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Corporations, Partnerships,
LLCs, and S Corporations
Business Organizations
Taxpayer = owners = flow-through entities
sole proprietorship
partnerships
LLCs
S Corporations
Taxpayer = corporation
C Corporation is taxed first, then shareholders may be
taxed on distributions (double taxation).
•Corporation Legal Characteristics
• Limited liability of shareholders
– Owners of closely-held corporations often
are required to sign personal liability on
bank debt.
• Unlimited life
• Free transferability
– Closely-held corporations:buy-sell
agreement may prevent transferability.
• Centralized management
Affiliated Groups and Consolidations
Parent + all >= 80% domestic subsidiaries.
Affiliated groups may elect to file a consolidated tax
return - applies to all members of affiliated group.
Advantage: losses and profits of affiliated
members offset. Like financial accounting,
intercompany transactions are eliminated.
If the same individual(s) own 80% or more of more
than one corporation, these corporations are a
‘controlled group’ (see Ch 11 end). They may not
file a consolidated return, but the tax bracket
benefits are limited.
Computing Corporate Taxable Income
Page 1 of the Form 1120 resembles a financial
income statement or a Schedule C in a personal
tax return (Ch 9).
Use chapters 5, 6, 7 and 8 for general rules on
business income.
Deduct only 50% of meals and entertainment
expenses.
Deduct charitable contributions up to 10% of
taxable income BEFORE charity and before
dividends-received deduction.
Dividends-received Deduction
Ownership
Deduction
< 20% of stock
70% DRD
20%<= own < 80%
80% DRD
80%<= own
100% DRD
Reason for DRD? Mitigate “triple” taxation.
Additional details: DRD can’t create loss - tricky
computations not in this text.
Book Versus Taxable Income - Schedule M-1
This schedule reconciles book income to taxable
income.
net book income - line 1
federal tax expense for books - line 2
lines 3 - 6 explain increases in taxable income
relative to books.
lines 7 - 9 explain decreases in taxable income
relative to books.
line 10 = taxable income before NOLD and DRD =
line 28 form 1120
Try problem AP7.
Book Versus Taxable Income
Book-tax differences are scrutinized by IRS.
The Schedule M-1 contains permanent and
temporary items.
The tax footnote in the financial statement contains
numerous estimates of amounts that are finalized
by the time the return is filed. Thus, Schedule M-1
items will not exactly = amounts in F/S footnotes.
Computing Regular Tax
The surtax rates of 39% and 38% eliminate
bracket benefits for ‘rich’ corporations.
Corporations with taxable income > $18.33
million just pay a flat rate of 35% on all
income.
Personal service corporations are taxed at a
flat 35% rate.
Tax Credits
Credits directly reduce computed tax.
Deductions only reduce the income subject to
tax. Thus, $1 of credit provides $1 of benefit.
$1 of deduction only provides $1 x the tax
rate.
Tax credits are generally limited to some % of
tax before credits. Often a provision permits
carry back or carry forward of excess credits.
Biggest credits: R&D credit, foreign tax credit
(see Chapter 12).
Payment and Filing Requirements
Tax return due 15th day of 3rd month, may
extend to 15th day of 9th month.
Estimated payments are due on the 15th
day of 4th, 6th, 9th, and 12th months.
Must pay 100% of tax due (small
corporations (TI < $1 mill) may use safeharbor rule of paying 100% of prior year
tax).
Underpayment penalty is computed like
interest expense but is nondeductible.
Distributions to Investors
Interest payments are deductible.
Payments on stock are non-deductible.
Payments on stock are taxable dividends to the
shareholder if the corporation has either current or
cumulative earnings and profits.
E&P similar to tax basis retained earnings
 Payments in excess of earnings and profits are
first a return of capital and then a gain to the
shareholder.
Distributions to Investors
Nondeductibility of dividends makes paying
dividends hard to explain.
One result is the high leverage of many
corporations, because interest expense is
deductible.
Investors may prefer that the corporation
keep the funds and reinvest them; sell
stock for a capital gain in future.
Will administration eliminate double
taxation?
Partnerships
The partnership agreement states the rights and
obligations of partners, and the % of profits and losses
allocable to each partner. Such agreements permit
flexibility.
General partnership: all partners have unlimited
liability; joint and severable
Limited partnership: one or more limited partners are
only liable for their contributed capital. Legally, all
limited partnerships have at least one general partner.
Limited liability partnership (LLP) used for professional
services. General partners are not liable for malpractice
of other partners.
