Chapter 13 presentation

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporations, Partnerships,Estates & Trusts

1

Chapter 13

Comparative Formsof Doing Business

The Big Picture

• Milly and Doug are going to start a dot.com business in which they both will participate on an active basis.

• They will use savings to finance the business.• Limited liability is important in their choice of business form,

but minimizing taxes is also important. • They have narrowed the choice of business forms to

– A C corporation, or – A general partnership.

The Big Picture

• Annual earnings of the business before taxes are expected to be $200,000.– Any after-tax profit will be distributed to Milly and Doug.

• Assume that both Milly and Doug are single and that their marginal tax rate is 28%.

• Advise Milly and Doug on the choice of business form. • Read the chapter and formulate your response.

Choice of Form of Business Entity

• Many factors affect the choice of business entity– Both tax and nontax– Understanding the comparative tax consequences

related to the different types of entities is important for effective tax planning

Principal Forms of Doing Business

• Sole Proprietorship

• Partnership

• C corporation

• S corporation

• Limited liability company (LLC)

Limited Liability Company (LLC)

• Hybrid business form that combines the corporate characteristic of limited liability for owners with tax characteristics of a partnership

Filing Requirements

C Corporation

•Files Form 1120

S Corporation

• Files Form 1120S

Sole Proprietorship

• Files Schedule C,

Form 1040

Partnership & LLC

• Files Form 1065

Nontax Factors—Capital Formation

Sole Proprietorship

• Limited ability to raise capital

Partnership

• Can raise funds through pooling of owner resources

• Ltd. p’ship can raise capital from investors

C Corporation

• Greatest ease and potential for raising capital

S Corporation

• Greatest ease and potential for raising capital, but limited number of investors

Nontax Factors—Limited Liability

Sole Proprietorship

• Unlimited liability

Partnership

• General partners are jointly and severally liable

• Ltd. partners’ liability is limited to investment

C Corporation

• Generally have limited liability

S Corporation

• Generally have limited liability

Other Nontax Factors

• Estimated life of business

• Number of owners and their roles in management of the business

• Freedom of choice in transferring ownership interests

• Organizational formality and related costs

Single vs. Double Taxation

Sole Proprietorship

• Single taxation

Partnership and LLC

• Single taxation

C Corporation

• Double taxation

S Corporation

• Generally, single taxation

• May be subject to built-in gains tax and passive investment income tax

Alternative Minimum Tax

Sole Proprietorship

• Directly subject to AMT

Partnership and LLC

• Indirectly subject to AMT

• AMT adjustments & preferences flow through and partners subject to AMT

C Corporation

• Directly subject to AMT

• May have advantage here since corp AMT rate is only 20%

S Corporation

• Indirectly subject to AMT

• AMT adjustments & preferences flow through and S/H’s subject to AMT

Controlling the Entity Tax

• Various techniques can be used to control the tax liability, whether imposed on the entity or owners, such as:– Distribution policy– Recognizing the interaction between the regular

tax liability and the AMT liability– Utilization of special allocations– Fringe benefits– Minimizing double taxation

Fringe Benefits (slide 1 of 2)

• Generally produce the following tax consequences:– Deductible by entity (employer) providing the

fringe benefit– Excludible from gross income of taxpayer

(employee) who receives the fringe benefit

Fringe Benefits (slide 2 of 2)

• Favorable tax treatment of fringe benefits is available only to employees– For owner of entity to be an employee, the entity must be a

corporation• Partners in a partnership are not employees

• Greater-than-2% shareholders in an S corp are treated as partners

– If not an employee• Deduction of cost of fringe benefit is disallowed

• Owner must include cost of fringe benefit in gross income

Minimizing Double Taxation of C Corporations (slide 1 of 5)

• Several techniques are available for reducing the double taxation of C corps including:– Making distributions to shareholders that are

deductible by corp– Retaining earnings at corp level– Making distributions treated as a return of capital– Making the S corp election

Minimizing Double Taxation of C Corporations (slide 2 of 5)

• Deductible distributions include:– Salary payments to shareholder-employees– Rental payments to shareholder-lessors– Interest payments to shareholder-creditors

• IRS scrutinizes these types of transactions– Must be reasonable

Minimizing Double Taxation of C Corporations (slide 3 of 5)

