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    Chapter 13 presentation Chapter 13 presentation Presentation Transcript

    • 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
    • Minimizing Double Taxation of C Corporations (slide 2 of 5)
      • 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
    • Minimizing Double Taxation of C Corporations (slide 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
    • Minimizing Double Taxation of C Corporations (slide 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
    • Minimizing Double Taxation of C Corporations (slide 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 (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
    • 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
    • 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
    • Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 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
    • Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 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)
      • 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...
    • Purchase of Business Interest—Buyer’s Issues (slide 2 of 3)
      • Partnership
        • Purchaser buys partnership interest
        • Purchaser may ask partnership to make §754 election to step up inside basis in assets
    • Purchase of Business Interest—Buyer’s Issues (slide 3 of 3)
      • 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.
    • Refocus On The Big Picture (slide 2 of 5)
      • 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
    • Refocus On The Big Picture (slide 3 of 5)
      • 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
        • Combined entity/owner tax liability $ 56,000
        • After-tax cash flow ($200,000 - $56,000) $144,000
    • Refocus On The Big Picture (slide 4 of 5)
      • 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
        • Combined entity/owner tax liability $ 56,000
        • After-tax cash flow ($200,000 X $56,000) $144,000
    • Refocus On The Big Picture (slide 5 of 5)
      • 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)
    • Tax Attributes of Different Business Forms (slide 2 of 19)
      • 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 Attributes of Different Business Forms (slide 3 of 19)
      • 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 Attributes of Different Business Forms (slide 4 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 5 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 6 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 7 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 8 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 9 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 10 of 19)
      • 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.
    • Tax Attributes of Different Business Forms (slide 11 of 19)
      • 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.
    • Tax Attributes of Different Business Forms (slide 12 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 13 of 19)
      • 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.
    • Tax Attributes of Different Business Forms (slide 14 of 19)
      • 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).
    • Tax Attributes of Different Business Forms (slide 15 of 19)
      • 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.
    • Tax Attributes of Different Business Forms (slide 16 of 19)
      • 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
    • Tax Attributes of Different Business Forms (slide 17 of 19)
      • §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 Attributes of Different Business Forms (slide 18 of 19)
      • 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 Attributes of Different Business Forms (slide 19 of 19)
      • 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