Transcript Slide 1

Chapter 13.
Comparing
Organizations.
Howard Godfrey, Ph.D., CPA
Professor of Accounting
Copyright 2009
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
Forms of Doing Business
• Sole Proprietorship
• Partnership
Limited liability co (LLC)
• C corporation
• S corporation
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
Proprietorship
Files Schedule C,
Form 1040
Partnership & LLC
File Form 1065
C Corporation
Files Form 1120
S Corporation
Files Form 1120S
Nontax Factors—Capital Formation
Proprietorship
Limited ability to
raise capital
Partnership
• Can raise funds through
pooling of owner
resources
• Ltd. partnership can raise
capital from investors
C Corporation
S Corporation
• Greatest ease
• Greatest ease and
and potential for potential for raising capital,
raising capital
but limited number of
investors
Nontax Factors—Limited Liability
Proprietorship Partnership
Unlimited
General partners are
liability
jointly and severally
liable
Ltd. Partner’s liability is
limited to investment
C Corporation S Corporation
Generally have Generally have limited
limited liability liability
Other Nontax Factors
• Estimated life of business
• Number of owners and their
roles in management
• Freedom of choice in
transferring ownership
interests
• Organizational formality and
related costs
Single vs. Double Taxation
Proprietorship
Single taxation
Partnership
Single taxation
C Corporation
S Corporation
Double taxation
• Generally, single taxation
(unless you have
policy of not
• May be subject to built-in
paying dividends) gains tax and passive
investment income tax
Jan is single with no dependent.
Jan has an office supply business.
She has these annual results:
Sales
$1,000,000
Operating expenses
(800,000)
Net income
$200,000
Jan will incorporate the business.
She will draw a salary of $100,000.
All after-tax earnings will be
invested in growth of corporation.
Do your recommend an S election?
Suppose there will be losses.
Alternative Minimum Tax
Proprietorship
Directly subject to
AMT
Partnership
• 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 (dividends?)
– Recognizing the interaction between
the regular tax liability and the AMT
liability
– Utilization of special allocations
– Fringe benefits
– Minimizing double taxation
On 1-1-08, Jan invested $200,000 in Concord Corp.
On 1-1-08, Jan invested $200,000 in Shelby Corp.
Jan received all stock of both corporations.
Shelby corporation immediately elected S Status
Concord
Shelby
Summary of 2008 Transactions
C Corp.
S Corp.
Revenue
$100,000 $100,000
Compensation to Jan
(40,000)
(40,000)
Other Expenses
(20,000)
(20,000)
Net Income before income tax
$40,000
$40,000
Dividends paid to Jan
$10,000
$10,000
How much total corp. income tax is paid for 2008?
How much total income reported in 2008 by Jan?
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
Six unrelated individuals have a 50% ownership interest in
one of these businesses. Each business pays health
ins. premiums for owners who all work in the businesses.
Summary of 2008 Transactions
Revenue
Concord
C Corp.
Shelby
S Corp.
Pineville
Partnership
$100,000
$100,000
$100,000
Compensation of owners (1)
(40,000)
(40,000)
(40,000)
Health insurance premiums
(10,000)
(10,000)
(10,000)
Other Expenses
(20,000)
(20,000)
(20,000)
Net Income before tax
$30,000
$30,000
$30,000
Income reported by all owners
For AGI-1040 deduct by all owners
From AGI-1040 ded. by all owners
1. For partners, compensation is a guarenteed payment.
Min. Double Tax - C Corp (1 of 5)
• Several techniques are available for
reducing the double taxation of C
corps including:
–Making distributions to
shareholders that are deductible by
corporation
–Retaining earnings at corp level
–Making distributions treated as a
return of capital
–Making the S corp election
Min. Double Tax - C Corp (2 of 5)
• Deductible distributions include:
– Salary payments to shareholderemployees
– Rental payments to shareholder-lessors
– Interest payments to shareholdercreditors
• IRS scrutinizes these types of
transactions
– Must be reasonable
Min. Double Tax - C Corp (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
Min. Double Tax - C Corp (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
Min. Double Tax - C Corp (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 (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 (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
Investing in Business - No Debt
Beth owns a building with basis of $250,000 and FMV
of $400,000. She invests building in a new business.
