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Chapter 13. Comparative Forms of Doing Business. 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.

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Presentation Transcript
Chapter 13

Chapter 13

Comparative Forms

of Doing Business


Choice of form of business entity
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
Principal Forms of Doing Business

  • Sole Proprietorship

  • Partnership

  • C corporation

  • S corporation

  • Limited liability company (LLC)


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
Filing Requirements

  • S Corporation

  • Files Form 1120S

  • C Corporation

    • Files Form 1120

Sole Proprietorship

  • Files Schedule C,

    Form 1040

Partnership & LLC

  • Files Form 1065


Nontax factors capital formation
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
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
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
Single vs. Double Taxation

  • Sole Proprietorship

  • Single taxation

  • Partnership and LLC

  • Single taxation

  • S Corporation

  • Generally, single taxation

  • May be subject to built-in gains tax and passive investment income tax

  • C Corporation

  • Double taxation


Alternative minimum 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
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
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
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
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
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
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
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
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
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
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
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


Distributions
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
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
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

  • 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
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
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
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
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
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
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
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
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
Purchase of Business Assets—Buyer’s Issues Owner’s Sale to Third Party (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
Purchase of Business Assets—Buyer’s Issues Owner’s Sale to Third Party (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
Sale of Business Interest—Seller’s Issues Owner’s Sale to Third Party (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
Sale of Business Interest—Seller’s Issues Owner’s Sale to Third Party (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
Sale of Business Interest— Owner’s Sale to Third Party 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
Purchase of Business Interest—Buyer’s Issues Owner’s Sale to Third Party (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
Purchase of Business Interest—Buyer’s Issues Owner’s Sale to Third Party (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
Purchase of Business Interest—Buyer’s Issues Owner’s Sale to Third Party (slide 3 of 3)

  • S Corp or C Corp

    • Purchaser buys stock

    • There is no effect on underlying assets owned by the entity


Tax attributes of different business forms slide 1 of 19

Maximum Max Tax Tax Owner’s Sale to Third Party

# 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 1 of 19)


Tax attributes of different business forms slide 2 of 19

Maximum Max Tax Tax Owner’s Sale to Third Party

# 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 2 of 19)


Tax attributes of different business forms slide 3 of 19

Tax Year Timing of Income Owner’s Sale to Third Party

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 3 of 19)


Tax attributes of different business forms slide 4 of 19

Tax Year Timing of Income Owner’s Sale to Third Party

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 4 of 19)


Tax attributes of different business forms slide 5 of 19

Contribution of Character of Income Owner’s Sale to Third Party

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 5 of 19)


Tax attributes of different business forms slide 6 of 19

Contribution of Character of Income Owner’s Sale to Third Party

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 6 of 19)


Tax attributes of different business forms slide 7 of 19

Loss Allocation Limitation on Loss Owner’s Sale to Third Party

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 7 of 19)


Tax attributes of different business forms slide 8 of 19

Loss Allocation Limitation on Loss Owner’s Sale to Third Party

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 8 of 19)


Tax attributes of different business forms slide 9 of 19

At-risk Rules Passive Loss Rules Owner’s Sale to Third Party

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 9 of 19)


Tax attributes of different business forms slide 10 of 19

At- risk Rules Passive Loss Rules Owner’s Sale to Third Party

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 10 of 19)


Tax attributes of different business forms slide 11 of 19

Capital Gains Owner’s Sale to Third Party 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 11 of 19)


Tax attributes of different business forms slide 12 of 19

Consequence of Treatment of Owner’s Sale to Third Party

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 12 of 19)


Tax attributes of different business forms slide 13 of 19

Consequence Treatment of Owner’s Sale to Third Party

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 13 of 19)


Tax attributes of different business forms slide 14 of 19

Sale of Ownership Interest Owner’s Sale to Third Party .

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 14 of 19)


Tax attributes of different business forms slide 15 of 19

Sale of Ownership Interest Owner’s Sale to Third Party .

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 15 of 19)


Tax attributes of different business forms slide 16 of 19

Fringe Benefits §1244 Built-in Owner’s Sale to Third Party

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 16 of 19)


Tax attributes of different business forms slide 17 of 19

§1231 Gains Foreign Tax Owner’s Sale to Third Party

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 17 of 19)


Tax attributes of different business forms slide 18 of 19

Tax Owner’s Sale to Third Party

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 18 of 19)


Tax attributes of different business forms slide 19 of 19

Tax Owner’s Sale to Third Party

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

Tax Attributes of Different Business Forms (slide 19 of 19)



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