Chapter 14 Choice of Business Entity: Operations and Distributions Choice of Business Entity: Operations and Distributions ©2009 South-Western, a part of Cengage Learning Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

14-2 © 2009 South-Western, a part of Cengage Learning Taxation of Operations The general formula for computing income tax is: Gross Income less:Deductions Taxable Income times:Tax rate (for entity) Income tax less:Tax prepayments and Tax credits Tax (refund) due with return

14-3 © 2009 South-Western, a part of Cengage Learning Let’s concentrate on the exceptions to the general formula common to each entity.

14-4 © 2009 South-Western, a part of Cengage Learning Sole Proprietorship vMany items are reported elsewhere on the owner’s return and not reported as part of the proprietorship’s income FInvestment income and expense FCapital gains and losses FSection 1231 gains and losses FPassive activity items FCharitable contributions FOwner’s personal expenses FTax credits FNet operating losses

14-5 © 2009 South-Western, a part of Cengage Learning Partnership vIncome and expenses are reported by the partners according to their ownership interest vItems which would receive special treatment on a partner’s return are reported separately FAll items listed separately for sole proprietorships FAmounts expensed under Section 179 FAlternative minimum tax items FNondeductible expenses

14-6 © 2009 South-Western, a part of Cengage Learning vLosses are deductible subject to three limitations FLimited to the amount of a partner’s basis (capital recovery concept) FLimited to the partner’s at-risk amount FLimited by passive activity rules Partnership

14-7 © 2009 South-Western, a part of Cengage Learning vPartner’s basis is adjusted to reflect partnership income and losses reported FIncreased for income or gains VDesigned to prevent double taxation FDecreased for losses VDesigned to prevent double benefit and reflect capital recovery Partnership

vTransactions between a partner and partnership are subject to related- party rules FPartner who has > 50% interest in a partnership is a related party FLosses on sales are disallowed © 2009 South-Western, a part of Cengage Learning 14-8

14-9 © 2009 South-Western, a part of Cengage Learning Corporation vTaxable income is determined at the corporate level under the general formula vExceptions: FNet capital losses are not deductible FCorporations must recapture additional depreciation for Sec property = 20% of straight-line depreciation taken

14-10 © 2009 South-Western, a part of Cengage Learning Corporation FDividends-Received deduction VDesigned to relieve triple taxation problem VCorporation may deduct a % of the dividends received from other corporations Percent owned Deduction % < 20% 70% > 20% and < 80% 80% > 80% 100%

14-11 © 2009 South-Western, a part of Cengage Learning Corporation FPassive activity losses VCorporations are not subject to the passive activity rules ïPersonal service corporations must follow them ïClosely-held corporations may use passive losses to offset active income but not portfolio income FCharitable contributions are limited to 10% of taxable income VBefore dividend-received deductions and any carryovers VExcess contributions may be carried forward 5 years

14-12 © 2009 South-Western, a part of Cengage Learning Corporation FNet operating loss cannot be used in the current year or distributed to shareholders VMay be carried back 2 years and forward 20 until used VMay elect to forego the carry back

14-13 © 2009 South-Western, a part of Cengage Learning S Corporation vIncome and expenses are reported by the shareholders according to their ownership interest FItems which would receive special treatment on a shareholder’s return are reported separately FLosses are deductible subject to the three limitations faced by partnerships vS corporations are also subject to the corporate depreciation recapture rules for Section 1250 property

14-14 © 2009 South-Western, a part of Cengage Learning vMay not use take the dividend-received deduction vNOLs are subject to three limitations FBasis limitation FAt-risk limitation FPassive activity loss limitation S Corporation

14-15 © 2009 South-Western, a part of Cengage Learning Entity Distributions The tax treatment of distributions to an owner depends on the amount and kind of the distribution and the entity making the distribution. vDistributions are either FLiquidating FNonliquidating

14-16 © 2009 South-Western, a part of Cengage Learning What are the effects of nonliquidating distributions made by each entity?

14-17 © 2009 South-Western, a part of Cengage Learning Sole Proprietorship vDistribute cash FNo tax consequences to owner / entity vDistribute property FNo gain or loss recognized until owner sells the property

14-18 © 2009 South-Western, a part of Cengage Learning Partnership vDistribute cash FPartner recognizes no gain unless amount exceeds partner’s basis; excess is capital gain FNo tax consequences to partnership vDistribute property FPartner recognizes no gain or loss; Basis is the lesser of carryover basis or partner's basis FNo tax consequences to the entity

14-19 © 2009 South-Western, a part of Cengage Learning C Corporation vDistribute cash FShareholder reports VDividend income to the extent of earnings and profits or corporation, then VReturn of capital to the extent of basis, then VCapital gain FNo tax consequences to corporation vDistribute property FShareholder reports same as cash FCorporation reports gain “as if the property was sold” for its FMV. No loss allowed.

14-20 © 2009 South-Western, a part of Cengage Learning S Corporation vDistribute cash FShareholder recognizes no gain unless amount exceeds basis; excess is capital gain FNo tax consequences to corporation vDistribute property FSame as for cash FCorporation reports gain “as if the property was sold” for its FMV. No loss allowed.

14-21 © 2009 South-Western, a part of Cengage Learning What are the effects of liquidating distributions made by each entity?

14-22 © 2009 South-Western, a part of Cengage Learning Sole Proprietorship vDistribute cash FNo tax consequences to owner / entity vDistribute property FWhen property is sold; gain or loss = FMV less basis

14-23 © 2009 South-Western, a part of Cengage Learning Partnership vDistribute cash FPartner recognizes VNo gain unless amount exceeds partner’s basis; excess is capital gain VIf only cash is distributed, loss may be recognized FNo tax consequences to partnership vDistribute property FPartner recognizes no gain or loss; Basis is the lesser of carryover basis or partner's basis FNo tax consequences to the entity

14-24 © 2009 South-Western, a part of Cengage Learning C Corporation vDistribute cash FShareholder reports capital gain or loss = amount less basis FNo tax consequences to corporation vDistribute property FShareholder reports same as cash FCorporation reports gain or loss “as if the property was sold” for its FMV

14-25 © 2009 South-Western, a part of Cengage Learning S Corporation vDistribute cash FShareholder recognizes capital gain or loss equal to distribution amount less basis FNo tax consequences to corporation vDistribute property FShareholder reports same as for cash FCorporation reports gain or loss “as if the property was sold” for its FMV

14-26 © 2009 South-Western, a part of Cengage Learning Tax Planning With proper tax planning, owners of entities can minimize their overall tax liability by taking full advantage of the progressive tax rate structure. FIncome splitting FChildren as employees FFamily entities