Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 11 The Choice of Business Entity

Slide 11-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Choice of entity  This is a tax planning chapter - HOW to use rules  Pass-through losses  After-tax cash flows to individual investor.  Family income shifting  Partnership versus S Corp characteristics  Closely-held corporations  Constructive dividends limit corporate tax avoidance.  accumulated earnings tax, personal holding company tax, tax rates on members of a controlled group.

Slide 11-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Passthrough entities  Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income.  Single level of taxation.  Cash distributions are generally NOT taxable.

Slide 11-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Benefits of passthrough losses  Passthrough loss is generally deductible in the year the loss is generated at the individual’s marginal tax rate.  Corporation loss must be carried (back) forward and used to offset income in a taxable year where profits are reported. NOL deduction provides a benefit at the corporation’s tax rate in the year the NOL offsets profits.

Slide 11-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Example:  Investor A has $200,000 of taxable income in 1996, 1997 and 1998 before his investment in Entity X. Entity X has an end of year loss in 1996 and 1997 of (50,000) per year and has profits in 1998 of $200,000. What is the net present value at 10% of the tax refunds or payments due on Entity X losses and profits if X is a:  a) pass-through entity? b) corporation?

Slide 11-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Pass-through example  1996 deduction = (50,000) x 36% = (18,000) refund  1997 deduction = (50,000) x 36% = (18,000) refund  1998 income = $200,000 x 36% = 72,000 tax  NPV tax cost at 10% if END of year payments = 22,824

Slide 11-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Corporation example  1998 net income = $100,000, corporate tax = 22,250  NPV = Why is this better even though the tax refund was delayed?  lower corporate tax rates  BUT, if corporation pays a dividend, then individual also taxed on 77,750 x 36% = 27,990.  NPV of total tax of 50,240 = 37,730, worse than pass-through.

Slide 11-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Passthrough entities only have a single level of tax  The preceding example illustrates the benefits of a pass-through entity:  a) use losses immediately  b) single level of taxation

Slide 11-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Family income shifting  Goal - have income taxed at lower rates (e.g. children’s rates) or avoid estate tax.  Remember, income shifting is the RESULT of shifting property ownership - can’t assign income.  If childen or other relatives are made partners or co-shareholders, they own part of the business.  The transfer of ownership may have GIFT TAX consequences if relatives don’t pay FMV.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Limits on family income shifting  Family members cannot be partners in a personal service business unless they can perform the services.  Family members providing services must first receive reasonable compensation before net income is allocated.  Income of family partnerships is allocated according to proportionate interests in partnership capital.  Income of all S corporations is allocated according to the proportionate shares of stock held by each shareholder.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Other considerations  Gift tax  Legal and accounting costs of creating and operating business  Dilution of parents’ wealth - transfers must be complete and legally binding, irrevocable.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Partnership versus S Corporation  S Corps require an IRS election, incorporation documents, possible corporate state tax payments.  Parnership agreements have more flexibility, but require more careful legal drafting.  Partners (but not S Corp shareholders) receive tax basis for liabilities of the partnership.  S Corporation shares are transferable. Partnership interests are not - requires new partnership agreement.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Type of flow-through entity  Liability  Full - General partnership  Limited liability partnership - general partners are not personally liable for malpractice-related claims of another general partner.  Limited parnership - at least one general partner, but other partners have no liablity.  Limited liability company (treated like partnership for tax, corporation legally).  S Corporation creates limited liability.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Closely-held corporations  Biggest challenge is how can the investors avoid double taxation of corporate earnings.  If shareholders are also creditors, interest expense is deductible to corporation.  If shareholders are also employees, wage expense is deductible to corporation.  If shareholders are also landlords, rent expense is deductible to corporation.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Closely-held corporations  IRS challenge turns “unreasonable” payments into constructive dividends.  How does the IRS decide what is unreasonable?  interest  wages  rent

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Accumulating corporate profits as a tax shelter  Keep earnings in corporation.  Small corporations are taxed at low rates.  Delay paying dividends.  Possibly convert ordinary dividend to capital gain by selling stock.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 IRS weapons against using corporation as tax shelter  Accumulated earnings tax  Penalty is to assess tax on accumulated taxable income at highest individual tax rate - like forcing a deemed dividend.  Common traits that IRS looks for:  Little or no dividends paid  Abundance of liquid assets not reinvested in production capacity.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 IRS weapons against using corporation as tax shelter  Personal Holding Company tax  Similar penalty assesses tax on undistributed earnings at 39.6%  Applies to corporations whose income is principally dividends, interest, rents and royalties.  Application of Accum. Earn Tax and PHC tax: rules prevent abuse, so practical assessment of these taxes is rare.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Controlled group tax rates.  Aggregate the taxable income of all members of a controlled group (>= 80% common ownership).  Compute tax.  Allocate tax according to proportion of taxable income.  These rules prevent disbursing corporate income into numerous units all taxed at 15%.