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Chapter. 10. Partnerships, LLCs, and S Corporations. Business Organizations. Taxpayer = owners = flow-through entities sole proprietorship partnerships LLCs S Corporations Taxpayer = corporation

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Chapter

10

Partnerships, LLCs, and S Corporations


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Business Organizations

  • Taxpayer = owners = flow-through entities

    • sole proprietorship

    • partnerships

    • LLCs

    • S Corporations

  • Taxpayer = corporation

    • C Corporation is taxed first, then shareholders may be taxed on distributions (double taxation).


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Passthrough Entities

  • Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income.

  • Single level of taxation.

  • Cash distributions are generally NOT taxable.


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Benefits of Passthrough Losses

  • Pass through loss is generally deductible in the year the loss is generated at the individual’s marginal tax rate.

  • Corporation loss must be carried (back) forward and used to offset income in a taxable year where profits are reported. NOL deduction provides a benefit at the corporation’s tax rate in the year the NOL offsets profits.


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Passthrough Entities Only Have a Single Level of Tax

  • The preceding example illustrates the benefits of a pass-through entity:

  • a) use losses immediately

  • b) single level of taxation


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Partnership versus S Corporation

  • S Corps require an IRS election, incorporation documents, possible corporate state tax payments.

  • Partnership agreements have more flexibility, but require more careful legal drafting.

  • Partners (but not S Corp shareholders) receive tax basis for liabilities of the partnership.

  • S Corporation shares are transferable. Partnership interests are not - requires new partnership agreement.

  • Employee benefit planning favors S Corp.


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Partnerships

  • The partnership agreement states the rights and obligations of partners, and the % of profits and losses allocable to each partner. Such agreements permit flexibility.

  • General partnership: all partners have unlimited liability; joint and severable

  • Limited liability partnership (LLP) used for professional services. General partners are not liable for malpractice of other partners.


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Partnership Reporting

  • The partnership files an information return, Form 1065.

  • Included with the Form 1065 are Forms K-1, which show EACH partner’s share of income and deductions.

  • EACH partner reports his or her share on partnership income on Schedule E, as part of his or her Form 1040. “Non-ordinary” items are SEPARATELY STATED and retain their character on the partner’s return. Q9

  • Because the partnership does not pay tax, the partnership is referred to as a FLOW-THROUGH ENTITY.


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Self-Employment Income From Partnership

  • SE tax must be paid by the partner on

    • Guaranteed payments +

    • Distributive share of ordinary business income from partnership

  • Limited partners do NOT pay SE tax on share of ordinary income.


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Limited Liability Company

  • Treated as a corporation for liability purposes, but as a partnership for federal tax purposes.

  • Relatively new organizational form - less legal precedence.

  • Every state (and DC) permits LLCs.

  • Still unclear whether LLC income is subject to SE tax.


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S Corporations

  • Legally a corporation under state law.

  • An S Corporation is a flow-through entity for tax purposes.

  • Income and loss items are allocated among shareholders based on their % ownership of stock (this allocation is not flexible like partnership agreements).

  • Flow-through items retain their character on the individual tax return (e.g. ordinary income, capital losses, charitable contributions, etc).


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S Corporation Eligibility

  • Only individuals, estates and some trusts may be shareholders.

  • The number of shareholders (not including spouses) is limited to 100.

  • The corporation may only have one class of outstanding common stock.

  • Shareholders must unanimously elect S Corp status.


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S Corporation Operation

  • Shareholders can be paid a salary.

    • Salary is subject to payroll taxes and reduces ordinary income of the S Corporation.

    • S Corp can use corporate employee benefit plans for shareholder/employees.

    • Share of ordinary income is NOT subject to Self-Employment tax.

  • Allocable share of loss items can only be deducted up to BASIS, like with partnerships. Losses in excess of basis are carried over until the shareholder has basis again.


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Chapter

11

The Corporate Taxpayer


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The Corporate Taxpayer

  • Legal characteristics

  • Dividends-received deduction

  • Schedule M-1 reconciliation

  • Regular tax, credits, AMT

  • Payment and filing requirements

  • Double taxation

  • Tax incidence


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Corporation Legal Characteristics

  • Limited liability of shareholders

    • Owners of closely-held corporations often are required to sign personal liability on bank debt.

  • Unlimited life

  • Free transferability

    • Closely-held corporations:buy-sell agreement may prevent transferability.

  • Centralized management


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Affiliated Groups and Consolidations

  • Parent + all >= 80% domestic subsidiaries.

  • Affiliated groups may elect to file a consolidated tax return - applies to all members of affiliated group.

  • Advantage: losses and profits of affiliated members offset. Like financial accounting, intercompany transactions are eliminated.

  • If the same individual(s) own 80% or more of more than one corporation, these corporations are a ‘controlled group’ (see Ch 12 end). They may not file a consolidated return, but the tax bracket benefits are limited.


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Computing Corporate Taxable Income

  • Page 1 of the Form 1120 resembles a financial income statement or a Schedule C in a personal tax return (Ch 10).

  • Use chapters 6, 7, 8 and 9 for general rules on business income.

  • Deduct only 50% of meals and entertainment expenses.

