2. 2
The Big Picture (slide 1 of 2)
• The Todd sisters have decided to begin a catering
business to handle private parties, weddings,
anniversaries, and other large social events.
– Their parents previously owned several restaurants so they
are familiar with food service operations.
• All sisters will participate in the operation of the
business and will provide the funds for capital
acquisitions (e.g., delivery trucks, kitchen equipment,
and food preparation facilities) and working capital
needs.
• Due to the cost of the premiums, the sisters plan on
minimal liability insurance coverage.
3. 3
The Big Picture (slide 2 of 2)
• In the first few years of operation, the sisters
anticipate losses.
• When and if the business becomes profitable,
however, they would consider expansion.
– Any such expansion would require obtaining
additional capital from outside sources.
• In what type of entity should the Todd sisters
conduct the business?
– Read the chapter and formulate your response.
4. 4
Corporations
(slide 1 of 3)
• Compliance with state law is important for
corporate tax treatment, but entity must also
comply with Federal tax law
5. 5
Corporations
(slide 2 of 3)
• Prior to 1997-An entity may be treated as a
corporation depending on the corporate
characteristics it possesses:
– Continuity of life
– Centralized management
– Limited liability
– Free transferability of interests
6. 6
Corporations
(slide 3 of 3)
• After 1996—Check-the-box Regulations
– Entity can elect to be taxed as corporation or
partnership regardless of attributes
• Allows entities with more than 1 owner to elect to be
taxed as either a partnership or a corporation
• Entities with only 1 owner can elect to be taxed as a
corporation or a sole proprietorship
7. 7
Business Entities
(slide 1 of 2)
• The following are the possible types of
business entities
– Sole proprietorship: Not a separate taxable entity
– Partnership: Conduit entity (flow-through entity)
8. 8
Business Entities
(slide 2 of 2)
• Possible types of business entities
– Regular corporation: Separate taxable entity
– S corporation: Conduit entity
– Limited liability company: Generally conduit
entity (i.e., partnership)
9. 9
The Big Picture - Example 3
Different Forms of Business Entities
• Return to the facts of The Big Picture on p. 20-1.
• The Todd sisters should consider a C or an S corp. to
obtain limited liability for their business.
– An LLC will also provide this result.
• On the other hand, the conduit effect of an S corp. or
a partnership will allow them to use the initial losses
anticipated for the business.
– Under the conduit concept, such losses could be deducted
on their individual income tax returns
10. 10
Similarities between Corporate and
Individual Tax Rules (slide 1 of 3)
• The gross income and gains and losses from property
transactions of a corp. are determined in much the
same manner as for individuals
– Both individuals and corporations are entitled to exclusions
from gross income
• e.g., Interest on municipal bonds
• Business deductions of corporations parallel those
available to individuals
• Corporate deductions are allowed for all ordinary and
necessary expenses paid or incurred in carrying on a
trade or business
11. 11
Similarities between Corporate and
Individual Tax Rules (slide 2 of 3)
• Corporations usually have the same choices of
accounting periods as do individuals
– May choose a calendar year or a fiscal year
– Corporations enjoy greater flexibility in the
election of a tax year
• For example, corporations usually can have different tax
years from those of their shareholders
• Also, a newly formed corporation generally has a free
choice of any approved accounting period without
having to obtain the consent of the IRS
12. 12
Similarities between Corporate and
Individual Tax Rules (slide 3 of 3)
• Both individuals and corporations must use the accrual method
in determining cost of goods sold if they maintain inventory
for sale to customers
– The accrual method must also be used by large corporations (annual
gross receipts in excess of $5 million)
• The cash method of accounting, however, is available to small
corporations and in the following additional situations:
– An S election is in effect
– The trade or business is farming or timber
– A qualified personal service corporation is involved
– A qualified service provider (e.g., plumbing business) is involved, and
annual gross receipts (for the past three years) do not exceed $10
million
• Even if the service provider is buying and selling inventory
13. 13
Corporate Tax Differences
(slide 1 of 3)
• The treatment of many items of income and
expense are similar for corporations and
individuals; however, differences include the
following:
• Capital gains and losses for corporations
– Long-term capital gains are taxed at the same rates
as ordinary income
– Net capital losses are not currently deductible but
are carried back 3 and forward 5 years as short-
term losses
14. 14
