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Chapter 13. Comparing Organizations. Howard Godfrey, Ph.D., CPA Professor of Accounting Copyright 2009.

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Presentation on theme: "Chapter 13. Comparing Organizations. Howard Godfrey, Ph.D., CPA Professor of Accounting Copyright 2009."— Presentation transcript:

1 Chapter 13. Comparing Organizations. Howard Godfrey, Ph.D., CPA Professor of Accounting Copyright 2009

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 Forms of Doing Business Sole Proprietorship Partnership Limited liability co (LLC) C corporation S corporation

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 Proprietorship Files Schedule C, Form 1040 Partnership & LLC File Form 1065 C Corporation Files Form 1120 S Corporation Files Form 1120S

6 Nontax Factors—Capital Formation Proprietorship Limited ability to raise capital Partnership Can raise funds through pooling of owner resources Ltd. partnership 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 Proprietorship Unlimited liability Partnership General partners are jointly and severally liable Ltd. Partner’s 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 Freedom of choice in transferring ownership interests Organizational formality and related costs

9 Single vs. Double Taxation Proprietorship Single taxation Partnership Single taxation C Corporation Double taxation (unless you have policy of not paying dividends) S Corporation Generally, single taxation May be subject to built-in gains tax and passive investment income tax

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11 Alternative Minimum Tax Proprietorship Directly subject to AMT Partnership 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

12 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 (dividends?) –Recognizing the interaction between the regular tax liability and the AMT liability –Utilization of special allocations –Fringe benefits –Minimizing double taxation

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14 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

15 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

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17 Min. Double Tax - C Corp (1 of 5) Several techniques are available for reducing the double taxation of C corps including: –Making distributions to shareholders that are deductible by corporation –Retaining earnings at corp level –Making distributions treated as a return of capital –Making the S corp election

18 Min. Double Tax - C Corp (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

19 Min. Double Tax - C Corp (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

20 Min. Double Tax - C Corp (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

21 Min. Double Tax - C Corp (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

22 Entity Formation (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

23 Entity Formation (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

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26 Basis Considerations Proprietorship N/A Partnership Profits & losses affect partner’s basis Partner’s basis is increased by share of entity debt 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 by affected by corporate liabilities

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28 Distributions Distributions can be made to partners, LLC owners, or S corp. shareholders tax- free –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

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31 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

32 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

33 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

34 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

35 Redemption of ownership interest by the entity May generate no income for owner. May generate ordinary income for owner. May generate capital gain for owner.

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38 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

39 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

40 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

41 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

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43 Liquidating Dist. of Assets to Owner. Owner’s Sells to Third Party. (1 of 3) Partnership –Distribution rules determine partner’s basis in assets received from ptship –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

44 Liquidating Dist. of Assets to Owner. Owner’s Sells to Third Party. (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

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46 Liquidating Dist. of Assets to Owner. Owner’s Sells to Third Party. (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

47 Purchase of Business Assets— Buyer’s Issues (slide 1 of 2) 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

48 Purchase of Business Assets— Buyer’s Issues (slide 2of 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

49 Sale of Bus -Seller’s Issues (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

50 Sale of Bus -Seller’s Issues (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

51 Sale of Bus -Seller’s Issues (3 of 3) C Corp –Sale treated as sale of stock Results in capital gain or loss to shareholder –No corporate level consequences

52 Purchase of Bus-Buyer’s Issues (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...

53 Purchase of Bus-Buyer’s Issues (2 of 3) Partnership –Purchaser buys partnership interest –Purchaser may ask partnership to make §754 election to step up inside basis in assets

54 Purchase Bus-Buyer’s Issues (2 of 3) S Corp or C Corp –Purchaser buys stock –There is no effect on underlying assets owned by the entity

55 Purchase Bus-Buyer’s Issues (3 of 3) S Corp or C Corp –Purchaser buys stock –There is no effect on underlying assets owned by the entity

56 Tax Attributes - Max No. of owners Max Tax Tax Paid by PropOne individual35%Owner Ptshp or LLCAt least 235%Partner S CorpMax =100 individuals, estates and some trusts 35%Shareholder (Corp. may have built-in gains tax or PII tax C Corp35% corp, plus 15% max on dividends Corp pays first, then owner pays on dividends

57 Tax Attributes Tax Year allowed Timing of taxation Income Allocation PropOwner’s YrOwner’s Year end N/A – 1 owner Ptshp or LLC Majority or prin. partners or least aggregate def. End of Ptshp year Profit-loss ratio, or special allocation. S CorpCalendar year or business purpose End of corp tax year Per share, Per day C CorpNo restrictions (generally) Corp reports at Year End. Shareholders report div. received N/A

58 Tax Attributes Contribute Prop. to Entity Character of income taxed to Owner Prop.Not taxable.Retains source characteristics. Ptshp or LLC Generally not taxable. Conduit-Retains source characteristics. S CorpTaxable unless transaction meets Sec. 351. Conduit-Retains source characteristics. C CorpTaxable unless transaction meets Sec. 351. Source characteristics are lost when income is distributed.

59 Tax Attributes Loss Allocation to Owners Limit on Loss Deduction of Owners Prop.Not applicableAmount invested plus liabilities of business Ptshp or LLC Profit and loss sharing ratios Ptr’s investment plus share of partnership liabilities S CorpPer share, Per day S/H’s investment plus loans from S/H to corp. C CorpNot Applicable

60 Tax Attributes At Risk Rules Applicable? Passive Loss Rules Applicable Prop. Ptshp. LLC S Corp. 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 C Corp.Yes, for closely held C corps. Indefinite carryover of unused losses. Yes, for closely held C corps. Indefinite carryover of unused losses.

61 Tax Attributes Capital GainsCapital Losses Prop.Owner level 0/15% tax Up to $3,000 against ord. income. Indefinite carryover of excess. Ptshp. LLC 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.

62 Tax Attributes Retaining earnings Non-liquidating distributions rules Prop. Taxable when earned. Increases investment (basis) Not taxable for sole proprietor Ptshp. LLC Same as proprietorship Not taxable unless cash or debt relief > ptnr’s basis S Corp. Same as proprietorship 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 Accum. E Tax. Taxed in yr received up to earned. Possible

63 Tax Attributes Sales of Ownership Interest Prop. Treated as a sale of each asset. Gain character depends on asset nature Ptshp. LLC Treated as sale of underlying ordinary income assets. Remainder treated as sale of partnership interest (capital gain). S Corp. or C Corp. Treated as sale of corporate stock (capital gain). Loss may be ordinary if § 1244 applies, otherwise capital.

64 Tax Attributes Fringe Benefits for Owners Sec. 1244 available Built-in Gains Effect PropNo N/A Ptshp or LLC No N/A S CorpSome if < 2% owner YesPossible Corp. Level Tax C CorpAvailable. Limited by non- discrimination rules. YesNot Effect

65 Tax Attributes Sec. 1231 Gains and Losses Foreign Tax Credits Prop.Taxable or deductible by owner. 5 Yr. Lookback rule. Owner level Ptshp. LLC S Corp. Conduit—same as proprietorship C Corp.Taxable/deductible at corp. level. 5 yr. Corporate level lookback rule Available

66 Tax Attributes Alternative Minimum Tax ACE Adjustment Tax Preference Items PropApplies at owner level (26%, 28%) N/ADetermined at owner level Ptshp or LLC S Corp Applies at partner or shareholder level N/AConduit-entity preferences pass through to owners for their AMT calculation C CorpApplies corprate level (20%) 75% X (ACE less AMTI) is added to AMTI (or subtracted) Subject to AMT at Corporate Level

67 The End


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