1 Ann invests cash
FMV
$100,000 20%
2 Beth invests building
FMV
$400,000 80%
Total Assets
$500,000
3 Owner Equity
Ann
$100,000 20%
Beth
$400,000 80%
Type of Entity
Give answers in $000
Corp Prtnrshp
a. Beth's Realized Gain 1001
1001
b. Beth's Recog. Gain
351
721
c. Beth's basis in entity 358
722
d. Entity's basis in build. 362
723
Investing in Business - Debt
Beth owns a building with basis of $250,000 and FMV
of $450,000. She invests building in a new business.
Beth has mortgage of $50,000, assumed by the business.
1 Ann invests cash
FMV
$100,000
18%
2 Beth invests building
FMV
$450,000
82%
Total Assets
$550,000
Mortgage Payable
$50,000
3 Owner Equity
Ann
$100,000
20%
Beth
$400,000
80%
Type of Entity
Give answers in $000
Corp Prtnrshp
1001
1001
a. Beth's Realized Gain
721, 52, 31
b. Beth's Recog. Gain 351, 357
358
722
c. Beth's basis in entity
362
723
d. Entity's basis in build.
Basis Considerations
Proprietorship Partnership
N/A
• Profits & losses affect
partner’s basis
• Partner’s basis is increased
by share of entity debt
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 by
affected by corporate
liabilities
On 1-1-08, Jan invested $200,000 in Concord Corp.
On 1-1-08, Jan invested $200,000 in Shelby Corp.
Jan received all stock of both corporations.
Shelby corporation immediately elected S Status
Concord
Shelby
Summary of 2008 Transactions
C Corp.
S Corp.
Revenue
$100,000 $100,000
Compensation to Sue
(40,000)
(40,000)
Other Expenses
(20,000)
(20,000)
Net Income before income tax
$40,000
$40,000
Dividends paid to Jan
$10,000
$10,000
On 1-1-09, Jan sold all Concord Stock for $300,000.
On 1-1-09, Jan sold all Shelby Stock for $300,000.
What is Jan's total gain on these stock sales?
Distributions
• Distributions can be made to partners,
LLC owners, or S corp. shareholders taxfree
– 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
Partnership Current Distribution - No Debt
Basis
FMV
Basis
FMV
Cash
$20,000
$20,000 A, Cap
$16,000
$40,000
Build.
0
30,000 B, Cap
16,000
40,000
Land
20,000
50,000 C, Cap
8,000
20,000
Totals $40,000 $100,000 Totals
$40,000 $100,000
In a current distribution, C withdraws 20% of land:
Entity's Basis in Land
4,000
Fair Market Value
10,000
Gain for C
731(a)
Gain for Entity
731(b)
C's Basis in Land
732(a)
C's Basis in Entity
733
What if liquidating distribution? What if C corp? S corp?
Corporate Property Distribution
Asset
Bk. Val.
FMV
Equity Bk. Val.
Cash
$20,000 $20,000 Stock
$30,000
Land
60,000 160,000 Ret. Earn. 50,000
Totals
$80,000 $180,000 Totals
$80,000
Carl owns 100% of the stock (basis: $30,000).
Carl received distribution of 25% of land.
Corp. basis in land distributed
$15,000
FMV of land distributed
$40,000
Carl's income
301
Corporation's Gain
311(a), (b)
Carl's Land Basis
301(d)
Carl's Stock Basis
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
Redemption of ownership
interest by the entity
• May generate no income for
owner.
• May generate ordinary
income for owner.
• May generate capital gain
for owner.
Corporate Stock Redemption
Book Val.
Book Val.
Cash
$40,000 Stock
$30,000
Land
60,000 Ret. Earn.
