever you want. Anyone can own it. There's no issues. Foreign partners may have issues. And this is a really important one. I'm going to, you know, take a pause here to discuss this. It's really important to note that foreign individuals, they can own partnerships. This is a situation where limited partnerships, general partnerships are very, very common. Still, if foreigners have. Foreigners own part of a US business that is not a C corporation, obviously can't hold ownership in an S corp. A lot of countries, basically Every country views LLCs as if they're C corporations which creates a interesting mismatch, right. Where what happens is the foreign country views the tax that's paid by the, you know, the owners of the LLC as if it's a corporate tax as and can have a problem with the foreign tax credit basically making taxes uncreditable, which when you distribute income back up to the foreign country, the foreign owner, it can create a level of double to true double taxation. So if you have foreign owners, we should talk, you know, talk to your tax advisor, make sure they have experience with cross border structuring and they can do it. Even Canada has this issue, right? Canada views LLCs if they're C corporations so it has a problem, so it can really bump up the overall tax rate. There's also what's called hybrid and reverse hybrid entities. This is what I was just talking about where one country views it as transparent, one country views it the other way. Right? Foreign LLCs are not viewed as if the same way as if it's a US LLC from the US perspective. Most foreign LLCs are viewed from the US perspective as if they're corporations. So you really have to watch out. The biggest benefit that the US has here is what's called the check the box regulation ctb and what that allows businesses to do is choose how they're taxed. You can have an LLC taxed as a C corporation. You can have an LLC taxes and S Corporation LLCs can be taxes, partnerships, things like that. So it's, since it's largely elective, you can have, you can use an LLC to be held by a foreign individual, but you probably just want to use a corporation. What people do is they hold by an llc, they check the box. I've always found that was a little clunky. Why not just be a corporation? You know, why make extra, why make extra work? Right. Unless you're really just really excited to file extra forms with the IRS and with a state. Right. I never really understood that. But you can, you know, as I note other concerns at the bottom, it is incredibly, incredibly, incredibly easy to foot fault in with S corporations. I've seen it many times where you know, they make a loan to one partner, not the other, that may blow the S election. So you may be a C corporation. And I always say this is if you're an LLC and you make the S election, if you blow the S election, you don't go back to being taxed as a partnership, you go, you go to being taxed as a C corporation. And if they're meant returns, whole, whole thing. So if you're looking to sell your business, that's something a buyer is absolutely going to look at. If you're looking to get an investor, you know, it's really hard to get investors in S corporations. We do a lot of times when they're being sold or investment what's called f reorgs which basically allows you to be taxed as the partnership. So for a lot of times, you know, when I'm talking to clients, I often say, you know, what are your goals for one year? For five years and for 15 years, right, one year. They can usually explain five years, probably 15 years. Who even knows, right? Who knew 15 years ago in 2009, right. How much the world had changed would change by 2024. So I think it's really important to have that conversation. Think about the long term and what you're trying to accomplish. So you know, it's important. Like I said, comparing S corporations with partnerships, right. They're both pass throughs, whereas C corporations, right. I always say this, look, pass throughs. If you're going to distribute all or the vast majority, even probably most of the income 2/3 or so, you're going to have lower overall taxes. But if you don't distribute, right. With a partnership or an S corporation, any sort of pass through, the taxes are actually higher if you don't distribute because you're going to have to come out of pocket for it. If you're a corporation, since the corporation is the one that actually pays the taxes, the taxes are lower overall, right? On a year over year basis. If you're not distributed, there's also a qualified small business stock. Section 1202 following along. You notice I skipped it. Section 1202, the code is not a loophole. It is, it is quirky, it has some very, very finicky rules and it exists somewhat on an island because it really doesn't. This kind of exclusion does not exist anywhere else. So it's something that you really want to watch out for and think about when you're trying to, when you're trying to qualify. Basically a business is a qual has qualified small business stock. If it is in certain business areas it is much easier because this is how the code section works to talk about the business types that do not qualify. Right. First off, has to be an active bit trader business. So that's really important. Cannot be some sort of passive investment company generally Speaking, it's a little more broad than this, but any service business, financial services, insurance, things like that, right? So lawyers, doctors, wore out financial services, real estate management, things like that, those are out. Those are not qualified. But if you have a company that's doing software development, if you are a company that is buying and selling things online, right. Depending on what it is that may qualify, you have to hold the stock for five years. You have to get the stock from the company itself and initial issuance. There's other rules around whether there was a redemption of a large redemption they're worried about. Since you can't get qualified for the business stock by buying