Chapter 13Chapter 13

©2006 South-Western©2006 South-Western

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Choice of Business Entity:Choice of Business Entity:General Tax and Nontax General Tax and Nontax

FactorsFactorsFormationFormation

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Introduction

Taxpayers must choose a form for a business entity

Choice is based on tax and non-tax factors

Non-Tax Factors

1 Is the number of owners restricted?2 Do owners have limited liability?3 Can ownership interest be freely transferred?4 Do owners have a large degree of management

control?5 Does entity continue regardless of ownership

changes? 6 Is there a high cost of organizing the entity?7 Does the entity have an ability to raise additional

capital?

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Let’s look at the non-tax factors and how they affect each entity.

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Sole Proprietorship

The owner: Has unlimited liability Can easily transfer

ownership interest Has full management

control

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A sole proprietorship is a business owned by one individual.

The entity: Ceases to exist when

ownership changes Has a low cost of

formation Has a limited ability to

raise capital

Partnership

The owners: Are fully liable (except for

limited partners) Cannot easily transfer

ownership interest Have full management

control

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The entity: Ceases to exist if >50%

ownership changes Has a moderate cost of

formation Has a good ability to

raise capital

A partnership exists when two or more persons engage collectively in a profit

making activity.

Corporation

The owners: Have limited liability Can easily transfer

ownership interest Have no right to direct

management Are not limited in

number

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A corporation is an artificial entity created under the auspices of state law.

The entity: Continues to exist when

ownership changes Has a relatively high cost

of formation Has an excellent ability

to raise capital

S Corporation

The owners: Have limited liability Can easily transfer

ownership interest Have no right to direct

management Are limited to a

maximum number of 75

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An S corporation is a regular corporation with special tax attributes.

The entity: Continues to exist when ownership changes Has a relatively high

cost of formation Has an excellent ability

to raise capital

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S Corporation Election

Requirements for electing S statusNo more than 100 shareholdersShareholders must be individuals, estates,

tax-exempt organizations, or certain trustsShareholders may not be nonresident

aliensOnly one class of outstanding stock is

allowedAll shareholders must consent to election

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S Corporation ElectionTermination

Terminating electionMay be voluntarily terminated by consent

of >50% of shareholdersInvoluntary termination occurs when any

requirements are violated Must wait 5 years before applying for S status

again

Limited Liability Company

The owners: Have limited liability Cannot easily transfer

ownership interest Have full management

control Not limited to number of

owners

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The limited liability company (LLC) has corporate characteristics with the conduit tax treatment of partnerships.

The entity: Ceases to exist when

ownership changes Has a moderate cost of

formation Has a good ability to

raise capital

Limited Liability Partnership

The owners: Have liability only for

their own acts Cannot easily transfer

ownership interest Have full management

control Must have at least 2

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The limited liability partnership (LLP) is a general partnership with limited liability for owners.

The entity: Ceases to exist when

ownership changes Has a moderate cost of

formation Has a good ability to

raise capital

Let’s look at the tax factors and how they affect each entity.

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General Income Tax Factors

Three tax factors also influence choice of entityIncidence of Income Taxation

Who pays the tax, the entity or the owner?Double Taxation

Is the same income taxed to the entity and the owner?

Employee versus Owner Can owners be treated as employees of the

entity?

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#1: Who Pays the Tax?

Sole Proprietorship: conduit to ownerForm 1040, Schedule C

Partnership: conduit to partnersForm 1065, Schedule K-1Items that receive special tax treatment are

reported separately from operations

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#1: Who Pays the Tax?

S Corporation: conduit to shareholdersForm 1120S, Schedule K-1Separable items like partnership

C Corporation: Corporation paysForm 1120

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#1: Who Pays the Tax? Personal Service Corporation

A corporation is a personal service corporation (PSC) ifThe principal activity is performance of

personal servicesThe services are performed by owner-

employees, those who own > 10% of the stock

PSC’s pay tax on the income at a 35% rateEncourages payment of salary to owners

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#2: Is Double Taxation a Problem? No

Sole ProprietorshipsPartnershipsS Corporations

YesC Corporations

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#3: Owners Treated as Employees? Sole Proprietors - No Partners - No

But may receive guaranteed payments and fringe benefits

S Corporation shareholders - YesSalary and fringe benefits are deductible by the

corporation C Corporation shareholders - Yes

All payments made to/for owner-employees allowable

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How do fringe benefits and employment taxes

apply to employees of each entity?

