Transcript Document

Taxation of Alternative
Forms of Business
Proprietorship
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Not a separate legal entity
Income reported by and taxed to
proprietor
Partnership
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4-1
Separate legal entity, but not a taxable
entity
Partnership files information return
Income reported by and taxed to partners
when earned by the partnership
Taxation of Alternative
Forms of Business continued
Corporation
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Separate legal entity
C corporation
 Taxable entity – income reported by and taxed
to the corporation
 Dividend distributions are not deductible by the
corporation, and are taxable income to the
recipient shareholders
 Increases in value of shares taxed as capital
gains when stock is sold
4-2
Taxation of Alternative
Forms of Business continued
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S corporation
 Not a taxable entity – files an information
return
 Income reported by and taxed to shareholders
when earned by the corporation
 Limited to 75 non-corporate shareholders
Limited Liability Company (LLC)
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4-3
Generally elect to be taxed as partnerships
Calculating After-Tax
Business Accumulations
Some more notation
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4-4
tp = partner-level tax rate on ordinary income
tc = corporate income tax rate
Rp = before-tax return on partnership investment
rp = after-tax rate of return on partnership earnings
= Rp(1 – tp)
Rc = before-tax return on corporate investment
rc = after-corporate-level-tax (but before shareholderlevel tax) rate of return on corporate earnings
= Rc(1 – tc)
ts = effective annualized tax rate on shares
After-Tax Partnership
Accumulation
Assume that partnership distributes
cash each year to the partners sufficient
to pay tax, then reinvests remaining
after-tax earnings for n periods, then
liquidates
After-tax accumulation =
$I[1 + Rp(1-tp)]n
(same as IV1 from Chapter 3)
4-5
After-Tax Corporate
Accumulation
Assume that corporation makes no
dividend distributions; it reinvests all
after-corporate-tax earnings for n
periods, then liquidates
After-tax accumulation =
$I[1 + Rc(1 – tc)]n (1-tcg) + tcg$I
(similar to IV2 from Chapter 3)
4-6
Choice of Partnership or
Corporate Form
Assuming Rp = Rc, difference in aftertax accumulations depends on tp, tc, tcg,
and n
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4-7
If tp = tc and tcg = 0, after-tax
accumulations are identical
If tp = tc and tcg > 0, the partnership form
dominates the corporate form for all n
If tp > tc and tcg = 0, the corporate form
dominates the partnership form for all n
If tp > tc and tcg > 0, either form may be
preferred
Choice of Form continued
Why might Rp  Rc?
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4-8
Liability issues
Administrative and reporting cost
differences
Access to capital
Owner control over management
Comparing Partnership and
Corporate Forms when Rp  Rc
One approach: find a rate of return to
corporate form at which investor is
indifferent
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4-9
rc* = {[(1+rp)n – tcg]/(1 – tcg)}1/n – 1
For any given set of tax rate variables and
time horizon, can solve for rc* using the
above formula. Then solve for the
required before-tax rate of return, Rc*,
using: Rc* (1 – tc) = rc*
For any Rc > Rc*, corporate form preferred;
otherwise, partnership form preferred
Example
4-10
Let Rp = 10%, tp = 40%, tc = 35%,
tcg = 20%, and n = 5. Then rp = 10%(1 40%) = 6%
rc* = {[1.065 - .20]/(1-.20)}1/5 –1
= 0.073 or 7.3%
Rc* = 7.3%/(1 - .35) yields Rc* = 11.2%
Interpretation: The corporation must
produce a before-tax rate of return 1.2%
higher than the partnership, to overcome
its tax disadvantage
Example continued
Suppose n = 25.
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4-11
rc* = {[1.0625 - .20]/(1-.20)}1/25 –1
= 0.067 or 6.7%
Rc* = 10.3%
Interpretation: Over a longer time horizon,
the tax deferral of the lower capital gains
tax on the corporate liquidation becomes
more valuable, and the required corporate
before-tax rate of return is only .3% higher
than the partnership return
Example continued
Finally, suppose n = 50
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4-12
rc* = {[1.0650 - .20]/(1-.20)}1/50 –1
= 0.064 or 6.4%
Rc* = 9.8%
Interpretation: Over a very long time
horizon, the corporation is preferred to the
partnership even with a lower before-tax
return. Why? The annual corporate tax
rate is lower than the annual partnership
tax rate, and the capital gains tax is
deferred 50 years.
Effective Annualized Tax
Rate on Shares
4-13
Example showed that increased deferral
of capital gains taxation reduces the
required corporate return
One way to calculate the impact of such
deferral is the effective annual tax rate
– the rate of annual taxation on
increased corporate value at which the
shareholder would end up with the
same after-tax accumulation
ts = 1 – rp/rc*
Example continued
When n = 5, rc* = 7.3%, and
ts = 1 - .06/.073 = 17.8%
When n = 25, rc* = 6.7%, and
ts = 1 - .06/.067 = 10.4%
When n = 50, rc* = 6.4%, and
ts = 1 - .06/.064 = 6.3%
Interpretation?
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Comparisons of Corporate and
Partnership Forms over Time
Review Table 4.4 in text
How were these numbers calculated?
I would use:
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4-15
rc* = {[(1+rp)n – tcg]/(1 – tcg)}1/n – 1
Rc* = rc*/ (1 – tc)
Required Corporate Return
with Dividends
Recall our initial assumption that the
corporation pays no dividends
Would we expect the payment of
dividends to increase or decrease the
required corporate rate of return,
relative to the partnership? Why?
We can incorporate dividends into the
equation for rc*, but we won’t do so
4-16
Other Complications
Corporate and individual tax rates are
not constant
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Vary across taxpayers, given progressive
rate structures
Vary across time
Rates of return are not constant over
time
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4-17
Corporate net operating losses and
carryback/carryover rules affect timing of
taxation
Other Complications
continued
Different types of investors have
different tax characteristics and thus
different rates
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4-18
Fully taxable individual investors
Tax-exempt investors (pension funds, nonprofit organizations)
Corporations
Foreign investors
Broker-dealers
Other Organizational Forms
and Their Tax Characteristics
Foreign subsidiaries
Closely held corporations
Not-for-profit corporations
Tax-imputation corporations
REITs
REMICs
4-19