Partnerships and Limited Liability Companies

No gain or loss is recognized when you transfer property to a partnership or limited liability company (LLC) in exchange for an interest in the partnership or LLC. Gain may be recognized if your liabilities are assumed by noncontributing partners and these liabilities exceed your adjusted basis in the property you transfer to the business. Gain can also be recognized when a partnership or LLC interest is given in exchange for services you render.

Business's basis in transferred property. The business's basis in the property received is the same as your basis (increased by any gain you may have had to recognize). The business's holding period in the property it received includes your holding period in the property.

Owner's basis in partnership/LLC interest. Your basis in the interest is the same as your basis in the property transferred to the business, decreased by any liabilities you are relieved of and increased by any liabilities assumed by the business and any gain you recognize on the transfer.

Corporations

No gain or loss is recognized if property is transferred to a corporation by you and other persons solely in exchange for stock in such corporation, and immediately after the exchange such person or persons are in control of the corporation (at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation). So if you transfer your computer, office furniture, truck, and $10,000 cash to your corporation in exchange for 100% of its stock, you aren't taxed on the transfer of the property. You cannot recognize any loss on the transfer.

If any loans are transferred as part of the incorporation (e.g., a loan on the truck), there may or may not be immediate tax results to you. You must recognize gain to the extent that the sum of your liabilities assumed by the corporation exceeds your basis in the property transferred.

The corporation does not have any gain or loss when it issues its stock for money or other property received during the incorporation.

Corporation's basis in transferred property. The corporation's basis in the assets you transfer to it is the same as your basis in the transferred property, increased by any gain recognized by you. The corporation's holding period in the property received includes your holding period in the property you transferred.

Shareholder basis in stock. Your basis in the stock received equals the basis of the property you transferred to the corporation. Your holding period in the property transferred carries over to the stock received, so you may immediately have a long-term holding period (depending on when you acquired the property you transferred to the corporation).

Debt Financing

Debt means borrowing money that must be repaid. For instance, you may go to a friend or a bank to raise the $10,000 you need to start up. The $10,000, plus interest, must be repaid to the lender (creditor) over a fixed period.

There are many places to look for loans: your own resources (e.g., using home equity loans), family and friends, and commercial loans (e.g., SBA-backed loans are obtained through commercial lenders and not directly from the SBA).

The positive thing about debt financing is that the relationship is limited in a couple of ways. First, the lender usually has no say in how you run your business. As long as you repay the loan on time, the lender is happy (you may be required to provide financial information on an ongoing basis to keep your loan in good standing). Second, the relationship has a limited duration. Once you've repaid the loan, you do not have to deal with the lender (unless you borrow new money).

The negative thing about debt is that it can be costly to you. Except when borrowing from family or friends in some cases, you must repay not only the amount you borrow (“principal”), but also interest. Typically, you will have to make money payments to the lender and this can be a drain on your cash flow.

Taxwise, you can deduct the interest you pay to the lender as a business expense. Repayment of principal is not deductible. You cannot disguise equity financing as debt in order to create an interest deduction. “Thin capitalization” (too much debt compared with equity) can raise IRS eyebrows and result in the disallowance of interest deductions.

There are a number of online ways to obtain loans for your business. For example, peer-to-peer lending may provide small amounts of needed capital. Sites include Lending Club (www.lendingclub.com) and Funding Circle (www.fundingcircle.com). However, steer clear of fly-by-night, easy money offers.

Before borrowing, read the Small Business Borrowers' Bill of Rights at www.responsiblebusinesslending.org. Check here whether your prospective lender is a signatory to this bill of rights.

Royalty financing. A twist on debt financing is an arrangement called royalty financing. It uses a percentage of company's revenue over a set period of time to repay a loan; there usually is a ceiling on the amount that the lender will be paid.

Equity Financing

Equity means ownership, so equity financing means sharing some ownership with an investor in exchange for money and/or property. For instance, say you need to raise $10,000 and you find an investor willing to provide it; you might give a 1%, 5%, or other interest in your business to the investor to secure this money.

There are a number of ways to find investors: Ask family or friends or look for angel investors (private individuals or groups who want to invest in small businesses). You can find interested angels through Angel Capital Association (www.angelcapitalassociation.org). Venture capital is typically used for startups with rapid, high-growth potential in such fields as biotechnology, information technology, and other emerging technology, that need $500,000 and up to launch; it is usually not suitable for the average small business start-up.

The positive thing about equity financing is that you are not required to make any paybacks to the investor; the investor is gambling on your success and will share in that some time in the future. In other words, with an investor, there is no monthly drain on cash flow as there is with debt servicing.

The negative thing about equity financing is that you have to share your profits. You also have created a long-term relationship with your investor: There is no fixed end to the relationship as there is with debt, which ends when the loan is repaid. Depending on the size of the investor's interest in your business, the investor may have a say in your day-to-day operations.

Taxwise, there is usually no immediate tax impact when an investor joins you in the business. Neither you, nor the company is taxed on the capital contribution (money and/or property) made to the company.