• Retain earnings at corporate level– Double tax is avoided unless corp makes

distributions (actual or deemed) to shareholders• Must watch out for accumulated earnings tax problems

– For distributions made in 2003 and thereafter the 15%/0% rate for qualified dividends reduces the potential negative impact of double taxation

Minimizing Double Taxation of C Corporations (slide 4 of 5)

• Make return of capital distributions– For ongoing businesses, redemption provisions

may help reduce gross income at the shareholder level

– Corporate liquidation provisions can be used if business will cease to operate in corporate form

Minimizing Double Taxation of C Corporations (slide 5 of 5)

• Electing S corp status– Generally eliminates double taxation but other

factors must be considered such as:• Will all shareholders consent to election?

• Can qualification requirements be met currently and on an ongoing basis?

• Are conditions favorable to an S corp election and how long will those conditions be favorable

• Distribution policy may cause problems paying tax at shareholder level

Entity Formation (slide 1 of 2)

• Generally, owners make contributions of cash and property to entity in exchange for an ownership interest– Generally, tax-free to both the entity and the owner

• In corporate setting, requirements of §351 must be met

– Owners and entities take a carryover basis in their ownership interest and in assets contributed, respectively

Entity Formation(slide 2 of 2)

• If FMV of property contributed > adjusted basis, may want to make special allocation– Required in partnerships– Not available for C corps or S corps

Basis Considerations

Sole Proprietorship

• N/A

Partnership and LLC

• Profits & losses affect partner’s basis

• Partner’s basis is increased by share of p’ship liabilities

C Corporation

• Shareholder’s basis is not affected by corporate profits & losses

S Corporation

• Shareholder’s basis is increased by profits, decreased by losses, not affected by corporate liabilities

The Big Picture – Example 17 Effect On Basis Of Ownership Interest (slide 1 of 2)

• Return to the facts of The Big Picture on p. 13-2. • In the 3rd year of operations, the entity chosen by

Milly and Doug (either a partnership or a corporation) needs additional working capital.

• Consequently, they agree to admit Peggy as an owner. – Peggy contributes cash of $100,000 to the entity for a 30%

ownership interest.

• The entity borrows $50,000 and repays $20,000 of this amount by the end of the taxable year.

• The profits for the year are $90,000.

The Big Picture – Example 17 Effect On Basis Of Ownership Interest (slide 2 of 2)

• If the entity is a partnership, Peggy’s basis at the end of the period is $136,000 ($100,000 investment + $9,000 share of net liability increase + $27,000 share of profits).– Note that Peggy’s basis would be the same if the entity is an LLC—an

entity form that Milly and Doug should have considered.

• If Peggy is a C corporation shareholder instead, her stock basis is $100,000 ($100,000 original investment).

• If the corporation is an S corporation (another entity form that Milly and Doug should have considered), Peggy’s stock basis is $127,000($100,000 + $27,000).

Distributions

• Distributions can be made to partners, LLC owners, or S corp. shareholders tax-free– The same distribution would produce dividend

income treatment for C corp. shareholders

• If appreciated property is distributed to S corp. shareholders, realized gain is recognized at the corporate level (same treatment as a C corp.)– This corporate-level gain is passed-through to the

S corp. shareholders

Passive Activity Losses (slide 1 of 2)

• Loss limits apply to owners of partnerships, LLCs, and S corps– Passive losses are separately stated items that flow

through to owners – Passive loss rules apply at the owner level

Passive Activity Losses (slide 2 of 2)

• For corporations, only apply if a closely held corp or a personal service corp – Closely held corp—more than 50% of value of stock at any

time during last half of year is owned by 5 or less individuals

• Passive losses can offset active income but not portfolio income

– Personal service corp—principal activity is performance of personal services by owner-employees who own more than 10% in value of corp’s stock

• General passive loss rules apply

At-Risk Rules

• At-risk rules apply to:– Partnerships– LLCs– S corps– Closely held C corps

• May be more troublesome for partnerships and LLCs since liabilities are included in partner’s basis in partnership interest

Special Allocations

• Partnership and LLCs have many opportunities to use special allocations– Not generally available in C corps and S corps

• May be able to achieve the same results using payments to owners for services, rents and interest

