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

 

To Pass Through or Not

Let’s look at the differences in business entities. There are basically only two forms: a closed entity and a pass-through entity. Each of these methods can be derived in different legal forms (corporate, LLC, partnership), but when you boil down their differences, it is how they are taxed that determines their applicability and utilization.

A closed entity simply means it is a separate and distinct legal entity. It has its own tax bracket and tax ID number. It files a tax return and pays tax on taxable income. Any losses are carried over to future years and applied against income in those future years. These loss-carry-forwards can be very valuable when doing tax planning with companies that have wide fluctuations in income.

The most common closed entity is a C Corporation. As a separate entity, you own it by purchasing stock. If you are the forming shareholder, you are issued stock in exchange for the initial capitalization of the company. The company has two financial statements, a profit and loss (called the income statement), and the balance sheet. The balance sheet shows the book value of the corporation which will increase or decrease based on the income and expenses of the company and any changes in the value of assets or liabilities due to business decisions (examples: increase inventory, buy machinery, borrow money, pay off loans.) Here is the important point - all income held in the corporation and not distributed will be taxed. This income represents a gain to the corporation but it is referred to as trapped gains because it will have to be taxed when it is distributed in future years as either dividends or liquidation proceeds to the shareholders. In essence, building retained earnings subjects all the gains to a second level of tax.

Pass through entities do not trap gains. Although this kind of entity has a tax payer ID number, it only files an information return. But all the income “passes through” to shareholders, members, or partners on their personal tax returns. The legal forms of this kind of entity can be an S Corporation, LLC taxed as a partnership or limited and general partnerships.

A Limited Liability Company (LLC) could elect to be taxed as a closed entity or as a pass through. Ownership in an LLC is not stock but is expressed in member interests. When it operates as a closed entity, the LLC files a tax return and is taxed similar to a C corporation.

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