San Diego Business Lawyer Blog

One of the first decisions new San Diego business owners make is whether or not to incorporate or form some other formal business entity. The decision often seems daunting and turning to a San Diego Business Lawyer and tax professional are important first steps. If the business owner opts for a limited liability company ("LLC") or an S-Corporation (which is taxed like a partnership as opposed to the C-Corporation subject to double taxation), double taxation is not an issue. Thus, the first way to avoid double taxation is to choose a business entity that is not double taxed. This includes forming a California Corporation and then electing S-Corporation status with the IRS. Many small business owners have nonetheless formed corporations without electing S-Corporation status. This may be because a tax professional recommended it or because the business owner simply didn't consider the various business entities available when forming the corporation. Whatever the reason, the choice of a C-Corporation for small businesses isn't inherently a bad one. It does, however, become imperative that these C-Corporations take steps to avoid or at least limit double taxation.

The easiest way to avoid double taxation is to elect to be taxed as an S-Corporation with the Internal Revenue Service. However, to qualify for S-Corporation status the IRS requires that your corporation be a domestic corporation, issue only one class of stock, distribute profits and losses in proportion to shareholder interests and have no more than 100 shareholders who are natural persons and U.S. citizens. Another corporation or LLC cannot own stock in an S-Corporation nor can foreign nationals. If opting for S-Corporation taxation, it is important to timely file Form 2553 with the IRS - no later than the 15th day of the third month following the date of incorporation. If a business is already incorporated, it can still opt for S-Corporation taxation the following year by filing Form 2553 by December 31st. However, it's important to consult with a tax professional before doing so especially where the company was initially advised not to elect S-Corporation status.

If you are a small corporation and do not elect S-Corporation status, the following is a short list of legitimate ways to minimize double taxation:

Accumulate Earnings: Leaving profits in the corporation avoids double taxation since there are no dividends to tax. Saving is advantageous so long as the money is eventually re-invested toward growth. It is a good short term plan. However, if too much profit is retained, the corporation can face an additional Accumulated Earnings Tax (a substantial penalty in addition to the regular corporate tax). The goal is to prevent corporations from accumulating profits for the sole purpose of avoiding income tax. The IRS looks to see if the corporation is accumulating earnings and profits beyond the reasonable needs of the business. Generally, accumulated earnings up to $250,000 ($150,000 for some personal service corporations) are considered reasonable. For earnings in excess of this amount, corporations may still show the IRS that the retained earnings are reasonable based on the needs of the business. If you choose to retain earnings, consult with your tax professional.

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At first glance, the differences between triple net leases (NNN), gross leases and modified gross leases seem complicated. Many of the definitions found on the internet are convoluted and even experienced real estate professionals have trouble figuring out what some bloggers are trying to say. The differences, however, are not that complicated. In the simplest terms, commercial leases can be separated into two major categories: those where the tenants pay all of the property's expenses (NNN leases) and those where the landlords pay all of the property's expenses (gross leases). A base year lease, or modified gross lease, calls for existing expenses to be paid by the landlord, but any annual increases in expenses to be assumed by tenants. A base year lease is somewhere in between the NNN lease and the gross lease.

Most retail leases are triple net leases and the common area maintenance expenses (CAM expenses) that the tenants pay for include just about every imaginable cost for the operation of the property including in most cases property taxes, utilities, maintenance, insurance and management fees. Each tenant is responsible for its pro rata share of the CAM expenses. The actual terms in NNN leases vary widely from lease to lease and how favorable the terms are to the tenant depend on the tenant's negotiating power. Gross leases are less common but still used today. This is largely because landlords are reluctant to take on the risk of increased costs over time. A base year lease or modified gross lease eliminates this problem by transferring the risk of increased costs to the tenants. The base year lease provides landlords security by passing on increased costs to tenants.

Most office leases are some variant of a base year lease. In a base year lease, a base year is selected (usually the first year of the lease). The landlord agrees to pay the property's expenses for the base year. The landlord continues to pay the property expenses at the base year level and the tenant agrees to pay its pro rata share of any increases in property expenses. If the property expenses for the base year (say 2010) are $40,000 and the expenses increase to $50,000 for the year 2011, a tenant with 20% of the square footage would pay $2,000 (20% of the $10,000 increase) in 2011 in addition to the tenant's base rent (with a NNN lease, the tenant would pay its pro rata share of the entire $50,000 in 2011 or $10,000 in addition to the base rent). Each year thereafter, the tenant pays its pro rata share of the property's expenses but only to the extent that those expenses exceed the $40,000 established in the base year. In most cases, the annual increase in expenses is estimated at the start of each year and tenants pay monthly to spread out the cost over the year. In the above example, if at the beginning of 2011 the landlord over estimated the increase in property expenses at $12,000, the tenant would pay monthly payments of $200 (20% of 12,000 divided by 12 months) totaling $2,400. The tenant thus overpays $400. At the end of 2011, the landlord would perform an expense reconciliation resulting in the extra $400 being credited back to the tenant.

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