Difficulties of Beginning your own Business (Case Study)

Facts: After 20+ years of working for other firms, Penelope (enrolled agent, age 41), Mark (CPA, age 43), and John (CVA, age 65) want to leave the firms they are currently employed by and become their own bosses. Penelope specializes in taxes, Mark is the auditor, and John is a business valuation expert. There are so many options available as to how they can structure the new business. The appropriate business entity for any individual(s) will depend on their particular facts and circumstances. You are a valued colleague and friend of this threesome, and they have come to you seeking advice as to how to structure their new business.They have the knowledge to figure it out themselves but are looking for the advice of an unbiased third party. Please consider the following tax and nontax considerations as you recommend an entity choice to Penelope, Mark, and John.Part I: Discuss the various forms of organization that are available to Penelope, Mark, and John. There are a number of diffe rent forms of organizations for Penelope, Mark, and John to choose. The four main ones are a partnership, Limited Liability Corporation (LLC), S Corporation, or C Corporation. In a partnership all partners are personally liable for debts and obligations. Each partner claims their share of income and losses on their individual tax returns. An LLC covers the owner from personal liability from business debts. As with a partnership, the taxes for an LLC are passed through to the owners. An S Corporation, as with an LLC, the income and taxes pass through to the owners. C Corporations are considered separate entities and pays corporate income taxes separate from the shareholders. With a C Corporation, the shareholders are also taxed on the dividends received.Part II: Make your recommendation as to what form of organization you believe will be best, and be sure to explain the reasoning for your choice. The best organization for Penelope, Mark, and John is a Limited Liability Corporation (L LC). The owners will receive the benefits of limited liability as with a corporation, but the pass through option for the taxes. The LLC is not considered a separate entity so is not subjected to double taxation.Part  III: Discuss the tax consequences of contributing cash, property, and/or services to the new entity. There are no tax consequences for the members of the LLC for contributing cash, property, or services.Part IV: Discuss, in detail, how this entity is taxed (if at all) and what filing requirements it has with the IRS. A multi-member LLC is taxed as a partnership by the IRS. The LLC can elect to be taxed as a corporation by filing form 8832. The LLC files an informational tax return, Form 1065 and Schedule K-1, but is not taxed itself. Individually each member files a Form 1040 and reports their share of the LLC income or losses from the Form Schedule K-1. Each member must pay taxes, which include self-employment tax, on their share regardless if any income is distribu ted. (IRS.gov)Part V: Discuss how income and distributions may or will be allocated to Penelope, Mark, and John. The profits are shared based on percentage of ownership or equally. This needs to be decided during the set-up.Part VI: Discuss, in detail, how the individuals are taxed (if at all) with respect to the net profits from this entity and what filing requirements they will each have with the IRS. With the LLC the individual partners are liable for filing their own personal income taxes based on the guidelines of the IRS, which will include self-employment taxes and any estimated taxes. The individual return Form 1040 will also include a Schedule K-1. All credits and deductions are passed through to each member. The amount of the credits and deductions that each member files for are divided by the percentage that each member has in the company.Part VII: Discuss how Penelope, Mark, and John will calculate their basis in the new entity. Be sure to include the impact that debt ha s on basis, if any. When a partnership interest is acquired in other ways than contributions, usual basis rules apply (Code Sec 742). Since the cost is the initial basis of purchased interest it can be adjusted by the following criteria; additional contributions, partnership’s accumulated taxable income as stated separately ( ¶ 19.3), tax-exempt income from the partnership, increases in the partnership liabilities. (Code Sec. 752(a)).Part VIII (Limited Liability): Discuss the exposure that Penelope, Mark, and John's personal assets will have to the debts and lawsuits of the entity you have recommended. All personal assets of the members of the LLC are covered by the limited liability. If the company is ever sued the personal assets are protected from being taken. In choosing the Limited Liability Corporation,  Penelope, John, and Mark will be protected personally from any misconduct or illegal actions of one of the other members. Each one will be able to how to contribute and manage the company. Also, by choosing the LLC option, the company and members will not be subjected to double taxation. An LLC has no limitation on members as with an S and C corporation, but have the protection. Penelope, Mark, and John will be able to focus on their individual experience to help grow the company as needed.