Corporate Tax Differences
(slide 2 of 3)
• Depreciation recapture
– Additional depreciation recapture under § 291 can
occur on disposition of real estate by corporations
– The additional ordinary income element is 20% of
the excess of the § 1245 recapture potential over
the § 1250 recapture
15. 15
Corporate Tax Differences
(slide 3 of 3)
• Charitable contributions for corporations
– Limit on deduction is 10% of taxable income
– Accrual basis corporation allowed deduction for the accrual
of a donation made in following tax year (under certain
circumstances)
– Contribution of certain inventory produces a deduction
equal to basis plus 50% X (FMV – basis)
• To qualify for this treatment, the inventory must be used by the
charity in its exempt purpose for the care of children, the ill, or the
needy
16. 16
Domestic Production
Activities Deduction
• Applies equally to C corporations and
individuals
– The deduction is limited to 9% of the lesser of :
• Qualified production activities income or
• Taxable income
– The deduction cannot exceed 50% of W–2 wages
included in production costs
17. 17
Corporate Deductions
• Certain deductions are available only to
corporations, such as:
– Dividends received deduction (DRD)
– Organizational expenditures
18. 18
Dividends Received
Deduction (DRD) (slide 1 of 2)
• Purpose of deduction is to mitigate multiple taxation
– Amount of DRD depends on both the percentage of stock
ownership and the taxable income of the recipient
corporation
Percentage of Ownership by
Corporate Shareholder Deduction Percentage
Less than 20% 70%
20% or more (but less than 80%) 80%
80% or more 100%
19. 19
Dividends Received
Deduction (DRD) (slide 2 of 2)
1. Multiply dividends received by deduction percentage
2. Multiply taxable income by deduction percentage
3. The deduction is limited to the lesser of Step 1 or
Step 2, unless subtracting the amount derived from
Step 1 from taxable income generates a negative
number
-If so, the amount derived in step 1 should be
used
20. 20
DRD Examples
Z Corp owns 60% of X Corp’s stock in years 1, 2 & 3. Dividend of $200 is
received each year. Limit (Step 1) is 80% × $200 = $160.
1 2 3_
Income 400 301 299
Dividend rec’d 200 200 200
Expenses (340) (340) (340)
Income before DRD 260 161 159
80% of income 208 129 127
Year #1 $208 > $160, so $160 DRD
Year #2 $129 < $160, so $129 DRD
Year #3 DRD causes NOL ($159-$160), so $160 DRD is used.
$2 less income results in $31 more DRD.
21. 21
Organizational Expenditures
(slide 1 of 2)
• A corporation may elect to amortize
organizational expenses over a period of 15
years or more
– A special exception allows the corporation to
immediately expense the first $5,000 of these costs
• Phased out on a dollar-for-dollar basis when these
expenses exceed $50,000
22. 22
Organizational Expenditures
(slide 2 of 2)
• Organizational expenditures include the following:
– Legal services incident to organization
– Necessary accounting services
– Expenses of temporary directors and of organizational
meetings of directors and shareholders
– Fees paid to the state of incorporation
• Expenditures connected with issuing or selling shares
of stock or other securities or with the transfer of
assets to a corporation do not qualify
– These expenditures are generally added to the capital
account and are not subject to amortization
23. 23
Corporate Tax Rates
Taxable Income Tax Rate
Not over $50,000 15%
Over $50,000 but not over $75,000 25%
Over $75,000 but not over $100,000 34%
Over $100,000 but not over $335,000 39%*
Over $335,000 but not over $10,000,000 34%
Over $10,000,000 but not over $15,000,000 35%
Over $15,000,000 but not over $18,333,333 38%**
Over $18,333,333 35%
*5% of this rate represents a phaseout of the benefits of the lower tax rates on
the first $75,000 of taxable income.
**3% of this rate represents a phaseout of the benefits of the lower tax rate
(34% rather than 35%) on the first $10 million of taxable income.
24. 24
Corporate Tax Returns
(slide 1 of 2)
• Form 1120 must be filed whether the
corporation has taxable income or not
• Due date for the return is the 15th day of the
third month following year-end
– Automatic extension of 6 months can be obtained
by filing Form 7004
25. 25
Corporate Tax Returns
(slide 2 of 2)
• Taxable Income and accounting net income is
reconciled using Schedule M-1
• Schedule M-2 is used to reconcile beginning and
ending retained earnings
• Schedule M–3 must be filed by certain corporations
– Designated “Net Income (Loss) Reconciliation for
Corporations With Total Assets of $10 Million or More”
• Prepared in lieu of Schedule M–1
• Because it will reveal significant differences between book and
taxable income, Schedule M–3 will enable the IRS to more quickly
identify possible abusive transactions
26. 26
Corporate Formation
(slide 1 of 3)
• Transfers of property by shareholders to a
newly-formed corp. in exchange for its stock
receive nonrecognition treatment under §351 if
transferors control (80%) the corp.
