Business Structure Reviews
Creating a Tax-Efficient Business Structure
How a business enterprise is structured is probably the most important factor in determining the level of state taxation. A tax-efficient business structure can save the company taxes and improve the bottom line. Several factors go into the study to determine the most tax-efficient structure including, the type of entity, ownership, state of domicile, and the amount and location of assets.
Type of Entity - It is necessary to review the entire business structure including the type of entities. Different types of entities are subject to various taxes and some types of entities, flow-through entities, for example, may be exempt from certain types of taxes. Effective tax planning strategies often involve the mere changing of the form of the entity. Therefore, it is necessary to identify the business structure by type of entity (C-Corporation, S-Corporation, Partnership, Limited Liability Company).
Shareholder/Partner/Member - For each of the entities identified in the business structure, it will be necessary to identify all the shareholders/partners/members and their respective ownership percentages. The various state tax statutes include provisions that may mandate or allow the filing of a combined or consolidated return. Entities may be excluded from forced consolidation or combination by selecting a different entity type or by structuring business activities to require a different apportionment method.
State of Commercial Domicile - For each of the entities identified in the business structure, it is necessary to identify the state of organization and more importantly, the state of commercial domicile. Occasionally, a state tax statute will apply a different standard, tax, or calculation of the tax depending on whether the entity is a domestic entity or a foreign entity.
Assets - It is necessary to identify all the tangible and intangible assets owned by each of the entities within the corporate structure. It is necessary to identify the dollar amount of assets and a brief description of the assets included in each of the entities. In state tax planning, the movement of assets from one entity to another entity can often create either favorable or unfavorable tax results.
Examples of Tax-Efficient Entities
Here are a few examples of the type of entities used in restructuring business enterprises. These entities are used to shift income where it will escape tax or be taxed at a lower rate. They may not always work for a specific business because there are several other factors that contribute to the tax environment.
Intellectual Asset Holding Company - Intellectual assets are transferred into a subsidiary located in a low or no-tax state. The subsidiary then licenses these assets back to the operating company in exchange for a royalty. The operating company deducts the royalty payment thereby reducing its state income tax liability. The Intellectual Asset Holding Company escapes taxation in most states, except those that require unitary or combined filing, because it is domiciled in a state that has no tax or that does not tax income from intellectual property.
Passive Investment Holding Company - Passive investments including stocks and bonds are transferred into a holding company located in a low or no-tax state. The holding company accumulates the dividend and interest income. It may loan it back to the operating company or pass it up in the form of a dividend. Income taxes for the operating company are reduced because the dividend and interest income is not reported on its return. The holding company generally escapes tax altogether because it is domiciled in a state that has no tax or that does not tax income from passive investments.
Employee Leasing Company - In the most common application, the employees of an operating company are terminated and then simultaneously hired by another entity, the employee leasing company. The employees are leased back to the operating company in exchange for a fee. The employee leasing company is the common law employer of the employees. The tax benefits accrue to the employee leasing company taking advantage of deductions and/or credits not available to the operating company. The employee leasing company may also qualify for lower unemployment tax rates.
Mortgage Company - Mortgages secured by real property can be transferredinto a separate entity located in a state that does not tax the interest income. The new entity must normally avoid being taxed as a financial institution. The interest income from the mortgage loans accumulates in the mortgage company. It may loan it back to the operating company or pass it up in the form of a dividend. Income taxes for the originating company are reduced because the interest income is not reported on its return. The mortgage company generally escapes tax altogether because it is domiciled in a state that does not tax interest income.
These income shifting strategies are very complex and difficult to implement. These strategies should not be implemented without the consultation and assistance provided by competent tax advisors, like the tax professionals in the EHTC SALT Group and competent outside legal counsel.