Chapter 13 presentation

Chapter 13 Comparative Forms of 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
Sole Proprietorship
Files Schedule C,
Form 1040
Partnership & LLC
Files Form 1065
C Corporation
Files Form 1120
S Corporation
Files Form 1120S

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

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

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

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

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 3 rd 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

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

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

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

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...

Partnership
Purchaser buys partnership interest
Purchaser may ask partnership to make §754 election to step up inside basis in assets

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.

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 $ 61,250
Tax at shareholder level:
Milly ($69,375 X 15%) 10,406
Doug ($69,375 X 15%) 10,406
Combined entity/owner tax liability $ 82,062
After-tax cash flow ($200,000 - $82,062) $117,938

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%) 28,000
Doug ($100,000 X 28%) 28,000
After-tax cash flow ($200,000 - $56,000) $144,000

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%) 28,000
Doug ($100,000 x 28%) 28,000
After-tax cash flow ($200,000 X $56,000) $144,000

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% Owner
Partnership 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)

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 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/loss
LLC Principal tax year sharing ratio
Ptrs or “least Some special
aggregate allocations OK
deferral” year

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

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

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

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

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

At-risk Rules Passive Loss Rules
Applicable? Applicable? .
Sole Prop., Yes, at the Yes, at the
Partnership owner, partner owner, partner or
and S Corp. or shareholder shareholder level.
level. Indefinite Indefinite carryover
carryover of of unused losses
unused losses

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.

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.

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

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.

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).

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.

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

§1231 Gains Foreign Tax
and Losses Credits
Sole Prop. Taxable or deductible Owner level
by owner. 5 yr.
lookback rule.
Partnerships Conduit—same Conduit—same
and S Corps as S.Prop. as S.Prop.
C Corp. Taxable/deductible Available
at corp. level 5 yr. Corporate level lookback rule

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
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

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:
Dr. Donald R. Trippeer, CPA
[email_address]
SUNY Oneonta

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