Disposition of a Business or an Ownership Interest

• Disposing of a business may be viewed as either:– A sale of an ownership interest, or– A sale of assets

• Tax consequences are, in general, more favorable for a sale of an ownership interest

Sale of Assets by Entity —Seller’s Issues (slide 1 of 3)

• Sole Proprietorship– Treated as a sale of separate assets– Gain or loss is calculated for each asset

• Character of income or loss depends on nature of asset

Sale of Assets by Entity —Seller’s Issues (slide 2 of 3)

• Partnership, LLC, or S Corp—Same as proprietorship– Gain/loss flows through to shareholders or partners

• They report & pay tax on gain or loss

• Distribution of cash proceeds does not cause double tax since basis is adjusted by gain/loss

Sale of Assets by Entity —Seller’s Issues (slide 3 of 3)

• C Corp—double taxation occurs– Gain is determined for each asset and tax paid by

corporation– Net cash is distributed

• Taxed as dividend, return of capital or capital gain to shareholder

Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 1 of 3)

• Partnership– Distribution rules determine partner’s basis in

assets received from partnership– Partner has gain if cash received > basis– Partner has loss if cash, inventory and unrealized

receivables are only assets rec’d and are < basis– Character of gain on asset sale depends on nature

of assets received by partner– No double tax

Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 2 of 3)

• S Corp– S Corp has gain if appreciated assets distributed to

shareholders– No corporate level tax unless “built-in gain”– Shareholder has gain (tax) on receipt of assets >

basis (after basis increase for gain)– Shareholder’s basis in assets = FMV, so no gain on

later sale of assets

Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 3 of 3)

• C Corp– Double tax– Gain on distribution and tax at entity level– Net (after tax) assets distributed at FMV & result

in gain to shareholder

Purchase of Business Assets—Buyer’s Issues (slide 1 of 2)

• The purchaser of individual assets is not generally affected by the type of entity through which the seller operates:– The buyer (whether individual, partnership, LLC,

C corp or S corp) allocates the total amount paid to the individual assets acquired

– Part of the cost may be allocated to intangible assets such as goodwill

Purchase of Business Assets—Buyer’s Issues (slide 2 of 2)

• Asset cost is recovered through depreciation, amortization, sale of inventory, collection of accounts receivable, etc...

• The buyer can contribute the assets to a partnership or C corp under §721 or §351– If the C corp is qualified, an S corp election can be

made

Sale of Business Interest—Seller’s Issues (slide 1 of 3)

• Sole Proprietorship– No distinction between sale of interest or assets

• Partnership– Sale of partnership interest results in ordinary

income to partner for share of partnership’s ordinary income assets; capital gain for remainder

Sale of Business Interest—Seller’s Issues (slide 2 of 3)

• S Corp– Sale treated as sale of stock

• Results in capital gain or loss to shareholder

– In general, no corporate-level consequences• However, if purchaser is not qualified shareholder,

S election is automatically terminated

Sale of Business Interest—Seller’s Issues (slide 3 of 3)

• C Corp– Sale treated as sale of stock

• Results in capital gain or loss to shareholder

– No corporate level consequences

Purchase of Business Interest—Buyer’s Issues (slide 1 of 3)

• If the purchaser acquires an interest in one of these types of entities, he or she is treated as follows:

• Sole Proprietorship– Purchaser is deemed to buy assets

• Purchase price is allocated to assets

• Assets are depreciated, amortized, etc...

Purchase of Business Interest—Buyer’s Issues (slide 2 of 3)

• Partnership– Purchaser buys partnership interest– Purchaser may ask partnership to make §754

election to step up inside basis in assets

Purchase of Business Interest—Buyer’s Issues (slide 3 of 3)

• S Corp or C Corp– Purchaser buys stock– There is no effect on underlying assets owned by

the entity

Refocus On The Big Picture (slide 1 of 5)

• Although Milly and Doug have narrowed their choice of tax entity to either a C corporation or a general partnership, the tax adviser should point out factors that the clients have overlooked.– Since Milly and Doug desire limited liability, this eliminates the use of

a general partnership. – Likewise, the limited partnership option (which does provide limited

liability for the limited partner) is not feasible since both Milly and Doug intend to be active in operating the business.