70,000
Totals
$100,000 Totals
100,000
Ed owns 25% of stock (basis: $10,000).
Redeem all of Ed's stock for cash of $25,000.
Case A
Case B
Cash distributed
$25,000 $25,000
Ed's dividend income
Ed's capital gain
Ed's ending stock basis
Case B. Ed owned 100% of stock (basis $40,000).
Corp. redeemed 25% of his stock for $25,000.
Jan and Joe each own 50% of a business.
Each has a basis of $20,000. There is no debt.
They each take a distribution of half of the
land and half of after-tax cash balance.
Basis
This is the only
Cash $10,000
transaction on Jan. 1
Land $20,000
$30,000
C Corp
S Corp
Entity Gain on sale
Entity Tax Paid
Flow-through gain to Joe
Joe's revised stock basis
Assets distributed to Joe
Joe's Gain on dist.
Joe's basis in land
FMV
$10,000
$60,000
$70,000
Ptship
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
Jan and Joe each own 50% of a business.
Each has a basis of $20,000. There is no debt.
On 1-1-08, Big Company buys all assets for FMV amount.
Basis
FMV
Jan & Joe receive liquid.
Cash $10,000
$10,000
distributions on 1-1-08.
Land $20,000
$60,000
$30,000
$70,000
C Corp
S Corp
Ptship
Entity Gain on dist.
Entity Tax Paid
Joe's flow-through gain
Joe's Gain (Loss) on liquid.
Cash distributed to Joe
Joe's gain: Type?
Liquidating Dist. of Assets to Owner.
Owner’s Sells to Third Party. (1 of 3)
• Partnership
– Distribution rules determine partner’s
basis in assets received from ptship
– 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 Dist. of Assets to Owner.
Owner’s Sells to Third Party. (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
Corporate Liquidation
Assets Book Val. FMV
Equity Book Val.
Cash
$20,000 $20,000 Stock
$30,000
Land
80,000 100,000 Ret. Earn.
70,000
Totals $100,000 $120,000 Totals
$100,000
Bob owns all stock with basis of $30,000.
Bob liquidates the Corporation.
Bob receives all land with FMV of $100,000
All cash is used for taxes and liquidation exp.
Land distributed - FMV
$100,000
Bob's dividend income
Bob's capital gain
331
Corporate gain
336
Bob's basis in land
334
Liquidating Dist. of Assets to Owner.
Owner’s Sells to Third Party. (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)
• 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 2of 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 Bus -Seller’s Issues (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 Bus -Seller’s Issues (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 Bus -Seller’s Issues (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 Bus-Buyer’s Issues (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 Bus-Buyer’s Issues (2 of 3)
• Partnership
–Purchaser buys partnership
interest
–Purchaser may ask partnership to
make §754 election to step up
inside basis in assets
Purchase Bus-Buyer’s Issues (2 of 3)
S Corp or C Corp
–Purchaser buys stock
–There is no effect on
underlying assets owned
by the entity
Purchase Bus-Buyer’s Issues (3 of 3)
S Corp or C Corp
–Purchaser buys stock
–There is no effect on
underlying assets owned
by the entity
Tax Attributes Max
Tax
Tax Paid by
35%
Owner
Ptshp or LLC At least 2
35%
Partner
S Corp
35%
Shareholder
(Corp. may
have built-in
gains tax or
PII tax
35% corp,
plus 15%
max on
dividends
Corp pays
first, then
owner pays
on dividends
Max No. of
owners
Prop
C Corp
One individual
Max =100
individuals,
estates and
some trusts
Tax Attributes
Tax Year allowed
Timing of
taxation
Income Allocation
Prop
Owner’s Yr
Owner’s Year N/A – 1 owner
end
Ptshp
or LLC
Majority or prin.
partners or least
aggregate def.
End of Ptshp Profit-loss
year
ratio, or special
allocation.
S Corp Calendar year or
business purpose
C Corp No restrictions
(generally)
End of corp
tax year
Per share,
Per day
Corp reports N/A
at Year End.
