The Importance of Converting Equity to Capital

Guy Baker By
Guy Baker

MBA, MSFS

 

  1. Introduction
  2. The Beginning
  3. Why have a business entity
  4. To Pass Through or not
  5. Closed Entities and Pass through entities
  6. The benefits of owning a closed entity
  7. The Three Circles of Wealth – The Common Denominator
  8. The Three Big Questions
  9. I. Creating and Retaining Value
  10. II. Keeping Superkeepers
  11. III. Exit Strategies
  12. Additional strategies to build and retain wealth
  13. Conclusion

 

Why Have A Business Entity?

You may remember Julie Andrews in the Sound of Music. She sang this lyric – “Let’s start at the very beginning.” So let’s ask, “What is the primary reason you have a legal entity?” After all, you could just operate as a sole proprietor and put all of your accounting on a schedule C on your personal tax return. There is nothing you can deduct in a corporation or LLC that you essentially cannot deduct on a schedule C attached to your individual return. So why incorporate? Why a corporation and not an LLC or a partnership?

The general reason for forming a separate business entity is liability. If you can keep the liability at the entity level, you protect your personal assets. By being an employee, all liability stays at the entity level, providing you operate the entity with good governance. This means you have to keep accurate accounting records, hold a board of directors meeting, and document your meetings in the minutes of the corporation. In other words, you have to play the game by the rules. Your tax advisor has probably explained all of this to you at some time. But it is good to review.

Another reason for forming a separate business entity is the separate tax bracket. An entity files a separate tax return and pays taxes at a different tax rate than you do and by having multiple tax payers, you may be able to shift income legally from one entity to another for services, purchases or other expenditures. But these are only timing considerations. In the final analysis, at higher levels of income, this benefit is probably negligible and could add additional costs. Why? Because at higher levels of income the current tax brackets are higher for the corporation than for you as an individual.

Health insurance benefits for the employee/owner of a separate tax entity are deductible. They are not subject to the 3% AGI limitation on the individual return. You can also have a flexible spending account so long as you offer it to all your employees. This could allow you to pay your deductibles and co-pays with tax deductible dollars. But this is a case by case issue, so you need to do some analysis here to make certain there is a real benefit here. Also entertainment, travel expenses, and automobile deductions may be treated more favorably in an entity than on your schedule C. This is an issue to discuss with your tax advisor.

Forming a separate entity also gives you the ability to build a standalone organization and eventually capitalize on the value of your company’s income stream. Although it is possible to sell a sole proprietorship, a large company is rarely sold as a sole proprietor. It is almost always an entity because they are easier to audit and transfer. Another reason is that employees prefer to work for a company, rather than a sole proprietorship. An entity makes it easier to provide discriminatory benefits for these superkeepers if you think it will cause them to stay with you longer. You can also fractionalize ownership in an entity, which you cannot do with a sole proprietorship.

Key Points: The biggest benefit of an entity is the ability to isolate personal liability and shift income. There can be additional tax benefits such as lower cost for health benefits or disability coverage. You can also have a flexible spending account. A company allows you to build leadership and a succession management team. Plus an entity is easier to transfer to either management or a new buyer.

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