• Thus, the remaining choices to be reviewed are the following:– C corporation.– S corporation.– LLC.

Refocus On The Big Picture (slide 2 of 5)

C Corporation• The C corporation satisfies the clients’ limited liability

objective. • However, the C corporation is subject to the Federal income

tax at the entity level. – In addition, the shareholders are taxed (likely at a 15% rate) on the

distributions of the after-tax earnings. • Presuming taxable income of $200,000:

Tax at corporate level $ 61,250Tax at shareholder level:Milly ($69,375 X 15%) 10,406Doug ($69,375 X 15%) 10,406Combined entity/owner tax liability $ 82,062

After-tax cash flow ($200,000 - $82,062) $117,938

Refocus On The Big Picture (slide 3 of 5)

S Corporation• The S corporation also satisfies the limited liability objective. • Since the S corporation is not subject to Federal income

taxation at the entity level, only the shareholders are taxed on the earnings of the corporation.

• The following occurs:Tax at corporate level $ –0–Tax at shareholder level:Milly ($100,000 X 28%) 28,000Doug ($100,000 X 28%) 28,000Combined entity/owner tax liability $ 56,000

After-tax cash flow ($200,000 - $56,000) $144,000

Refocus On The Big Picture (slide 4 of 5)

LLC• The LLC also generally satisfies the limited liability objective. • Under the check-the-box Regulations, the owners can elect to

have the LLC taxed as a partnership. • Since the LLC is not subject to Federal income taxation at the

entity level, only the owners are taxed on the LLC’s earnings. • The following occurs:

Tax at the LLC level $ –0–Tax at the owner level:Milly ($100,000 x 28%) 28,000Doug ($100,000 x 28%) 28,000Combined entity/owner tax liability $ 56,000

After-tax cash flow ($200,000 X $56,000) $144,000

Refocus On The Big Picture (slide 5 of 5)

• It appears that either the S corporation or the LLC meets Milly and Doug’s objectives of having limited liability and minimizing their tax liability. – The LLC offers an additional advantage in that an LLC

does not have to satisfy the numerous statutory qualification requirements that must be met to elect and maintain S status.

• Based on the facts in this situation, however, it is unlikely that satisfying these requirements would create any difficulty for Milly and Doug.

Tax Attributes of Different Business Forms (slide 1 of 19)

Maximum Max Tax Tax # Owners Rate Paid By

.

Sole Prop. One individual 35% OwnerPartnership At least two 35% Partner(or LLC)

S Corp. Max = 100 35% Shareholder Individuals, (Corp. may estates, some have built-in trusts only gains or PII

tax)

Tax Attributes of Different Business Forms (slide 2 of 19)

Maximum Max Tax Tax # Owners Rate Paid By .

C Corp No max limit 35% corporate Corporation (some States level plus pays first, require at 15% max. then

owner least two on qualifying pays if owners) distributions distribution

Tax Attributes of Different Business Forms (slide 3 of 19)

Tax Year Timing of Income Allowed Taxation Allocation .

Sole Prop. Owner’s yr. Owner’s N/A yr. end (1 owner)

Partnership Majority or End of p/ship Profit/lossLLC Principal tax year sharing ratio Ptrs or “least Some special aggregate allocations OK

deferral” year

Tax Attributes of Different Business Forms (slide 4 of 19)

Tax Year Timing of Income Allowed Taxation Allocation

S Corp. Calendar year or End of Corp Per share, business purpose tax year per day

C Corp. No restrictions Corp reports at N/A (generally) end of tax yr; Shareholder reports dividends received

Tax Attributes of Different Business Forms (slide 5 of 19)

Contribution of Character of Income Property to Entity Taxed to Owners .

Sole Prop. Not taxable Retains source characteristics

Partnership Generally not Conduit-retains taxable source characteristics

Tax Attributes of Different Business Forms (slide 6 of 19)

Contribution of Character of Income Property to Entity Taxed to Owners .

