The first seminar of a four-part series on growing a business and preparing it for sale led by the co-chair of Kegler Brown's M+A practice, Eric Duffee. Eric partnered with Jeff Tubaugh and Maggie Gilmore of BDO for this presentation, which focused on the fundamentals of entity selection. It detailed different entity types and the related impacts from tax reform affecting them. It also discussed concerns related to outside investors, partnerships, various structural forms and the tax impact of each.

2. 2
Entity Selection – Fundamentals

3. 3
»LLCs
» Sole owner, SMLLC Single Member LLC
» Treated as a DRE “disregarded entity” for federal tax purposes
» Business’ taxable income included on sole owner’s individual return
» Top individual tax rate 37%
» Subject to self-employment taxes (FICA: SS and Medicare)
» Multiple members, default tax treatment is partnership
» No restrictions on owner type or number of owners
» Generally tax-free formation and liquidation
» Income allocated to owners and taxed at owner level
» Individual owners may be subject to self-employment taxes
» Active owners paid via Guaranteed Payment (versus Salary)
Legal Entities for Taxation Purposes

4. 4
»Corporations
» C Corporation
» Incorporate at the state level; generally incorporation is tax-free
» Business’ taxable income taxed at the corporate level at 21% federal rate
» Distributions to owners can be taxed as dividends at 15 or 20%
» No restrictions on owner type or number of owners
» Liquidations to owners generally a taxable event.
» S Corporation
» Restrictions on owner type or number of owners: no C Corporations, certain
trusts, or non-U.S. owners (limited to 100 shareholders)
» Income allocated to owners and taxed at owner level
» Individual owners involved in the business may take a salary
» Liquidations similar to C Corporations
Legal Entities for Taxation Purposes

5. 5
»C Corporations
» Advantages
» Business’ taxable income taxed at the corporate level at 21% federal rate
» No owner restrictions and ease of ownership transferability
» Federal, state and local income tax compliance at corporate entity
» Disadvantages
» Distributions to owners can be taxed as dividends at 15 or 20%
» Liquidations to owners generally a taxable event
» Sale of assets leaves owners of stock with non-recoverable tax basis in shell
company
C Corporation v. “Flow-Through”

6. 6
»Flow-Throughs
» Advantages
» Business’ taxable income may be offset with Small Business (199A) deduction,
lowering individual ETR from top rate of 37% to 29.6%
» Distributions to owners tax-free to the extent of tax basis
» One layer of taxable gain on sale of entity or assets
» Disadvantages
» On current business taxable income, higher ETR than C Corporation
» More complexity with income tax filings at federal, state, and local level
» Partnerships: Self-Employment taxes, complexity of ownership
» S Corporations: Liquidations to owners generally a taxable event, owner
restrictions which may impact ability to sell to 3rd party
C Corporation v. “Flow-Through”

7. 7
» Corporate tax rate reduced from 35% to 21%
» Significant tax changes to entities with international operations
» Individual top tax bracket reduced from 39.6% to 37%, with higher income
thresholds for higher brackets (through 1/1/2026)
» Flow-through entity owners ability to take Small Business 199A deduction,
effectively reducing the tax on business income from 37% to 29.6% (through
1/1/2026)
» Individual state tax itemized deduction capped at $10,000: this includes taxes
due on multi-state business taxable income paid at the owner-level
» Was there a mass change of business owners converting from flow-through
entity to C corporation to take advantage of lower tax rate?
» Short answer: No. Because of the double taxation of corporate profits (at
corporate level, and again at distribution), many small business owners opted to
keep their businesses structured as flow-through entities.
Tax Reform Impacts

8. 8
Outside Investors

9. 9
»Preferences?
» C Corporation
» Private Equity likes an operating C Corp or use of a “Blocker Corp” to protect their
investors from receiving flow-through income
» Ideal if stock can be sold later @ Capital Gain rates
» Partnerships
» Write-off of step-up in basis
» Preferential waterfalls for preferred investors
Outside Investors

10. 10
»Partnership Investments
» Preferred Units
» Accrue an annual return
» Accrual and capital contributions returned before common owner returned
» Gross Income trap (covered later)
» Write-off of Step-Up in Basis
» Purchase Price Allocation impact
» Offset to annual income
Outside Investors

