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 C Corporation Files Form 1120 S Corporation Files Form 1120S Sole Proprietorship Files Schedule C, Form 1040 Partnership & LLC Files Form 1065
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 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 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 Single taxation Partnership and LLC Single taxation C Corporation Double taxation S Corporation Generally, single taxation May be subject to built-in gains tax and passive investment income 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 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 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
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 In the 3 rd 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 $ 61,250 Tax at shareholder level: Milly ($69,375 X 15%) 10,406 Doug ($69,375 X 15%) 10,406 Combined entity/owner tax liability $ 82,062 After-tax cash flow ($200,000 - $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 $ –0– Tax at shareholder level: Milly ($100,000 X 28%) 28,000 Doug ($100,000 X 28%) 28,000 Combined entity/owner tax liability $ 56,000 After-tax cash flow ($200,000 - $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 $ –0– Tax at the owner level: Milly ($100,000 x 28%) 28,000 Doug ($100,000 x 28%) 28,000 Combined entity/owner tax liability $ 56,000 After-tax cash flow ($200,000 X $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) MaximumMax Tax Tax # Owners Rate Paid By. Sole Prop.One individual 35%Owner PartnershipAt least two 35%Partner (or LLC) S Corp.Max = %Shareholder Individuals,(Corp. may estates, somehave built-in trusts onlygains or PII tax)
Tax Attributes of Different Business Forms (slide 2 of 19) Maximum Max Tax Tax # Owners Rate Paid By. C Corp No max limit35% corporate Corporation (some States level pluspays first, require at 15% max. then owner least twoon qualifying pays if owners)distributionsdistribution
Tax Attributes of Different Business Forms (slide 3 of 19) Tax Year Timing of Income Allowed Taxation Allocation. Sole Prop.Owner’s yr.Owner’s N/A yr. end (1 owner) PartnershipMajority orEnd of p/ship Profit/loss LLCPrincipal tax year sharing ratio Ptrs or “least Some special aggregate allocations OK deferral” year
Tax Attributes of Different Business Forms (slide 4 of 19) Tax Year Timing of Income Allowed Taxation Allocation S Corp. Calendar year orEnd of CorpPer share, business purposetax yearper day C Corp. No restrictionsCorp reports atN/A (generally)end of tax yr; Shareholder reports dividends received
Tax Attributes of Different Business Forms (slide 5 of 19) Contribution ofCharacter of Income Property to Entity Taxed to Owners. Sole Prop. Not taxable Retains source characteristics Partnership Generally notConduit-retains taxablesource characteristics
Tax Attributes of Different Business Forms (slide 6 of 19) Contribution ofCharacter of Income Property to Entity Taxed to Owners. S Corp.Taxable unless Conduit-retains source meets §351 characteristics C Corp.Taxable unlessAll source character- meets §351 istics lost when income distributed to owners
Tax Attributes of Different Business Forms (slide 7 of 19) Loss AllocationLimitation on Loss to Owners Deductible by Owners Sole Prop.Not applicableAmount invested plus liabilities of business PartnershipProfit and lossPtr’s investment plus sharing ratiosshare of partnership liabilities
Tax Attributes of Different Business Forms (slide 8 of 19) 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 9 of 19) At-risk Rules Passive Loss Rules Applicable? Applicable?. Sole Prop.,Yes, at the Yes, at the Partnershipowner, 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 10 of 19) At- risk Rules Passive Loss Rules Applicable? Applicable?. C Corp.Yes, for closely heldYes, for closely held corporations. Indefiniteand personal service carryover of unusedcorporations. losses. Indefinite carryover of unused losses.
Tax Attributes of Different Business Forms (slide 11 of 19) Capital Gains Capital Losses. Sole Prop. Owner levelUp to $3,000 against 0/15% taxord. income. Indefinite carryover of excess. PartnershipConduit-ownersConduit-owners and S Corp.report shares samereport shares same as Sole Prop.as Sole Prop. C Corp.Taxed at CorporateCarried back 3 yrs, level up to 35 %.forward 5. Can only offset capital gains.
Tax Attributes of Different Business Forms (slide 12 of 19) Consequence of Treatment of Earnings Retained Nonliquidating by Owners Distributions. Sole Prop.Taxed when earned; Not taxable increases investmentin S.P. PartnershipSame as S.P. Not taxable unless cash or liability relief > Ptrs. basis
Tax Attributes of Different Business Forms (slide 13 of 19) Consequence Treatment of 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 14 of 19) Sale of Ownership Interest. Sole Prop.Treated as a sale of each asset. Gain character depends on asset nature. PartnershipTreated 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 CorporationTreated 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 16 of 19) Fringe Benefits §1244 Built-in Avail. to Owners? Available?Gains effect? Sole Prop. No NoN/A P’ship No NoN/A S Corp. Some if < 2%Yes Possible corp. owner level tax C Corp. AvailableYes No effect Limited by anti-discrim.rules
Tax Attributes of Different Business Forms (slide 17 of 19) §1231 Gains Foreign Tax and Losses Credits Sole Prop.Taxable or deductibleOwner level by owner. 5 yr. lookback rule. PartnershipsConduit—sameConduit—same and S Corpsas S.Prop.as S.Prop. C Corp.Taxable/deductibleAvailable at corp. level 5 yr. Corporate level lookback rule
Tax Attributes of Different Business Forms (slide 18 of 19) Tax Alternative ACE Preference Min. Tax Adjustment Items. Sole Prop.Applies at N/ADetermined at owner levelowner level (26% or 28%) PartnershipApplies atN/AConduit—entity or S Corp.ptr orpreferences shareholder (26% or 28%) level pass thru to owners for their AMT calc.
Tax Attributes of Different Business Forms (slide 19 of 19) Tax Alternative ACEPreference Min. Tax Adjustment Items. C Corp.Applies at Corp.75% x (ACESubject to level (20%)-AMTI) isAMT at added to AMTIcorporate (or subtracted)level