Equity crowdfunding. Small businesses can seek funding from small investors without having to go through extensive and costly government registration. Businesses cannot raise the funds directly from investors; they must use Securities and Exchange Commission (SEC)–approved portals (websites designed for this purpose).

Some equity crowdfunding sites include AngelList (https://angel.co/), Crowdfunder (www.crowdfunder.com/), Early Shares (www.earlyshares.com/), Fundable (www.fundable.com/), Equity Net (www.equitynet.com/), and WeFunder.com (www.wefunder.com).

Companies using equity crowdfunding to raise up to $1 million can offer shares to all types of investors, but investors’ net worth and income may limit their investments. Those with annual incomes under $100,000 can invest 5% of their annual income or $2,000, whichever is less. Those with higher annual incomes can invest up to 10% of their annual income. Under SEC rules, companies can do “mini-IPOs;” the rules, which are governed by SEC Reg. A, are not explained here. You can follow developments on equity crowdfunding through the Small Business & Entrepreneurship Council at www.sbecouncil.org/resources/crowdfunding.

Some states have created an exemption from the federal rules to allow intrastate equity crowdfunding. This means residents can invest in businesses within their state through crowdfunding platforms in their state. Table 25.1 lists the states that have intrastate equity crowdfunding rules. New Jersey and New Mexico should be active soon. If you are interested in raising capital through crowdfunding and are based in a state permitting intrastate equity crowdfunding, look for a platform in your state (a website dedicated to equity crowdfunding).

Other Financing

Debt and equity are not the only financing options for start-ups.

Grants. Business-related grants usually are limited to companies that will create jobs within an economically distressed area or provide some other community benefit; the grant application process is complex, so this financing option is limited. Grants are tax free. But some payments, called grants, may not be tax free (e.g., government assistance following natural disasters).

Contests. Contests, usually sponsored by major corporations, can provide first-prize winnings of $5,000, $25,000, or more. There is no central listing for contests; just stay alert to these opportunities. Prize winnings are fully taxable.

ROBS. In recent years, some businesses are using an owner's 401(k) fund to get started. Rollovers as business start-ups (ROBS), which are being aggressively marketed to would-be entrepreneurs, have been identified by the IRS as potential abusive transactions, according to Monika Templeton, director of the Employee Plan Examinations Office. The IRS also has a compliance project for ROBS (go to www.irs.gov and search “rollovers as business start-ups compliance project”). Here's how ROBS work: An entrepreneur uses his/her 401(k) or other plan benefits to finance a new venture without paying taxes on the funds in the plan. The entrepreneur incorporates the business and sets up a qualified retirement plan into which the owner rolls over the 401(k); the funds in the new qualified plan are then used to buy company stock (i.e., put cash into the company). While the IRS hasn't gone so far as to define this arrangement as abusive, it's on the IRS watch list so entrepreneurs should beware! More concerns and issues related to ROBS are in Chapter 16.

Crowdfunding donations. Raise money in small increments from complete strangers through websites designed for this purpose. These people essentially donate small amounts typically to help businesses with special projects. Websites for this purpose include Kickstarter (www.kickstarter.com/) and many others.

Find general information about small business loans, grants, and other finan-cing at SBA.gov at www.sba.gov/loans-grants.

Where to Get Your EIN

You can obtain your federal EIN by completing IRS Form SS-4, Application for Employer Identification Number, online at www.irs.gov and search “EIN Online” (see Chapter 1).

When you apply online, the IRS automatically enrolls you in the Electronic Federal Tax Payment System (EFTPS) (www.eftps.gov). This electronic system enables you to make tax payments, including estimated taxes, online. After automatic enrollment, you will receive an enrollment confirmation, along with a PIN and instructions within a few days. Without a payroll, you are not required to use EFTPS, but may choose to do so for the convenience. Millions of small businesses have voluntarily signed on to use EFTPS.

State EINs

States may assign their own tax identification numbers (also called business registration numbers) to your business for unemployment insurance reporting for employees and for other purposes, typically at the time you register to do business in your state. For more information about your state EIN, contact your state tax, revenue, or finance department.

If you do business in New York, Massachusetts, and South Carolina, you can register with the IRS and state in one step (go to www.irs.gov, search “state and federal online business registration,” and click on the applicable state).

Resale Number Distinguished

Business owners are responsible not only for income and employment taxes, but also for state and local sales taxes on the goods and services they sell. In order to properly remit sales tax that you collect to your state and to avoid paying sales tax on items you buy for resale, you need a resale number (states without sales tax—Alaska, Delaware, Montana, New Hampshire, and Oregon—do not issue resale numbers). Your state sales tax number (called a resale number, a seller's permit, or sales tax license) is not the same as your federal tax identification number.

Once you have your resale number, your state may permit you to continue to use it as long as you are in business; in other states you must renew the resale number periodically. For information on obtaining a resale number, contact your state tax, revenue, or finance department.

Other Numbers

As a business, you may need other identification numbers:

• The DUNS number is one assigned to you by D&B, a business credit rating service. This number is not used for tax purposes, but is required if you do any government contracting. Having this number also enables you to more easily build business credit.

