CHOICE OF ENTITY TAX CONSIDERATIONS

1. CHOICE OF ENTITY TAX CONSIDERATIONS Thomas F. Schnellenberger September 20, 2006 1607621

2. OVERVIEW • Sole Proprietorship • Single Member Limited Liability Company (“SMLLC”) • General Partnership • Limited Partnership • Limited Liability Company (“LLC”) • S Corporation • C Corporation Ms. Big Bucks is contemplating how to organize her new business:

3. OVERVIEW • Ms. Big Bucks uses $10 of personal funds and $50 of funds borrowed from bank • Year 1 losses = $50 (Ms. Big Bucks’ share) • Year 2 profits = $100 (Ms. Big Bucks’ share) • Business is sold at the end of year 2 for $1,000 • Ms. Big Bucks is active in the business Assume the following:

4. CHOICE OF ENTITY SOLE PROPRIETORSHIP

5. $50 Ms. Big Bucks Bank Note FORMATION CHOICE OF ENTITY SOLE PROPRIETORSHIP • Business bank account • Federal and state Employer Identification Numbers (“EINs”) and other tax registrations • Licenses • No liability protection • Self employment (“SE”) tax

6. Employment Tax Components and Rates Self-Employed EmployerEmployeeIndividual OASDI - Imposed on Earnings up to $94,200 (2006): Employer 6.2% 6.2% Employee __ 6.2% 6.2% Total OASDI 6.2% 6.2% 12.4% Medicare: Employer (1) 1.45% 1.45% Employee ___ 1.45% 1.45% Total Medicare 1.45% 1.45% 2.9% Total 7.65% (1) 7.65% 15.3% (2) (1) Deductible by employer in arriving at employer’s taxable income. (2) One-half deductible in arriving at adjusted gross income.

7. Self-employment Tax Income Tax Cash Income from Operations ($50.00) ($50.00)* Self-employment Inclusion Percent x 92.35% Self-employment loss (46.18) Self-employment Tax Rate x 15.3% Self-employment Tax benefit (7.06) 3.53 Net Taxable Income (46.47) Assumed Effective Rate x 38% Tax Cost < savings > ($7.06) ($17.66) 24.72 Net Cash $ 24.72 FIRST YEAR SOLE PROPRIETORSHIP Unless otherwise noted, it has been assumed that: (1) at-risk and passive loss rules are satisfied, and (2) Ms. Big Bucks has other sources of SE income against which loss can be offset. After-tax benefit of $24.72

8. Self-employment Tax Income Tax Cash Income from Operations $100.00 $100.00 Self-employment Inclusion Percent x 92.35% Self-employment Income 92.35 Self-employment Rate x 15.3% Self-employment Tax 14.13 (7.06)* Net Taxable Income 92.94 Assumed Effective Income Tax Rate x 38% Tax Cost < savings > $14.13 $35.32 (49.45) ($49.45) SECOND YEAR SOLE PROPRIETORSHIP * After-tax cost of $49.45

9. SOLE PROPRIETORSHIP SALE OF BUSINESS Income Tax Cash Sales price $1,000.00 $1,000.00 Basis Personal funds $ 10 Borrowed funds 50 Year 1 loss (50) Year 2 profit 100 (110.00) Gain 890.00 Estimated capital gains rate 17% Income tax $ 151.30 (151.30) Loan repayment (50.00) Net sales proceeds $ 798.70

10. NET CASH SOLE PROPRIETORSHIP Original investment ($10.00) First year tax 24.72 Second year tax (49.45) Sale proceeds 798.70 Total $763.97

11. CHOICE OF ENTITY SINGLE MEMBER LLC

12. SINGLE MEMBER LLC 100% Ownership Ms. Big Bucks Big Bucks LLC Bank Note $50 $10 FORMATION • Absent an affirmative election to be treated as a corporation, Big Bucks LLC will be disregarded for income tax purposes; i.e., treated as a sole proprietorship • Bank account • EINs • Licenses • Liability Protection • SE tax

