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Chapter 13 PowerPoint Presentation

Chapter 13

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Chapter 13

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  1. Chapter 13 Comparative Forms of Doing Business

  2. 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

  3. Principal Forms of Doing Business • Sole Proprietorship • Partnership • C corporation • S corporation • Limited liability company (LLC)

  4. Limited Liability Company (LLC) • Hybrid business form that combines the corporate characteristic of limited liability for owners with tax characteristics of a partnership

  5. Filing Requirements • S Corporation • Files Form 1120S • C Corporation • Files Form 1120 Sole Proprietorship • Files Schedule C, Form 1040 Partnership & LLC • Files Form 1065

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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...

  40. 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

  41. 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

  42. 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 1 of 19)

  43. 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 2 of 19)

  44. 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 3 of 19)

  45. 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 4 of 19)

  46. 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 5 of 19)

  47. 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 6 of 19)

  48. 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 7 of 19)

  49. 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 8 of 19)

  50. 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 9 of 19)