1. 11-1 Choice of Business Entity – Tax Factors  double-taxation of regular (C) corporate earnings  single level of tax on earnings of pass-through entities, assessed on entity owners  not all pass-through entities are created equally  Partnerships, LLPs and LLCs  S Corporations  tax treatment of start-up losses  Losses incurred by pass-through entities are deductible against owners’ income from other sources  limitations: PAL and at-risk limitations (chapter 15)  losses incurred in corporate form may be carried back/forward  tax reporting requirements

2. 11-2 Choice of Business Entity – Non-Tax Factors  legal liability  ease and costs of formation  cash flow needs of owners  Interaction of tax and non-tax factors  taxation of income and payment of tax liability  taxable versus non-taxable cash flows to owners

3. 11-3 Changes in Ownership and Organizational Form  Changes in ownership  expanding the business to include additional owners/investors is more complicated in partnership form than in corporate form  Changes in organizational form  termination of a corporation results in double taxation  taxable versus nontaxable restructurings  costs of restructuring

4. 11-4 Important Differences between Partnerships and S Corporations  S corporations provide limited liability to all shareholders, while partnerships must have at least one general partner  LLPs provide general partners protection from liability for malpractice of other general partners  Partnerships can make special allocations of taxable items among partners; all S corporation allocations must be based on stock ownership share

5. 11-5 Partnership and S Corporation Differences continued  Partners cannot be employees of their partnerships, while S corporation shareholders can be employees of their corporations  Partnership guaranteed payments and general partners’ share of partnership ordinary income are subject to SE tax, while S corporation shareholders’ share of corporation income is not

6. 11-6 Partnership and S Corporation Differences continued  Partnerships can involve greater numbers and types of owners than S corporations  Contributions (distributions) of property to (from) S corporations are more likely to result in taxable gain than contributions (distributions) to (from) partnerships

7. 11-7 LLCs  Provide the limited liability not available to general partners, without the participation restrictions of limited partners  Membership unrestricted versus S corporation shareholder restrictions  Special allocations possible  Contributions and distributions of property subject to partnership treatment versus S corporation treatment

8. 11-8 Closely-Held Corporations as Tax Shelters  Avoid double taxation by distributing cash flow in tax-deductible or nontaxable ways  salary payments, interest and principal on debt  Potential benefactors: high-income taxpayers willing to reinvest after-tax cash flow from business activities  goal: obtain tax benefit from lower corporate tax rates on initial increments of business taxable income  defer second level of tax into the future by avoiding dividend distributions

9. 11-9 Issues for Closely-Held Corporations  Constructive Dividends - Indirect distributions of earnings treated as dividends for income tax purposes  examples: excessive compensation, loans which are never repaid  intent: prevent owners of closely-held corporations from avoiding double taxation by taking cash out of the business disguised as deductible or nontaxable payments

10. 11-10 Issues for Closely-Held Corporations continued  Accumulated Earnings Tax - penalty tax on accumulations of earnings beyond ‘reasonable needs’ of the business  tax rate of 38.6%  intended to discourage retention of funds not reinvested in business activities  Personal Holding Company Tax - penalty tax on undistributed income of a PHC  tax rate of 38.6%  PHCs not subject to Accum. Earnings Tax

11. 11-11 Income Shifting  As previously discussed, the progressive nature of our tax rate system creates incentive to shift income to (usually related) taxpayers subject to lower marginal tax rates  Strategies for income shifting in closely-held businesses:  gift partnership interests or shares of stock to children or other family members  employ children/family members in the business activity

12. 11-12 Limits on Income Shifting  Assignment of income doctrine - income is taxed to the provider of services or owner of capital generating the income  if a partnership business is based on services provided by partners, a gift of a partnership interest to non-service providers will be ineffective  Kiddie tax - unearned income of children under 14 taxed at parents’ marginal tax rate

13. 11-13 Limits on Income Shifting continued  Controlled groups - corporate progressive rate schedule applied only once to entire group  parent-subsidiary controlled group - applies even if consolidated return not filed  brother-sister controlled group exists if 5 or fewer individuals control 2 or more corporations  Sec. 482 - gives IRS authority to re-allocate income of businesses under common control as necessary to prevent tax evasion