13. NET CASH SINGLE MEMBER LLC Original investment ($10.00) First year tax 24.72 Second year tax (49.45) Sale proceeds 798.70 Total $763.97

14. CHOICE OF ENTITY GENERAL PARTNERSHIP

15. GENERAL PARTNERSHIP Ms. Big Bucks Mr. Big Bucks $10 $10 50% General Partnership Interest 50% General Partnership Interest Big Bucks, General Partnership Bank $100 FORMATION

16. NET CASH GENERAL PARTNERSHIP Original investment ($10.00) First year tax 24.72 Second year tax (49.45) Sale proceeds 798.70 Total $763.97

17. CHOICE OF ENTITY LIMITED PARTNERSHIP

18. Ms. Big Bucks Mr. Big Bucks $10 $10 50% Limited Partnership Interest 50% General Partnership Interest Big Bucks, L.P. Bank Note $100 FORMATION CHOICE OF ENTITY LIMITED PARTNERSHIP • EINs • Bank account • Liability protection for limited partner only • Deductibility of losses subject to basis, at-risk and passive loss limitations • General partner subject to self-employment tax but limited partner is generally not

19. Mr. Big Bucks Ms. Big Bucks Taxable Loss <$10> (1) Taxable Loss <$90> Big Bucks, L.P. FIRST YEAR LIMITED PARTNERSHIP (1) Basis limitation results in loss limitation to Mr. Big Bucks.

20. Self-employment Tax Income Tax Cash Income from Operations ($90.00) ($90.00) Self-employment Inclusion Percent x 92.35% Self-employment Loss ($83.12) Self-employment Tax Rate x 15.3% Self-employment Tax Benefit ($12.72) (6.36) Net Taxable Income ($83.64) Assumed Effective Income Tax Rate x 38% Tax Cost/(Savings) ($12.72) ($31.78) 44.50 Net Individual Cash $ 44.50 FIRST YEAR MS. BIG BUCKS LIMITED PARTNERSHIP After-tax savings of $44.50

21. Self-employment Tax Income Tax Cash Income from Operations $0.00 ($10.00) $0.00 Self-employment Inclusion Percent x 92.35% Self-employment Income < loss > $0.00 Self-employment Tax Rate x 15.3% Self-employment Tax Cost < benefit > $0.00 0.00 Net Taxable Income ($10.00) Passive Loss Limitation 10.00 Net Taxable Income (0.00) Assumed Effective Rate x 38% Tax Cost < savings > $0 $ 0 0 Net Individual Cash $ 0 FIRST YEAR MR. BIG BUCKS LIMITED PARTNERSHIP No after-tax savings because of basis limitation

22. Ms. Big Bucks GP Mr. Big Bucks LP Big Bucks, L.P. Bank Note $100 First Year LIMITED PARTNERSHIP Guarantee $10 loss $90 loss LP’s basis limitation can be avoided if LP guarantees at least $10 of bank debt

23. Self-employment Tax Income Tax Cash Income < loss >from Operations $ 140.00 $ 140.00 < $ 0 > Self-employment Inclusion Percent x 92.35% Self-employment Income < loss > $ 129.54 Self-employment Tax Rate x 15.3% Self-employment Tax Cost < benefit > $ 19.82 < 9.91 > Net Taxable Income $ 130.09 Assumed Effective Income Tax Rate x 38% Tax Cost < savings > $ 19.82 $ 49.43 < 69.25 > Net Individual Cash < $ 69.25 > SECOND YEAR MS. BIG BUCKS LIMITED PARTNERSHIP After-tax cost of $69.25

24. Self-employment Tax Tax Cash Income < loss >from Operations $ 0 $ 60.00 Passive Loss Carryover < 10.00 > Net Taxable Income $ 50.00 Assumed Effective Rate x 38% Tax Cost < savings > $0 $ 19.00 < $19.00 > Net Individual Cash < $ 19.00 > SECOND YEAR MR. BIG BUCKS LIMITED PARTNERSHIP • After-tax cost of $19.00 (reduced because of carryover) • No self-employment tax because of LP status