Tax Basis in Partnership Interest
Cash plus adjusted basis contributed.
+ Share of partnership debt for which partner could
be responsible.
Partnership Reporting
The partnership files an information return,
Form 1065.
Included with the Form 1065 are Forms K-1,
which show EACH partner’s share of income
and deductions.
EACH partner reports his or her share on
partnership income on Schedule E, as part of
his or her Form 1040. “Non-ordinary” items are
SEPARATELY STATED and retain their
character on the partner’s return. Q9
Because the partnership does not pay tax, the
partnership is referred to as a FLOWTHROUGH ENTITY.
Guaranteed Payments
A guaranteed payment is a special allocation of
ordinary income to the partner receiving it - similar
in nature to a salary.
The receiving partner reports as ordinary income
BOTH:
1) his guaranteed payment
2) his share of partnership income after the guaranteed
payment.
Other partners report their shares of partnership
income after the guaranteed payment.
Self-Employment Income From Partnership
SE tax must be paid by the partner on
Guaranteed payments +
Distributive share of ordinary business income from
partnership
Limited partners do NOT pay SE tax on share of
ordinary income.
Adjusting Partnership Basis
These things increases basis:
Contributions (initial and ongoing): cash + adjusted basis
contributed
Positive income (taxable and tax-exempt)
Share of partnership liabilities for which partner is liable.
(Also allow nonrecourse real estate loans for limited
partners).
These things decrease basis:
Distributions
Losses and deductions (and shares of nondeductible
expenses).
Partnership Losses Limited to Basis
Partners CANNOT deduct losses in excess of
basis. See AP13, 14
Excess losses are carried forward indefinitely until
additional basis is restored.
by additional contributions or additional positive income.
This rule applies to EACH partnership separately.
AP 11, 12
Are there questions about examples in the text?
This can be complicated.
Limited Liability Company
Treated as a corporation for liability purposes, but
as a partnership for federal tax purposes.
Relatively new organizational form - less legal
precedence.
Every state (and DC) permits LLCs.
Still unclear whether LLC income is subject to SE
tax.
S Corporations
Legally a corporation under state law.
An S Corporation is a flow-through entity for tax
purposes.
Income and loss items are allocated among
shareholders based on their % ownership of stock
(this allocation is not flexible like partnership
agreements).
Flow-through items retain their character on the
individual tax return (e.g. ordinary income, capital
losses, charitable contributions, etc).
S Corporation Eligibility
Only individuals, estates and some trusts may be
shareholders.
The number of shareholders (not including
spouses) is limited to 100.
The corporation may only have one class of
outstanding common stock.
Shareholders must unanimously elect S Corp
status.
Shareholder Basis
Initial basis = cash + adjusted basis of contributed
property.
Loan FROM a shareholder to S Corp increases
basis for THAT shareholder. Any other debt of the
S Corp does NOT increase shareholder basis.
(E.g., a bank loan guaranteed by shareholder does
not increase basis for any shareholder, even the
one that guaranteed the loan).
Like partnerships, basis is increased by
contributions and income items. Basis is decreased
by distributions and loss items.
S Corporation Operation
Shareholders can be paid a salary.
Salary is subject to payroll taxes and reduces ordinary
income of the S Corporation.
S Corp can use corporate employee benefit plans for
shareholder/employees.
Share of ordinary income is NOT subject to SelfEmployment tax.
Allocable share of loss items can only be deducted
up to BASIS, like with partnerships. Losses in
excess of basis are carried over until the
shareholder has basis again.
Limitations on the Deduction of Allocated Losses
3 Provisions limit the deductibility of partnership/LLC and S
corporation losses
Overall Basis rules – partners/LLC member and S corporation
shareholders may deduct losses only to the extent of their respective
basis
Sec. 465 - partners may not deduct losses in excess of his/her at risk
amount
Sec. 469 - prohibits individuals and closely held corporations from
deducting PALs in excess of PAI
Section 704(d)
 A partners deduction cannot exceed his/her total investment
including share of debt.  If allocated share of partnership losses exceeds his/her
basis in the partnership interest excess does not reduce basis, but is carried forward
indefinitely and may be deducted when the partner has
basis.
 For purposes of this limitation - any distributions made to
the partner during the year are accounted for before the
application of the basis limitation
 The allocation of loss is the last adjustment to basis to be
applied.
At Risk Limitations
 While partners get tax basis in all debts, they are generally
at risk for their investment in the partnership + their portion
of recourse debt or qualified non-recourse debt.