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Fringe Benefits

Legislative grace allows employers to deduct amounts paid as fringe benefits but does not require employees to report income.Owner-employees

Related party concerns Nondiscriminatory rules

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Fringe Benefit Limitations

Sole proprietors are not employeesNo deduction allowed for salary or benefits

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Fringe Benefit Limitations

Partners and > 2% shareholders of S Corporations must include in income:Employer-provided group term life of

$50,000 or lessEmployer sponsored accident and health-

care plans Owner/employee can deduct for AGI

Cafeteria plans, and Meals and lodging provided by employer

Social Security Taxes

Taxes are paid half by employee and half by employerTotal rate is 15.3% = 2.9% Medicare + 12.4%

OASDI Maximum amount subject to OASDI is $90,000

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The social security tax is imposed on the wages of employees and the net self-employment income of self-employed individuals.

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Social Security Taxes

Self-employed taxpayers (sole proprietors and partners) pay both halvesBase is 92.35% of net self-employed

income Corporations and S corporations may

deduct the half paid for shareholder-employees

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Formation

At the formation of a business entity, a number of tax issues ariseHow to treat transfers of cash and property

to an entity in exchange for ownership?How to determine an owner’s initial and

continuing basis?How to treat costs incurred prior to and

during formation?What accounting period and method to

use?

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How are property transfer issuestreated by each entity?

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Sole Proprietorship

No tax effects ariseSole proprietorship is not an entity

separate from the ownerNo realization under the realization

conceptno second party involved in the transfer

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Partnership

No gain or loss recognized when property transferredRealized gain or loss is deferredPartner and partnership take a carryover

basis in the property Income is recognized if services are

performed in exchange for ownershipAll-inclusive income concept appliesIncome = FMV of partnership interest

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Corporations

No gain or loss recognized ifProperty is exchanged solely for stock, andThe shareholders control (> 80%

ownership) the corporation after transfer Income is recognized if services are

performed in exchange for stock

How are basis issues treated by each entity?

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Basic Basis Considerations

Owners obtain an initial basis either through purchase or the transfer of propertyIf by purchase, use the purchase costIf by transfer, use a carry-over basis and

holding period The entity generally takes a carry-over

basis for property transferred in

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Sole Proprietorship

Ownership of property never changes Owner’s basis remains unchanged

Partnership Basis determines the taxability of

distributions from the entity to the partner Initial basis = basis in property transferred

and/or FMV of services contributed

Increased by Decreased byAdditional contributions Distributions receivedPartner’s share of income Partner’s share of lossesPartner’s share of Partner’s share of

increases in entity debt decreases in entity debtEntity debt taken by partner Partner’s debt taken by entity

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C Corporation

Initial basis = basis in property transferred and/or FMV of services contributed

If any boot is received in the transferShareholder has wherewithal-to-pay and

must report gainBasis includes the amount of gain recognized

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C Corporation

Shareholders adjust basis in individual shares for stock dividends and stock splits

Shareholders who receive a distribution in excess of basis must report a capital gainExcess over capital recovery

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S Corporation

Initial basis = basis in property transferred and/or FMV of services contributed

If any boot is received in the transferShareholder has wherewithal-to-pay and

must report gainBasis includes the amount of gain

recognized

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S Corporation

Basis is adjusted for items affecting the shareholder’s capital recoveryFollow the adjustments made for a partner

with the exception of adjustments for debt

How are costs incurred prior to and during formation treated?

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Organizational and Start-up Costs

Expenditures that have a life extending beyond the end of the tax year must be capitalizedOrganization costs pertain to getting the

entity ready to operateStart-up costs are incurred by an entity

prior to beginning operations

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Organizational and Start-up Costs

Costs incurred prior to 10/23/04 are amortized over 60 months

Costs incurred after 10/22/04$5,000 may be expensed

Phased-out if total costs exceed $50,000Costs above $5,000 are amortized over

180 months

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What accounting period and method should be used?

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Accounting Periods

The annual accounting period concept requires all entities to report operations

on an annual basis.

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Accounting Periods

Taxpayers are generally free to choose their accounting period

Partnerships and S Corporations must use the taxable year of owners with >50% interestMay use natural business yearPartnerships may use year of principal

(> 5%) owners if majority partners’ years do not agree

Accounting Methods

Taxpayers must select an accounting method which properly characterizes income and deductions.

May use one of three methods: cash, accrual, hybridCorporations are generally required to use the

accrual methodPartnerships with a corporate partner are

generally required to use the accrual method

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End of Chapter 13