  • Deduct charitable contributions up to 10% of taxable income BEFORE charity and before dividends-received deduction.


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Dividends-received Deduction

  • Ownership Deduction

  • < 20% of stock 70% DRD

  • 20%<= own < 80% 80% DRD

  • 80%<= own 100% DRD

  • Reason for DRD? Mitigate “triple” taxation.

  • Additional details: DRD can’t create loss - tricky computations not in this text.


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Book Versus Taxable Income - Schedule M-1

  • This schedule reconciles book income to taxable income.

  • net book income - line 1

  • federal tax expense for books - line 2

  • lines 3 - 6 explain increases in taxable income relative to books.

  • lines 7 - 9 explain decreases in taxable income relative to books.

  • line 10 = taxable income before NOLD and DRD = line 28 form 1120


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Book Versus Taxable Income

  • Book-tax differences are scrutinized by IRS.

  • The Schedule M-1 contains permanent and temporary items.

  • The tax footnote in the financial statement contains numerous estimates of amounts that are finalized by the time the return is filed. Thus, Schedule M-1 items will not exactly = amounts in F/S footnotes.


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Computing Regular Tax

  • The surtax rates of 39% and 38% eliminate bracket benefits for ‘rich’ corporations.

  • Corporations with taxable income > $18.33 million just pay a flat rate of 35% on all income.

  • Personal service corporations are taxed at a flat 35% rate.


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Tax Credits

  • Credits directly reduce computed tax. Deductions only reduce the income subject to tax. Thus, $1 of credit provides $1 of benefit. $1 of deduction only provides $1 x the tax rate.

  • Tax credits are generally limited to some % of tax before credits. Often a provision permits carry back or carry forward of excess credits.

  • Biggest credits: R&D credit, foreign tax credit (see Chapter 13).


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Payment and Filing Requirements

  • Tax return due 15th day of 3rd month, may extend to 15th day of 9th month.

  • Estimated payments are due on the 15th day of 4th, 6th, 9th, and 12th months.

  • Must pay 100% of tax due (small corporations (TI < $1 mill) may use safe-harbor rule of paying 100% of prior year tax).

  • Underpayment penalty is computed like interest expense but is nondeductible.


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Distributions to Investors

  • Interest payments are deductible.

  • Payments on stock are non-deductible.

  • Payments on stock are taxable dividends to the shareholder if the corporation has either current or cumulative earnings and profits.

    • E&P similar to tax basis retained earnings

  • Payments in excess of earnings and profits are first a return of capital and then a gain to the shareholder.


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Distributions to Investors

  • Nondeductibility of dividends makes paying dividends hard to explain.

  • One result is the high leverage of many corporations, because interest expense is deductible.

  • Investors may prefer that the corporation keep the funds and reinvest them; sell stock for a capital gain in future.

  • Will administration eliminate double taxation?


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Incidence of the Corporate Tax

  • Corporations do not pay taxes - people do.

  • What are examples of ways that the incidence of the corporate tax could be born by individual taxpayers in the U.S.?

    • higher consumer prices

    • lower employee wages

    • lower dividends


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Chapter

12

The Choice of Business Entity


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Choice of Entity

  • This is a tax planning chapter - HOW to use rules

    • Pass-through losses

    • After-tax cash flows to individual investor.

    • Family income shifting

    • Partnership versus S Corp characteristics

    • Closely-held corporations

      • Constructive dividends limit corporate tax avoidance.

      • accumulated earnings tax, personal holding company tax, tax rates on members of a controlled group.


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Passthrough Entities

  • Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income.

  • Single level of taxation.

  • Cash distributions are generally NOT taxable.


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Benefits of Passthrough Losses

  • Passthrough loss is generally deductible in the year the loss is generated at the individual’s marginal tax rate.

  • Corporation loss must be carried (back) forward and used to offset income in a taxable year where profits are reported. NOL deduction provides a benefit at the corporation’s tax rate in the year the NOL offsets profits.


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Partnership versus S Corporation

  • S Corps require an IRS election, incorporation documents, possible corporate state tax payments.

  • Partnership agreements have more flexibility, but require more careful legal drafting.

  • Partners (but not S Corp shareholders) receive tax basis for liabilities of the partnership.

  • S Corporation shares are transferable. Partnership interests are not - requires new partnership agreement.

  • Employee benefit planning favors S Corp.


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Types of Flow-Through Entity

  • Liability

    • Full - General partnership

    • Limited liability partnership - general partners are not personally liable for malpractice-related claims of another general partner.

    • Limited liability partnership - partners not responsible for other parter’s malpractice.

    • Limited liability company (treated like partnership for tax, corporation legally).

    • S Corporation creates limited liability.


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Closely-held Corporations

  • Biggest challenge is how can the investors avoid double taxation of corporate earnings.

  • If shareholders are also creditors, interest expense is deductible to corporation.

  • If shareholders are also employees, wage expense is deductible to corporation.

  • If shareholders are also landlords, rent expense is deductible to corporation.


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Closely-held Corporations

  • IRS challenge turns “unreasonable” payments into constructive dividends.

  • How does the IRS decide what is unreasonable? (AP6)

    • interest

    • wages

    • rent


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