Download Chapter 13 Corporate Text

Chapter 13
Comparative Forms
of Doing Business
Corporations, Partnerships,
Estates & Trusts
Copyright ©2008 South-Western/Thomson Learning
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
Corporations, Partnerships, Estates & Trusts
C13 - 2
Principal Forms of
Doing Business
•
•
•
•
•
Sole Proprietorship
Partnership
C corporation
S corporation
Limited liability company (LLC)
Corporations, Partnerships, Estates & Trusts
C13 - 3
Limited Liability Company (LLC)
• Hybrid business form that combines the
corporate characteristic of limited liability
for owners with tax characteristics of a
partnership
Corporations, Partnerships, Estates & Trusts
C13 - 4
Filing Requirements
Sole Proprietorship
• Files Schedule C,
Form 1040
Partnership & LLC
C Corporation
S Corporation
• Files Form 1120
• Files Form 1065
• Files Form 1120S
Corporations, Partnerships, Estates & Trusts
C13 - 5
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
Corporations, Partnerships, Estates & Trusts
C13 - 6
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
Corporations, Partnerships, Estates & Trusts
C13 - 7
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
Corporations, Partnerships, Estates & Trusts
C13 - 8
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
Corporations, Partnerships, Estates & Trusts
C13 - 9
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
Corporations, Partnerships, Estates & Trusts
C13 - 10
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
Utilization of special allocations
Fringe benefits
Minimizing double taxation
Corporations, Partnerships, Estates & Trusts
C13 - 11
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
Corporations, Partnerships, Estates & Trusts
C13 - 12
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
Corporations, Partnerships, Estates & Trusts
C13 - 13
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
Corporations, Partnerships, Estates & Trusts
C13 - 14
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
Corporations, Partnerships, Estates & Trusts
C13 - 15
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%/5% rate for qualified dividends reduces the
potential negative impact of double taxation
Corporations, Partnerships, Estates & Trusts
C13 - 16
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
Corporations, Partnerships, Estates & Trusts
C13 - 17
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
Corporations, Partnerships, Estates & Trusts
C13 - 18
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
Corporations, Partnerships, Estates & Trusts
C13 - 19
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
Corporations, Partnerships, Estates & Trusts
C13 - 20
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
Corporations, Partnerships, Estates & Trusts
C13 - 21
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
Corporations, Partnerships, Estates & Trusts
C13 - 22
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
Corporations, Partnerships, Estates & Trusts
C13 - 23
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
Corporations, Partnerships, Estates & Trusts
C13 - 24
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
Corporations, Partnerships, Estates & Trusts
C13 - 25
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
Corporations, Partnerships, Estates & Trusts
C13 - 26
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
Corporations, Partnerships, Estates & Trusts
C13 - 27
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
Corporations, Partnerships, Estates & Trusts
C13 - 28
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
Corporations, Partnerships, Estates & Trusts
C13 - 29
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
Corporations, Partnerships, Estates & Trusts
C13 - 30
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
Corporations, Partnerships, Estates & Trusts
C13 - 31
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
Corporations, Partnerships, Estates & Trusts
C13 - 32
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
Corporations, Partnerships, Estates & Trusts
C13 - 33
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
Corporations, Partnerships, Estates & Trusts
C13 - 34
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
Corporations, Partnerships, Estates & Trusts
C13 - 35
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
Corporations, Partnerships, Estates & Trusts
C13 - 36
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
Corporations, Partnerships, Estates & Trusts
C13 - 37
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
Corporations, Partnerships, Estates & Trusts
C13 - 38
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...
Corporations, Partnerships, Estates & Trusts
C13 - 39
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
Corporations, Partnerships, Estates & Trusts
C13 - 40
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
Corporations, Partnerships, Estates & Trusts
C13 - 41
Tax Attributes of Different
Business Forms (slide 1 of 19)
Maximum
# Owners
Max Tax
Rate
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)
Corporations, Partnerships, Estates & Trusts
Tax
Paid By
.
C13 - 42
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
Corporations, Partnerships, Estates & Trusts
Tax
Paid By .
Corporation
pays first,
then owner
pays if
distribution
C13 - 43
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
Corporations, Partnerships, Estates & Trusts
Income
Allocation .
N/A
(1 owner)
Profit/loss
sharing ratio
Some special
allocations OK
C13 - 44
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
Corporations, Partnerships, Estates & Trusts
C13 - 45
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
Corporations, Partnerships, Estates & Trusts
C13 - 46
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
Corporations, Partnerships, Estates & Trusts
C13 - 47
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
Corporations, Partnerships, Estates & Trusts
C13 - 48
Tax Attributes of Different
Business Forms (slide 8 of 19)
S Corp.
C Corp.
Loss Allocation
to Owners
Limitation on Loss
Deductible by Owners
Per share/
per day
S/holder’s investment
plus loans from s/holder
to corporation
Not applicable
Corporations, Partnerships, Estates & Trusts
Not applicable
C13 - 49
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
Corporations, Partnerships, Estates & Trusts
C13 - 50
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.
Corporations, Partnerships, Estates & Trusts
Passive Loss Rules
Applicable? .
Yes, for closely held
and personal service
corporations.
Indefinite carryover
of unused losses.
C13 - 51
Tax Attributes of Different
Business Forms (slide 11 of 19)
Capital Gains
Capital Losses
.
Sole Prop.
Owner level
5/15% 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.
Corporations, Partnerships, Estates & Trusts
C13 - 52
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
Corporations, Partnerships, Estates & Trusts
C13 - 53
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.
Corporations, Partnerships, Estates & Trusts
C13 - 54
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).
Corporations, Partnerships, Estates & Trusts
C13 - 55
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.
Corporations, Partnerships, Estates & Trusts
C13 - 56
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
Corporations, Partnerships, Estates & Trusts
C13 - 57
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
Corporations, Partnerships, Estates & Trusts
C13 - 58
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
Tax
ACE
Preference
Adjustment
Items
.
N/A
Determined at
owner level
N/A
Corporations, Partnerships, Estates & Trusts
Conduit—entity
preferences
(26% or 28%)
pass thru to
owners for their
AMT calc.
C13 - 59
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)
Corporations, Partnerships, Estates & Trusts
Tax
Preference
Items .
Subject to
AMT at
corporate
level
C13 - 60