• State unemployment insurance may assign your business a number when you enroll to pay this tax.

Which Form of Bankruptcy to Use

Your choices for bankruptcy protection depend on how your business is organized (entity type) and whether you want to stay in business if possible.

• Sole proprietors. Owners are treated like other individuals. They can get a fresh start under Chapter 7 of the bankruptcy law, but most are forced to use a payment plan under Chapter 13.

• Family farmers. Farmers can use a simplified reorganization plan under Chapter 12 of the bankruptcy law if debts fall within a certain limit.

• Other business entities. The entities can be liquidated with proceeds distributed to creditors under Chapter 7, or can be reorganized under court supervision to continue operations under Chapter 11. Caution: General partners can be sued by the trustee in bankruptcy if partnership assets fall short of partnership debts.

Which type of bankruptcy solution is best for a business? It depends on the facts and circumstances. Sole proprietors may have no choice but to use the repayment plan, whether or not they continue the business operations.

Other entities may prefer to liquidate if they see the business as a failure (they have no heart for continuing the business); if the market is such that even if economic conditions recover, the business wouldn't be viable; or if the debts are so overwhelming that restructuring doesn't make economic sense.

Tax Implications of Bankruptcy

If some or all of your debts are extinguished in bankruptcy, you are not taxed on the discharge (cancellation) of indebtedness.

Bankruptcy can provide some relief from taxes. First, filing for bankruptcy creates an automatic stay on collection activities (the IRS as well as state and local tax authorities must stop hounding you for money). Second, some outstanding taxes can be dischargeable; others cannot. This is a highly complex area, and you are advised to work with a knowledgeable tax advisor if you are considering filing for bankruptcy.

Bankruptcy Alternative

If you want to continue your business, you can work with a credit professional to help restructure the company's debts. This lets you work your way out of debt in a manageable manner and avoid bankruptcy. For example, Corporate Turnaround (www.corporateturnaround.com) negotiates on your behalf with vendors, lessors, credit card companies, and other business creditors to set up a repayment plan that you can handle.

When you are seeking a company to help restructure your debt, look for members of the Turnaround Management Association (www.turnaround.org/Membership/Browse.aspx), an international nonprofit association dedicated to corporate renewal and turnaround management. Members sign a code of ethics to provide professional, competent assistance.

Tax Implications of Debt Forgiveness

If you don't file for bankruptcy and instead convince creditors to accept partial payment, the amount of debt forgiven is treated as discharge (or cancellation) of indebtedness income. Whether such income is taxable to you depends on whether you are insolvent at the time of the forgiveness (insolvency means your liabilities exceed your assets). If you are insolvent, no tax consequences result from the discharge of indebtedness. If you are not insolvent, the forgiveness is taxable, but you can opt to adjust tax attributes so you'll effectively pay the tax later. See Chapter 5.

Unamortized Costs

If you have been amortizing certain items, such as organizational or incorporation fees, you can deduct the unamortized amounts on a final return for the business. For example, say the business was formed in January 2014 and elected to amortize organizational costs above $5,000 over 180 months, but it goes under after 30 months. You can deduct 150/180 of your organizational costs on the final return, in addition to any of the amortization allowed for the final year of the return.

Other Expenses

You may incur special costs for going out of business. For example, a corporation may have to pay a special fee to the state corporation or franchise department when terminating. There may also be additional legal and accounting fees for winding up a business. Again, these costs are deductible business expenses.

Professionals who wind up their practice but continue to carry professional liability coverage to protect themselves from claims arising from work already performed can deduct the insurance premiums in full as a current deduction in the final year of the practice.

Special Rules for Corporations

Corporations must notify the IRS of their termination. This is done by filing Form 966, Corporate Dissolution or Liquidation, with the IRS within 30 days after the plan or resolution of liquidation is adopted.

The corporation must recognize gain or loss on the distribution of its assets to shareholders in complete liquidation. In determining gain or loss, the assets are valued at their fair market value on the date of the distribution. Thus, a C corporation should retain sufficient cash to cover its tax liability resulting from a liquidation.

Shareholders are taxed on the liquidation distribution of money and assets. Their gain (or loss) is the difference between their basis in the stock of the corporation and what they receive. This is the final so-called double tax, because a C corporation pays tax on the liquidation and then the shareholders do, too, on the net amount they receive.

You must also follow state rules for dissolving your corporation. Even if you shut your doors for business, you have to formally terminate the corporation under state law in order to avoid continuing tax and fee obligations to the state. In order to dissolve the corporation, your state tax obligations must be up to date; you cannot dissolve the corporation if you owe the state any money. Check with your state's finance/revenue/Treasury department.

Other Details

Once the business has been terminated and a final return filed, be sure to wind up all other matters for the company (see the checklist of actions to take in Table 25.2). This includes notifying suppliers, canceling leases and permits, and closing bank accounts and business credit cards.

Be sure to retain business records even after you have closed your doors. Follow basic recordkeeping rules. This means retaining income tax–related records for a minimum of 3 years and employment tax–related records for a minimum of 4 years.