immediately after the exchange
– Receipt of boot by shareholders triggers gain
recognition
– Receipt of stock for services is always taxable as
ordinary income
27. 27
Corporate Formation
(slide 2 of 3)
• Shareholder’s basis in shares received is
calculated as follows:
– Basis of property transferred + any gain
recognized – FMV of boot received
• Basis of boot will be its FMV
• Corp’s basis in property transferred is
calculated as follows:
– Shareholder’s adjusted basis of property
transferred + gain recognized on the transfer
28. 28
Corporate Formation
(slide 3 of 3)
• Thin capitalization can be a problem if there is
too much debt and not enough equity issued at
formation
– If debt has too many features of stock, it may be
treated as a form of stock
• Results in principal and interest payments being treated
as dividend distributions
29. 29
The Big Picture - Example 21
Minimum Capitalization
• Return to the facts of The Big Picture on p. 20-1.
• Suppose that the Todd sisters decide to conduct their catering
business in the corporate form—either a C or an S corp.
• In forming the corp., they should probably limit their capital
investment to whatever state law requires.
– Consider acquiring the capital assets needed to operate the business on
their own and leasing them to the corporation.
• e.g., delivery trucks, kitchen equipment, location for food preparation.
– This allows the sisters to claim depreciation while providing the corp.
with a deduction for the rent paid.
• This strategy forces the sisters to recognize rent income rather
than preferentially taxed dividends.
– However, no dividends are likely in the early years of the business.
30. 30
Corporate Distributions
(slide 1 of 5)
• Distributions to shareholders are treated as dividend
income to the extent of current or accumulated
earnings and profits (E&P)
• Distributions in excess of E&P are:
– First, a return of capital (to the extent of basis)
– Any excess is capital gain
31. 31
Corporate Distributions
(slide 2 of 5)
• Qualified dividend income is taxed like net
long-term capital gain
– Consequently, the tax rate on such income cannot
exceed 20%
• 0% for individual shareholders in the 15% or lower tax
bracket,
• 15% for individual shareholders in the 25% to 35% tax
brackets,
• 20% for individual shareholders in the 39.6% tax
bracket
32. 32
Corporate Distributions
(slide 3 of 5)
• E & P is similar to the accounting concept of retained
earnings, and is determined by making adjustments to taxable
income including
– As additions-
• Dividends received deduction
• Domestic production activities deduction
• Proceeds of life insurance policies on key employees
– As subtractions-
• Federal income taxes paid
• Charitable contributions in excess of the 10% limitation
• Excess capital losses (no carryback available)
• Nondeductible items (e.g., fines, penalties, losses between related parties)
• Accumulated E & P is the sum of the corporation’s past
current E & P that has not been distributed as dividends
33. 33
Corporate Distributions
(slide 4 of 5)
• Property distributions are measured by the
FMV of the asset and taxed to recipient like
cash dividends
– Shareholder’s basis in property is FMV
• Corporation recognizes gain when appreciated
property is distributed to shareholders
34. 34
Corporate Distributions
(slide 5 of 5)
• Constructive dividends are taxed as dividends
to the extent of the corporation’s E&P
• Examples of constructive dividends include:
– Unreasonable salaries and rents paid to
shareholder/employees
– Interest free loans to shareholders
– Shareholder use of corporate property at less than
arm’s length rate
35. 35
The Big Picture - Example 28
Constructive Dividends
• Return to the facts of The Big Picture on p. 20-1 and the suggestions made
in Example 21.
• If they choose the corporate form, the Todd sisters need to take
the following into account:
– Any salaries the sisters pay themselves should satisfy the
reasonableness test.
– Rent charged the corp. for the use of capital assets owned by the sisters
should meet the arm’s length standard.
– Loans made to the corp. for working capital purposes should provide
for a market rate of interest to be charged.
• The constructive dividend issue should not arise until the corp.
becomes profitable (and has E & P).
– These procedures should be structured at the outset so that the parties
will be prepared for a possible future challenge by the IRS.