11. 11
»Tax Impact of an Investment
» C Corp
» Issue of new shares is a non-tax event
» Stock basis of investors = cash investment
» Partnership
» Starting capital = cash investment
» Write-off of step-up in basis
» Issuing of new units requires additional tax calculations and special allocations
» What if we are an S Corp???
» Need to do some pre-transaction restructuring
Outside Investors

12. Pre-Structuring Organization of the Company
Op Co Inc. (S Corp)
Shareholders

13. 1313
Shareholders
Hold Co Inc
(S Corp)
Step 1 - Shareholders form Hold Co Inc and contribute shares of Op Co Inc to Hold Co and make QSUB
election for Op Co Inc.
Shareholders
Op Co Inc.
(S Corp.)
Hold Co Inc
(S Corp)
Op Co S Corp Shares
Op Co Inc.
(QSUB)
After
Hold Co Inc Shares
Note 1: Situation #1 of Revenue Ruling 2008-18

14. 1414
Op Co Inc.
(QSUB)
Hold Co Inc.
(S Corp)
Shareholders
Step 2 – Op Co, Inc. converts to an LLC
Op Co, LLC
(LLC)
Conversion
Note 1: At least one day after Step #1.

15. 1515
Hold Co Inc.
(S Corporation)
Shareholders
Step 3 - Buyer buys X% of Op Co LLC from Hold Co Inc
Buyer
(LLC)
Cash
Alternative option – Buyer contributions cash to Op Co LLC in exchange for units
Op Co LLC
(LLC)

16. 1616
Op Co LLC
(LLC)
Buyer
(LLC)
Shareholders
Hold Co Inc.
(S Corp)
Post-Closing Ownership

17. 17
» The Problem
» Complex partnership operating agreements that are more difficult for the common
investor to understand
» Owners not seeking counsel on the economics of the tax allocations = surprises
» Opportunities
» Increased cash for growth / possible partial redemption of existing owners
» Knowledge of industry
» Rapid growth
Private Equity / Family Office Investments

18. 18
» Things to know with tax allocations
» Typically new investors hold preferred units with a % annual yield that is paid or
accrued
» Annual tax allocations are NOT based on a % of units owned
» Targeted Capital Accounts & Liquidation Preferences
» Income allocated to get investors to their targeted capital amount based on a
deemed liquidation at book value (includes use of gross income items)
» Preferred Investors will get their yield and oftentimes their investment back
before the common unit holders start to receive their investment dollars back
» If company value drops over time, the investment of the common owners shifts to
preferred with the accrued yield
Private Equity / Family Office Investments

19. 19
» Things to know with tax allocations – An example:
» Owners A & B have 50/50 partnership
» Private equity firm receives membership units to give it a 1/3 ownership interest for
$1 million but holding preferred shares with 8% accrued annual yield
» Year 1 scenario – company has $0 net income
» Since PE firm accrued an 8% yield (not paid), their target becomes $1,080,000 so
they have to receive $80,000 of income
» Owners A & B would show $40,000 of loss each to net total allocations to $0
» Result = taxable income to PE Firm and need for tax distributions even though no
income was generated
Private Equity / Family Office Investments

20. 20
»Common Structure for Multi-Location Companies
Entity Structuring
OWNERS
STORE 2STORE 1 STORE 3

21. 21
»Better Structure for Multi-Location Companies
Entity Structuring
OWNERS
HOLDING
COMPANY LLC
STORE 1 STORE 2 STORE 3

22. 22
» Every state has its own unique taxes that have to be filed
» State income tax
» Gross receipts tax
» Privilege tax
» Payroll tax withholding (state, local, county, school district, etc.)
» Sales tax rates (including any add-ons for specific location)
» Personal property tax
» Food, beverage, liquor privilege – location-specific taxes on restaurants
» County taxes
» Business & licensing taxes (e.g., liquor license, facility license)
» Nexus issues for franchisors (market based vs cost of performance states)
M&A Due Diligence Trap - Tax Filing Issues

23. Contact Information
MAGGIE GILMORE, CPA
Tax Managing Director
mgilmore@bdo.com
614-573-7757
JEFF TUBAUGH, CPA
Tax Partner
jtubaugh@bdo.com
614-573-7785