S Corp. Taxable unless Conduit-retains source meets §351 characteristics

C Corp. Taxable unless All source character- meets §351 istics lost when

income distributed to owners

Tax Attributes of Different Business Forms (slide 7 of 19)

Loss Allocation Limitation on Loss to Owners Deductible by Owners

Sole Prop. Not applicable Amount invested plus liabilities of business

Partnership Profit and loss Ptr’s investment plus sharing ratios share of partnership liabilities

Tax Attributes of Different Business Forms (slide 8 of 19)

Loss Allocation Limitation on Loss to Owners Deductible by Owners

S Corp. Per share/ S/holder’s investment per day plus loans from s/holder to corporation

C Corp. Not applicable Not applicable

Tax Attributes of Different Business Forms (slide 9 of 19)

At-risk Rules Passive Loss Rules Applicable? Applicable? .

Sole Prop., Yes, at the Yes, at thePartnership owner, partner owner, partner orand S Corp. or shareholder shareholder level.

level. Indefinite Indefinite carryover carryover of of unused losses

unused losses

Tax Attributes of Different Business Forms (slide 10 of 19)

At- risk Rules Passive Loss Rules Applicable? Applicable? .

C Corp. Yes, for closely held Yes, for closely held corporations. Indefinite and personal service

carryover of unused corporations. losses. Indefinite carryover

of unused losses.

Tax Attributes of Different Business Forms (slide 11 of 19)

Capital Gains Capital Losses .

Sole Prop. Owner level Up to $3,000 against 0/15% tax ord. income. Indefinite carryover of excess.

Partnership Conduit-owners Conduit-owners and S Corp. report shares same report shares same as Sole Prop. as Sole Prop.

C Corp. Taxed at Corporate Carried back 3 yrs, level up to 35 %. forward 5. Can only offset capital gains.

Tax Attributes of Different Business Forms (slide 12 of 19)

Consequence of Treatment of Earnings Retained Nonliquidating by Owners Distributions .

Sole Prop. Taxed when earned; Not taxable increases investment in S.P.

Partnership Same as S.P. Not taxable unless cash or liability

relief > Ptrs. basis

Tax Attributes of Different Business Forms (slide 13 of 19)

Consequence Treatment of Of Earnings Retained Nonliquidating

by Owners Distributions .

S Corp. Same as S.P. Generally not taxable unless distribution > AAA or

stock basis. May be dividend if E & P from Sub C year.

C Corp. Taxed to corp. as Taxed in yr received up to earned. Possible AE & P or if > stock basis. AE Tax.

Tax Attributes of Different Business Forms (slide 14 of 19)

Sale of Ownership Interest .

Sole Prop. Treated as a sale of each asset. Gain character depends on asset nature.

Partnership Treated as sale of underlying ordinary income assets. Remainder treated as sale of partnership interest (capital gain).

Tax Attributes of Different Business Forms (slide 15 of 19)

Sale of Ownership Interest .

S Corporation Treated as sale of corporate stock or C Corp. (capital gain). Loss may be ordinary

if §1244 applies, otherwise capital.

Tax Attributes of Different Business Forms (slide 16 of 19)

Fringe Benefits §1244 Built-in

Avail. to Owners? Available? Gains effect?

Sole Prop. No No N/A

P’ship No No N/A

S Corp. Some if < 2% Yes Possible corp. owner level tax

C Corp. Available Yes No effect Limited by

anti-discrim.rules

Tax Attributes of Different Business Forms (slide 17 of 19)

§1231 Gains Foreign Tax and Losses Credits

Sole Prop. Taxable or deductible Owner level by owner. 5 yr. lookback rule.

Partnerships Conduit—same Conduit—sameand S Corps as S.Prop. as S.Prop.

C Corp. Taxable/deductible Available at corp. level 5 yr. Corporate level lookback rule

Tax Attributes of Different Business Forms (slide 18 of 19)

Tax Alternative ACE Preference

Min. Tax Adjustment Items .

Sole Prop. Applies at N/A Determined at owner level owner level

(26% or 28%)

Partnership Applies at N/A Conduit—entity or S Corp. ptr or preferences

shareholder (26% or 28%) level pass thru to owners for their AMT calc.

Tax Attributes of Different Business Forms (slide 19 of 19)

Tax Alternative ACE Preference Min. Tax Adjustment Items .

C Corp. Applies at Corp. 75% x (ACE Subject to level (20%) -AMTI) is AMT at added to AMTI corporate (or subtracted) level

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 70

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPAtrippedr@oneonta.edu

SUNY Oneonta