36. 36
Subchapter S Corporations
(slide 1 of 7)
• Requirements to qualify as a Subchapter S
corporation:
– Be a domestic corporation
– Have no more than 100 shareholders
– Shareholders must be individuals, estates, and
certain trusts
– No nonresident alien shareholders
– Have only one class of stock outstanding
37. 37
Subchapter S Corporations
(slide 2 of 7)
• S corporation election
– All shareholders must initially consent to the
election
– To be effective for the current year, election must
be made either in the prior year or by the 15th day
of the third month of the current year
38. 38
Subchapter S Corporations
(slide 3 of 7)
• Loss of S corporation election
– S election can be terminated voluntarily (e.g., by
majority of shareholders) or involuntarily (e.g.,
ceases to qualify as an S corporation or has
excessive investment income)
– If the election is terminated, the corporation
generally cannot reelect for 5 years
39. 39
Subchapter S Corporations
(slide 4 of 7)
• Operations
– S corporation generally applies the flow-through
concept (like partnerships), i.e., income is taxed
only to the owners
– Income or loss and separately stated items are
allocated to the owners on a per share per day basis
40. 40
Subchapter S Corporations
(slide 5 of 7)
• Operations
– Shareholders can deduct losses to the extent of
their basis in the S corp. stock and their loans to
the corporation
– Any remaining loss can be carried forward and
deducted when and if it is covered by basis
41. 41
Subchapter S Corporations
(slide 6 of 7)
• Basis in stock
– Original cost
• Plus: capital contributions and shareholder’s
proportionate share of S income and gains
• Less: distributions and shareholder’s proportionate
share of S losses and deductions
• If distributions exceed a shareholder’s basis,
the excess normally receives capital gain
treatment
42. 42
Subchapter S Corporations
(slide 7 of 7)
• Corporation’s basis in contributed property
– Generally a carryover basis from the contributing
shareholder
43. 43
The Big Picture - Example 39
Treatment Of Losses
• Return to the facts of The Big Picture on p. 20-1.
• Recall that the Todd sisters anticipate losses in the
early years of their catering business.
– If they form a C corp., such losses will be of no benefit to
the new corporation.
• No carryback will be available, and
• There will be only a potential for a delayed carryover.
– With an S election, however, losses pass through currently.
• Thus, the sisters will secure limited liability for their
business and the immediate tax benefit of any losses.
44. 44
Partnerships
(slide 1 of 6)
• Taxation
– Partnerships are flow-through entities
• Thus, tax reporting rather than tax paying entities
– Tax return (Form 1065) is due on the 15th day of
the fourth month following year-end
45. 45
Partnerships
(slide 2 of 6)
• Formation
– Like corporations, partnerships can be formed with
no recognition of gains or losses by the partners or
the partnership
– Exceptions to nonrecognition include:
• Receipt of boot on partnership formation
• Receipt of partnership interest for services rendered
• Transfer of property subject to a liability in excess of
basis
46. 46
Partnerships
(slide 3 of 6)
• Operations
– Income or loss and separately stated items are
allocated to the partners based on their
proportionate share of ownership
– Special allocations of income or expense items are
allowed as long as they have substantial economic
effect
– Partners can deduct losses to the extent of their
basis in the partnership
47. 47
Partnerships
(slide 4 of 6)
• Partner’s basis
– A partner’s basis in the partnership interest is
determined in a similar manner as a shareholder’s
basis in an S corporation
– In addition, a partner’s share of the entity’s
liabilities increases the partner’s basis
48. 48
Partnerships
(slide 5 of 6)
• Partnership’s basis in contributed property
– Generally a carryover basis from the contributing
partner
49. 49
Partnerships
(slide 6 of 6)
• Related party transactions
– Partners entering into transactions with their
partnership will, in most cases, be treated as an
outsider (i.e., not a related party)
• Guaranteed payments are payments to partners for
services or use of capital that are treated as payments to
outsiders
– Certain exceptions exist
50. 50
Refocus On The Big Picture (slide 1 of 3)
• A principal concern of the Todd sisters is limited
liability.
– A food preparation business involves potential liability.
• e.g., litigation resulting from food poisoning.
– This hazard is further magnified by carrying minimal
liability insurance coverage.
– To obtain limited liability, therefore, the choice of entity
cannot be a regular partnership
• It must be a C or S corp. or a limited liability company (LLC).
• The next concern is the pass-through of losses in the
early years of the business.
– This cannot be achieved with a C corp. and is only
available with an S corp. or an LLC.
51. 51
Refocus On The Big Picture (slide 2 of 3)
• In making the choice between a corporation and an
LLC, the future must be considered.
– If the business is successful, the sisters could expand.
– This is more easily accomplished with a corporation than
an LLC.
– A corporation can raise additional capital for expansion by
issuing more stock—even going public if necessary.
– Issuing additional stock may cause the S corporation
election to be lost, but by then S status will have served its
purpose (i.e., pass-through of losses).
52. 52
Refocus On The Big Picture (slide 3 of 3)
• When forming the corporation, the sisters should take the
following into account:
– Key assets (e.g., food preparation facilities) might better be purchased
by the sisters and leased to the corporation.
• This approach leads to a rent deduction for the corporation.
– A viable salary structure should be established for the services the
sisters perform.
• This generates a salary deduction for the corporation.
– Interest should be charged for the funds the sisters loan to the
corporation.
• This yields an interest deduction for the corporation.
– If the S corporation becomes a C corporation, these rent, salary, and
interest deductions will reduce the taxable income of the corporation
and thereby lower any corporate income tax imposed.