Shareholders
report div.
received
Tax Attributes
Contribute Prop. Character of income
to Entity
taxed to Owner
Prop.
Not taxable.
Retains source
characteristics.
Ptshp Generally not
Conduit-Retains
or LLC taxable.
source characteristics.
S Corp Taxable unless
Conduit-Retains
transaction
source characteristics.
meets Sec. 351.
C Corp Taxable unless
Source characteristics
transaction
are lost when income
meets Sec. 351. is distributed.
Tax Attributes
Loss Allocation
Limit on Loss
to Owners
Deduction of Owners
Prop.
Not applicable
Amount invested plus
liabilities of business
Ptshp Profit and loss
Ptr’s investment plus
or LLC sharing ratios
share of partnership
liabilities
S Corp Per share,
S/H’s investment plus
Per day
loans from S/H to corp.
C Corp Not Applicable
Not Applicable
Tax Attributes
At Risk Rules
Applicable?
Prop.
Yes, at the owner,
Ptshp. partner or
LLC
shareholder level.
S Corp. Indefinite
carryover of
unused losses
C Corp. Yes, for closely
held C corps.
Indefinite
carryover of
unused losses.
Passive Loss Rules
Applicable
Yes, at the owner,
partner or shareholder
level. Indefinite
carryover of unused
losses
Yes, for closely held C
corps. Indefinite
carryover of unused
losses.
Tax Attributes
Capital Gains
Prop.
Owner level
0/15% tax
Capital Losses
Up to $3,000 against
ord. income. Indefinite
carryover of excess.
Ptshp. Conduit-owners
Conduit-owners
LLC
report shares same report shares same
S Corp. 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
Retaining
earnings
Prop.
Taxable when
earned. Increases
investment (basis)
Ptshp. Same as
proprietorship
LLC
S Corp. Same as
proprietorship
C Corp. Taxed to corp. as
earned. Possible
Accum. E Tax.
Non-liquidating
distributions rules
Not taxable for sole
proprietor
Not taxable unless cash or
debt relief > ptnr’s basis
Generally not taxable unless
distribution > AAA or stock
basis. May be dividend if E &
P from Sub C year.
Taxed in yr received up to
earned. Possible
Tax Attributes
Sales of Ownership Interest
Prop.
Treated as a sale of each asset. Gain
character depends on asset nature
Ptshp. LLC
Treated as sale of underlying ordinary
income assets. Remainder treated as
sale of partnership interest (capital gain).
Treated as sale of corporate stock
(capital gain). Loss may be ordinary
if §1244 applies, otherwise capital.
S Corp.
or
C Corp.
Tax Attributes
Fringe Benefits
for Owners
No
Sec. 1244
available
No
N/A
No
No
N/A
S Corp Some if
< 2% owner
Yes
Possible Corp.
Level Tax
C Corp Available.
Limited by nondiscrimination
rules.
Yes
Not Effect
Prop
Ptshp
or LLC
Built-in Gains
Effect
Tax Attributes
Sec. 1231 Gains
and Losses
Prop.
Taxable or
deductible by
owner. 5 Yr.
Lookback rule.
Conduit—same as
proprietorship
Ptshp.
LLC
S Corp.
C Corp. Taxable/deductible
at corp. level.
5 yr. Corporate
level lookback rule
Foreign Tax Credits
Owner level
Conduit—same as
proprietorship
Available
Tax Attributes
Prop
Ptshp
or LLC
S Corp
Alternative
Minimum Tax
Applies at
owner level
(26%, 28%)
Applies at
partner or
shareholder
level
C Corp Applies
corprate level
(20%)
ACE
Adjustment
N/A
N/A
Tax Preference Items
Determined at
owner level
Conduit-entity
preferences pass
through to owners
for their AMT
calculation
75% X (ACE Subject to AMT at
less AMTI) is Corporate Level
added to
AMTI (or
subtracted)
The
End