25. Income Tax Cash Sales price $ 1,000 $1,000 Basis Personal funds $ 20 Borrowed funds 100 Year 1 loss < 100 > Year 2 profit 200 220 Allocable share x 50% < 110 > Gain $ 890.00 Assumed capital gains rate 17% Income tax $ 151.30 < 151.30 > Repay bank (Allocable Share) < 50 > Net sales proceeds $ 798.70 SALE OF BUSINESS LIMITED PARTNERSHIP

26. Ms. Big Bucks Mr. Big Bucks Original Investment < $ 10.00 > < $ 10.00 > First Year Tax 44.50 -0- Second Year Tax < 69.25 > < 19.00 > Sale Proceeds 798.70 798.70 Total $ 763.95 $ 769.70 NET CASH LIMITED PARTNERSHIP

27. CHOICE OF ENTITYLIMITED LIABILITY COMPANY (LLC)

28. CHOICE OF ENTITYLimited Liability CompanySimilar to limited partnership, but with limited liability for all.

29. SELF EMPLOYMENT TAX CHOICE OF ENTITY Treasury issued Proposed Regulations in 1997 which would exclude limited partners and LLC members from self-employment tax unless individual has any one of the following: (1) personal liability for debts or claims against the entity by reason of being owner, (2) authority to contract on behalf of the entity, or (3) participates in the entity’s business for more than 500 hours during the tax year.

30. CHOICE OF ENTITYS CORPORATION

31. Ms. Big Bucks Cash $10 100% Stock $50 S Corporation Bank Note FORMATION CHOICE OF ENTITY S CORPORATION • Bank account • EINs • S corporation election required • Licenses • Liability Protection

32. Income Tax Cash Income <loss> from Operations < $50* > $0 Basis Limitation 40 Net Taxable Income <loss> < $10 > Assumed Effective Rate x 38% Tax Cost <savings> < $3.80 > 3.80 Net Cash $3.80 FIRST YEAR S CORPORATION * Deductibility of loss subject to at-risk, basis limitation and passive loss rates. Assume individual is active in business. Salary????

33. Note FORMATION CHOICE OF ENTITY S CORPORATION Avoiding Basis Limitation Ms. Big Bucks $50 Cash $60 100% Stock Bank S Corporation Note: Guarantee by Ms. Big Bucks will not create basis

34. Tax Cash Income <loss> from Operations $100 $0 Suspended Loss Deductible < 40 > Net Taxable Income $ 60 Assumed Effective Rate x 38% Tax Cost <savings> $22.80 < 22.80 > Net Cash < $22.80 > SECOND YEAR S CORPORATION

35. S CORPORATION SALE OF BUSINESS Income Tax Cash Sales Price $ 1,000 $ 1,000 Basis Personal funds $10 Loaned funds 50 Year 1 loss <50> Year 2 profit 100 <110> Gain $ 890 Assumed Capital Gains Rate x 17% Income Tax $ 151.30 <151.30> Repay Bank Loan < 50.00> Net Cash $ 798.70

36. S CORPORATION Original Investment <$10.00> First Year Tax 3.80 Second Year Tax <22.80> Sale 798.70 Total $769.70 NET CASH

37. WHY NOT AN S CORP? CHOICE OF ENTITY S CORPORATION vs. PARTNERSHIP • Only natural persons and certain trusts can be shareholders • Maximum 100 shareholders (family members may be treated as one shareholder) • Only one class of stock permitted (except can have differing voting rights) • No special allocations • No tax basis for liabilities even if guarantee • A distribution of appreciated assets from an S corporation is a taxable event; such a distribution from a partnership or LLC generally is tax-free • Salary/payroll taxes