it from another shareholder, they don't want them to redeem that shareholder, then immediately resell or resell it, then redeem it. So there's rules around that. Also when you buy the stock, when you acquire it, and you don't have to just buy it, you can provide services and get equity in exchange, right? Sweat equity works. The assets have to be, you know, less than 50 million, right? And that's, you know, that's most businesses. But I always say that a lot of times this happens in conjunction with a raise. And people say, well, how much are the assets worth? And the answer is, well, how much does the capital raise say the assets are worth? Right. If you're buying, you know, they're selling 10% of the company for five and a half million dollars, well, that means the company's worth 55 million, right? Post money. And that would mean that the stock you acquired is not worth qualified. Small business stock. I have seen people, instead of raising at 50, at 55 or something like that, raise it 49,900 because they feel that it will be much, much easier to raise and the dollar amount's not that different or, you know, other factors for substantial. You can't, you know, people like, oh, well, I'll just be an llc. And then right before I sell, you know, or five years, where I sell, I'll become a C Corp, right? Or we an LLC for a period. No, substantially all of the time that the business, the business operates, it must be a C Corp, right? Substantially all is not defined in this context. Generally, you know, I want people over 80%. Some people say 90. I've seen people say as low as 60. I think that is extremely, extremely aggressive. So you really want to be a little conservative. If you're targeting usps, just start the business as a C Corp, you know, that's it. And it's also important to note that there are a number of states that decouple from this, which means they don't follow qualified small business stock. New Jersey. Right. I'm in New York. Never miss an opportunity to make a joke about New Jersey. New York follows. New Jersey doesn't. Right. So if you live in New Jersey, your taxes are higher. New Jersey will tax. Federal government won't. Right. Live in New York. Right. New York will not tax. If you qualify for small business stock again, up to 10 million per shareholder or it's also 10 times your initial investment. So if you invested, you know, 10 million in a company, right. Then you have 100. You have up to $100 million in qualified small business stock. 10 times 10 equals 100 even I can do that math. But if you Invest, you know, $200,000, then you have 10 million. It's basically the, the larger of 10 times your investment or $10 million for the vast majority of shareholders, it's 10 million bucks. There's other really kind of quirky rules around putting a partnership on top, an LLC on top afterward. There's rules around splitting it. There was an article in the Times maybe two years ago at this point about using trust to split it to maximize qualified small business stock. If you want to do that, talk to someone who has experience within it. I think it's really important. And then I think the last thing major point I'm going to bring up is state and local tax considerations. I discussed the GCT and the UBT at the high level but I want to dig into it a little more because I think it's really important. Think about it. And this is a situation where, you know, if you ignore state and local tax, that that's at your own peril. You know, it can really create issues. As I said earlier, New York City ignores the ignores s elections and it does that by, by imposing the general corporation tax GCT on s corporations. Conversely, every other kind of partnership, any partnership disregarded entities, sole proprietorships have what's called are subject to the unincorporated business tax or UBT. Whereas the GCT is 8.85% from $1. You make 100 bucks, you make, you pay $8.85 a tax. You're done with the UBT. The first $85,000 of income is not subject to tax. And then there's this kind of weird crediting mechanism. And what happens is as your income level goes up and this is on a per owner basis up to $135,000, your rate slowly ticks up. And then income once we hit 135,000, it's taxed flat at 4%. So there's also a credit that you can get if you're a resident of the city or the state. And there's different rules on that, which I'm not going to go into. I'm basically going to ignore them because they're just more complex and they're very formulaic. The rate for a lot of New York City residents is actually 3.08%, but I just say it's 4%. I've often found that if you tell a client that the rate's 4 and then it's 3.08, they don't really complain. If you tell them it's 3.08 and the rate's 4, they're going to complain. Right. So, so, so, you know, promise low, deliver high. Right. And that's the premise. A lot of people, they, you know, you get these small businesses in New York City and they become s corporations and as a result they actually pay more tax. Right. And that's not helpful. You know, that's not good. That's not what the code wants. They want you to choose the right thing. So I often ask people, you know, are you going to operate in New York City? Are you going to have clients in New York City? Right. Most jurisdictions at this point are market based sourcing. So even if you're not operating in the city, but you have a lot of clients in the city, you're coming into the city a bunch, et cetera, that can really trigger that. So you really want to watch out for that. And as I said earlier, New York City is not the only city that has this. New York City, you know, there's states that have taxes on pass through businesses. And I think it's important to really watch out. If you don't pay attention, you know, as the doctor will say, right. Pay attention to your salt, got to pay attention to your saw. That's it. I hope you learned something, hope you enjoy it. And you know, the idea is to have this coming out every two weeks. So talk to you again in two weeks. Thank you.