24. 24
» BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax,
advisory and consulting services to a wide range of publicly traded and privately held companies. For
more than 100 years, BDO has provided quality service through the active involvement of experienced
and committed professionals. The firm serves clients through more than 60 offices and over 500
independent alliance firm locations nationwide. As an independent Member Firm of BDO International
Limited, BDO serves multi-national clients through a global network of 67,700 people working out of
1,400 offices across 158 countries.
BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited,
a UK company limited by guarantee, and forms part of the international BDO network of independent
member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.
Material discussed is meant to provide general information and should not be acted on without
professional advice tailored to your firm’s individual needs.
© 2017 BDO USA, LLP. All rights reserved. www.bdo.com

25. Selecting the Right Entity:
ALTERNATIVES
Corporation (Inc.)
C-Corporation
S-Corporation
Limited Liability Company
(LLC)
Maybe, but probably not:
 General partnership
 Limited partnership
 Limited liability partnership
 Limited liability limited
partnership
 Panamanian bearer
corporation

26. Selecting the Right Entity:
CONSIDERATIONS
Protections
Taxes –
including losses
Maintenance/
upkeep
Flexibility
Compensation
alternatives
Investor
expectations/
Preferred equity
structures
Exit Readiness

27. Selecting the Right Entity:
WHAT STATE?
Somewhere else?Ohio Delaware

28. Selecting the Right Entity:
FORMALITIES
Proper formation
documents
Separate bank
accounts/books/
records; flow of funds
Arm’s length contracts
with insiders
Clean cap table Know the rules!

29. Capitalization
Debt
Secured vs. unsecured
Senior vs. mezzanine vs.
subordinated
Straight debt vs.
convertible debt
Bank vs. other lenders
Equity
Common
Preferred: preferred
yield/coupons,
“liquidation” preferences,
anti-dilution, protective
provisions, participating
vs. non-participating
“Sweat Equity”

30. Bringing on
“PARTNERS”
Know the value your “partners”
bring to the company
Prepare for the potential “business
divorce” with a “business pre-nup”
Transfer restrictions and buy-sell
agreements
Valuation + funding

32. QUESTION 1
Who owns this company?
No. Shareholder
Shares
Issued
Date
Issued
Date
Cancelled
1
Dr. Heinz
Doofenshmirtz
70 7/12/03
2
Roger
Doofenshmirtz
20 7/12/03 8/1/19
3 Perry the Platypus 10 7/12/03
SHARE LEDGER for DOOFENSHMIRTZ EVIL, INC
Authorized 100 Common Shares Without Par Value

33. QUESTION 2
Math!
Luke, Han, and Leia start a company called Rebel
Industries, LLC. Luke owns 50%, Han owns 37.5% and
Leia owns 12.5%. In order to finance growth and
operations, they agree to take on a preferred equity
investment from Jabba. Jabba provides Rebel with $1
million for 20% fully-participating preferred equity
with a 7% accruing preferred yield.
10 years later, they sell to Evil Galactic Empire,
Inc. for $10 million. Which of the four owners
gets most of the sales proceeds?

34. Pre-Issuance
Shares
Pre-Issuance
Percentage
Post-Issuance
Shares
Post-Issuance
Percentage
Preferred
Return
Waterfall for
Remainder
Total
Luke 400 50% 400 40% - $3,320,000 $3,320,000
Han 300 37.5% 300 30% - $2,490,000 $2,490,000
Leia 100 12.5% 100 10% - $830,000 $830,000
Jabba 0 0% 200 20% $1,700,000 $1,660,000 $3,360,000
800 100% 1000 100% $1,700,000 $8,300,000
$10,000,00
0

35. QUESTION 3
Tax Math!
Mr. Krabs owns Krusty Krab, Inc. Krusty Krab is a C-
corporation. He lives in a state with no state or local
income taxes. He receives two offers to purchase the
company as follows. Assuming the only assets are
goodwill/intangible assets with no tax basis, which
one will produce the most after-tax proceeds for Mr.
Krabs?
Offer 1: Stock purchase for $10 million
Offer 2: Asset purchase for $12 million

36. QUESTION 4
Can they do this?
Harry, Ron and Hermione form an S-Corp called
Hogwarts US, Inc. They’re looking to take on outside
investment from Snape Investment Funds, LLC. They
negotiate a deal to give Snape 10% preferred equity
and a 5% accruing preferred return on its initial
investment. Hogwarts US is generating significant
tax losses and will likely do so for the foreseeable
future. It’s important to everyone to continue
passing these losses through to the owners after
Snape’s investment.

37. Eric D. Duffee
Kegler Brown Hill + Ritter
eduffee@keglerbrown.com
keglerbrown.com/duffee
614-462-5433