38. CHOICE OF ENTITYC CORPORATION

39. Ms. Big Bucks Cash $10 100% Stock $50 Cash C Corporation Bank Note FORMATION CHOICE OF ENTITY C CORPORATION • Bank account • EINs • Licenses • Liability Protection

40. Income <loss> from Operations < $ 50 > Net Operating Loss Carryover < $ 50 > FIRST YEAR CHOICE OF ENTITY C CORPORATION

41. Income <loss> from Operations $ 100 Net Operating Loss Carryover Used < 50 > Net Taxable Income $ 50 Assumed Effective Rate x 18% Net Cash Cost to Corporation $ 9 SECOND YEAR CHOICE OF ENTITY C CORPORATION

42. C CORPORATION Corporate Corporate Individual Individual Income Tax Cash Income Tax Cash Sales Price $1,000 $1,000 Basis Original Investment $10 Bank Loan 50 Net Cash Investment 41 < 101 > from Operations Net Gain 899 Assumed Corporate Rate x 40% Corporate Tax $ 359.60 < 359.60 > Repay Bank Loan < 50.00 > Net Cash to Distribute $ 590.40 $ 590.40 $ 590.40 Individual Basis < 10.00 > Net Gain 580.40 Assumed Capital Gains Rate x 17% Tax 98.67 (98.67) Net Cash $491.73 SALE OF ASSETS

43. SALE OF STOCK C CORPORATION Income TaxCash Sales Price $ 950* $ 950 Basis 10 Net Gain $ 940 Assumed Capital Gains Rate x 17% Tax $ 159.80 < 159.80 > Net Cash $ 790.20 *Assume stock sold for $1,000 less $50 bank loan.

44. Sale Sale of of Assets Stock Original Investment < $10 > < $10 > First Year - 0 - - 0 - Second Year - 0 - - 0 - Sale $ 491.73 $ 790.20 Net Cash $ 481.73 $ 780.20 NET CASH C CORPORATION

45. COMPARISON OF NET CASH CHOICE OF ENTITY Sole Proprietorship/General Partner $763.97 Limited Partner 769.70 S Corporation 769.70 C Corporation – Sale of Assets 481.73 C Corporation – Sale of Stock 780.20

46. CHOICE OF ENTITY Tax Cash Corporate Profit $100 $100 Assumed Effective Corporate Tax Rate x 40% Income Tax $ 40 < 40 > Cash Available for Distribution $ 60 $ 60 Assumed Effective Individual Tax Rate x 17% Income Tax $10.20 <10.20> Net Cash $49.80 C CORPORATIONDOUBLE TAX ON DIVIDENDS

47. EMPLOYEE FRINGE BENEFITS CHOICE OF ENTITY Sole proprietors, partners (including LLC members) and more than 2% shareholders in an S corporation are not eligible for the following tax free benefits: • Group term life insurance • Disability insurance • §125/cafeteria plans • Educational expenses • Employee-paid parking • Health and accident plans • Meals and lodging furnished for the convenience of the employer

48. EMPLOYEE FRINGE BENEFITS CHOICE OF ENTITY To ameliorate adverse tax consequences to self-employed, a percent of health/medical insurance costs and actual costs are deductible in arriving at Adjusted Gross Income: • 2000 60% • 2001/2002 70% • 2003 100% • 2004 100% • 2005 100% • 2006 100%

49. Choice of EntityMulti-State Operations Operations in more than one state complicate flow through entity (partnership (for tax) or S corporation) operation because: • Each owner must file in multiple jurisdictions • Entities may be treated differently from state to state • Non-residents may be subject to withholding on income

50. Choice of EntityObservations Sole Proprietorship – simplest, but no liability protection.Single Member LLC – liability protection.General Partnership – no liability protection.Limited Partnership – liability protection and no self-employment tax for L.P.s.LLC – liability protection for all and flexible, but self-employment tax question.S Corporation – liability protection for all, but not as flexible. Can manage FICA (self-employment tax).C Corporation – liability protection for all, but double taxation not attractive.