Download C Corporation

Chapter 13
Comparative Forms
of Doing Business
Corporations, Partnerships,
Estates & Trusts
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1
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
C Corporation
• Files Form 1120
Partnership & LLC
• Files Form 1065
S Corporation
• Files Form 1120S
Nontax Factors—Capital Formation
Sole Proprietorship
Partnership
• Limited ability to raise
capital
• Can raise funds through
pooling of owner resources
• Ltd. p’ship can raise capital
from investors
C Corporation
S Corporation
• Greatest ease and potential
for raising capital
• Greatest ease and potential
for raising capital, but
limited number of investors
Nontax Factors—Limited Liability
Sole Proprietorship
Partnership
• Unlimited liability
• General partners are
jointly and severally liable
• Ltd. partners’ liability is
limited to investment
C Corporation
S Corporation
• Generally have limited
liability
• 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
Partnership and LLC
• Single taxation
• Single taxation
C Corporation
S Corporation
• Double taxation
• Generally, single taxation
• May be subject to built-in
gains tax and passive
investment income tax
Alternative Minimum Tax
Sole Proprietorship
Partnership and LLC
• Directly subject to AMT • Indirectly subject to AMT
• AMT adjustments &
preferences flow through and
partners subject to AMT
C Corporation
S Corporation
• Directly subject to AMT
• Indirectly subject to AMT
• May have advantage here • AMT adjustments &
since corp AMT rate is
preferences flow through and
only 20%
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
Partnership and LLC
• N/A
• Profits & losses affect
partner’s basis
• Partner’s basis is increased
by share of p’ship liabilities
C Corporation
S Corporation
• Shareholder’s basis is not
affected by corporate
profits & losses
• 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 3rd 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
Tax at shareholder level:
Milly ($69,375 X 15%)
Doug ($69,375 X 15%)
Combined entity/owner tax liability
After-tax cash flow ($200,000 - $82,062)
$ 61,250
10,406
10,406
$ 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
Tax at shareholder level:
Milly ($100,000 X 28%)
Doug ($100,000 X 28%)
Combined entity/owner tax liability
After-tax cash flow ($200,000 - $56,000)
$
–0–
28,000
28,000
$ 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
Tax at the owner level:
Milly ($100,000 x 28%)
Doug ($100,000 x 28%)
Combined entity/owner tax liability
After-tax cash flow ($200,000 X $56,000)
$
–0–
28,000
28,000
$ 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
# Owners
Max Tax
Rate
Tax
Paid By
Sole Prop.
Partnership
(or LLC)
One individual
At least two
35%
35%
Owner
Partner
S Corp.
Max = 100
Individuals,
estates, some
trusts only
35%
Shareholder
(Corp. may
have built-in
gains or PII tax)
.
Tax Attributes of Different
Business Forms (slide 2 of 19)
Maximum
# Owners
C Corp No max limit
(some States
require at
least two
owners)
Max Tax
Rate
35% corporate
level plus
15% max.
on qualifying
distributions
Tax
Paid By .
Corporation
pays first,
then owner
pays if
distribution
Tax Attributes of Different
Business Forms (slide 3 of 19)
Tax Year
Allowed
Timing of
Taxation
Sole Prop.
Owner’s yr.
Owner’s
yr. end
Partnership
LLC
Majority or End of p/ship
Principal
tax year
Ptrs or “least
aggregate
deferral” year
Income
Allocation .
N/A
(1 owner)
Profit/loss
sharing ratio
Some special
allocations OK
Tax Attributes of Different
Business Forms (slide 4 of 19)
S Corp.
Tax Year
Allowed
Timing of
Taxation
Income
Allocation
Calendar year or
business purpose
End of Corp
tax year
Per share,
per day
C Corp. No restrictions
(generally)
Corp reports at
N/A
end of tax yr;
Shareholder reports
dividends received
Tax Attributes of Different
Business Forms (slide 5 of 19)
Contribution of
Property to Entity
Character of Income
Taxed to Owners .
Sole Prop.
Not taxable
Retains source
characteristics
Partnership
Generally not
taxable
Conduit-retains
source characteristics
Tax Attributes of Different
Business Forms (slide 6 of 19)
Contribution of
Property to Entity
Character of Income
Taxed to Owners .