 S corporation shareholders are not at-risk for S corporation
debt unless it is directly from the shareholder to the
corporation
 Qualified non-recourse debt - nonrecourse debt secured by
real estate, which are obtained from a bank, S&L, or other
commercial lender. Excludes seller financed loans, and
non-real estate non recourse loans
 This means tax basis for partners/LLC members may differ
from at-risk basis because of the classification of debt as
recourse v. non-recourse.
At Risk Limitations
Continued
 Regular tax basis rules and Sec. 465 limitations are applied
sequentially
 Only losses allowed by Sec. 704(d) can be limited by Sec.
465.
 Where basis and at risk are the same, losses will be
disallowed under the general tax basis rules.
 Where basis and at risk differ, losses can be disallowed
under both sections
 Sec. 465(e) discusses at risk recapture, when at risk basis
is negative (excess distributions or debt reduction), amount
taken into income is typically ordinary income rather than
capital
Sec 469 - Passive Activity Loss Limitations
.
 If a partner cannot take a loss because of the above
limitations, the passive activity loss rules cannot be applied
until the above limitations are lifted.
 General rule - passive activity losses are disallowed to the
extent the passive activity losses exceed passive activity
income.
 Net disallowed PALs are carried forward to tax years when
PAI is available.
 Passive Activities are aggregated to determine the
limitation.
Sec. 469 (continued)
 Passive Activity
 TP does not materially participate in the activity
 Partner is a limited partner
 Partnership is engaged in a rental activity (2 exceptions, real estate
professionals and general partners who actively participate but
make less than $150,000)
 Passive losses disallowed must be allocated to all passive
activities on a pro-rata basis. You cannot choose which
passive activities you want to take the losses from, etc.
 Suspended passive losses can be taken in the year the
passive activity is disposed by the taxpayer.
The Choice of Business
Entity
Choice of Entity
This is a tax planning chapter - HOW to
use rules
Pass-through losses
After-tax cash flows to individual investor.
Family income shifting
Partnership versus S Corp characteristics
Closely-held corporations
 Constructive dividends limit corporate tax avoidance.
 accumulated earnings tax, personal holding company
tax, tax rates on members of a controlled group.
Passthrough Entities
Partnerships (includes LLCs) and S Corps are not
taxed as entities. Investors pay tax on their share
of entity income.
Single level of taxation.
Cash distributions are generally NOT taxable.
Benefits of Passthrough Losses
Passthrough loss is generally deductible in the
year the loss is generated at the individual’s
marginal tax rate.
Corporation loss must be carried (back) forward
and used to offset income in a taxable year where
profits are reported. NOL deduction provides a
benefit at the corporation’s tax rate in the year the
NOL offsets profits.
Passthrough Entities Only Have a Single Level of
Tax
The preceding example illustrates the benefits of a
pass-through entity:
a) use losses immediately
b) single level of taxation
Partnership versus S Corporation
S Corps require an IRS election, incorporation
documents, possible corporate state tax payments.
Partnership agreements have more flexibility, but
require more careful legal drafting.
Partners (but not S Corp shareholders) receive tax
basis for liabilities of the partnership.
S Corporation shares are transferable. Partnership
interests are not - requires new partnership
agreement.
Employee benefit planning favors S Corp.
Types of Flow-Through Entity
Liability
Full - General partnership
Limited liability partnership - general partners are not
personally liable for malpractice-related claims of another
general partner.
Limited partnership - at least one general partner, but
other partners have no liability.
Limited liability partnership - partners not responsible for
other parter’s malpractice.
Limited liability company (treated like partnership for tax,
corporation legally).
S Corporation creates limited liability.
Closely-held Corporations
Biggest challenge is how can the investors avoid
double taxation of corporate earnings.
If shareholders are also creditors, interest expense
is deductible to corporation.
If shareholders are also employees, wage expense
is deductible to corporation.
If shareholders are also landlords, rent expense is
deductible to corporation.
Closely-held Corporations
IRS challenge turns “unreasonable” payments into
constructive dividends.
How does the IRS decide what is unreasonable?
(AP6)
interest
wages
rent
Accumulating Corporate Profits as a Tax Shelter
Keep earnings in corporation.
Small corporations are taxed at low rates.
Delay paying dividends.
Possibly convert ordinary dividend to capital gain
by selling stock.
Controlled Group Tax Rates
Aggregate the taxable income of all members of a controlled
group (>= 80% common ownership).
Compute tax.
Allocate tax according to proportion of taxable income.
These rules prevent disbursing corporate income into
numerous legal entities all taxed at 15%.