S Corp.
Taxable unless
meets §351
Conduit-retains source
characteristics
C Corp.
Taxable unless
meets §351
All source characteristics lost when
income distributed to
owners
Tax Attributes of Different
Business Forms (slide 7 of 19)
Loss Allocation
to Owners
Limitation on Loss
Deductible by Owners
Sole Prop.
Not applicable
Amount invested plus
liabilities of business
Partnership
Profit and loss
sharing ratios
Ptr’s investment plus
share of partnership
liabilities
Tax Attributes of Different
Business Forms (slide 8 of 19)
Loss Allocation
to Owners
Limitation on Loss
Deductible by Owners
S Corp.
Per share/
per day
S/holder’s investment
plus loans from s/holder
to corporation
C Corp.
Not applicable
Not applicable
Tax Attributes of Different
Business Forms (slide 9 of 19)
Sole Prop.,
Partnership
and S Corp.
At-risk Rules
Applicable?
Passive Loss Rules
Applicable? .
Yes, at the
owner, partner
or shareholder
level. Indefinite
carryover of
unused losses
Yes, at the
owner, partner or
shareholder level.
Indefinite carryover
of unused losses
Tax Attributes of Different
Business Forms (slide 10 of 19)
At- risk Rules
Applicable?
C Corp.
Yes, for closely held
corporations. Indefinite
carryover of unused
losses.
Passive Loss Rules
Applicable? .
Yes, for closely held
and personal service
corporations.
Indefinite carryover
of unused losses.
Tax Attributes of Different
Business Forms (slide 11 of 19)
Capital Gains
Capital Losses
.
Sole Prop.
Owner level
0/15% tax
Up to $3,000 against
ord. income. Indefinite
carryover of excess.
Partnership
and S Corp.
Conduit-owners
report shares same
as Sole Prop.
Conduit-owners
report shares same
as Sole Prop.
C Corp.
Taxed at Corporate
level up to 35 %.
Carried back 3 yrs,
forward 5. Can only
offset capital gains.
Tax Attributes of Different
Business Forms (slide 12 of 19)
Consequence of
Earnings Retained
by Owners
Treatment of
Nonliquidating
Distributions .
Sole Prop.
Taxed when earned;
increases investment
Not taxable
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
Of Earnings Retained
by Owners
Treatment of
Nonliquidating
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
earned. Possible
AE Tax.
Taxed in yr received up to
AE & P or if > stock basis.
Tax Attributes of Different
Business Forms (slide 14 of 19)
Sole Prop.
Partnership
Sale of Ownership Interest
.
Treated as a sale of each asset. Gain
character depends on asset nature.
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
or C Corp.
Treated as sale of corporate stock
(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%
owner
Yes
Possible corp.
level tax
C Corp.
Available
Limited by
anti-discrim.rules
Yes
No effect
Tax Attributes of Different
Business Forms (slide 17 of 19)
§1231 Gains
and Losses
Foreign Tax
Credits
Sole Prop.
Taxable or deductible
by owner. 5 yr.
lookback rule.
Owner level
Partnerships
and S Corps
Conduit—same
as S.Prop.
Conduit—same
as S.Prop.
C Corp.
Taxable/deductible
at corp. level
5 yr. Corporate
level lookback rule
Available
Tax Attributes of Different
Business Forms (slide 18 of 19)
Sole Prop.
Alternative
Min. Tax
Applies at
owner level
(26% or 28%)
Partnership Applies at
or S Corp. ptr or
shareholder
level
for their
Tax
ACE
Preference
Adjustment
Items
.
N/A
Determined at
owner level
N/A
Conduit—entity
preferences
(26% or 28%)
pass thru to
owners
AMT calc.
Tax Attributes of Different
Business Forms (slide 19 of 19)
Alternative
Min. Tax
C Corp.
ACE
Adjustment
Applies at Corp. 75% x (ACE
level (20%)
-AMTI) is
added to AMTI
(or subtracted)
Tax
Preference
Items .
Subject to
AMT at
corporate
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 protected]
SUNY Oneonta
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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