1. Chapter 13 Choice of Business Entity: General Tax and Nontax Factors
Formation
Kevin Murphy
Mark Higgins
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2. Taxpayers must choose a form for a business entity
Introduction
Taxpayers must choose a form for a business entity
Choice is based on tax and non-tax factors

3. Non-Tax Factors Is the number of owners restricted?
Do owners have limited liability?
Can ownership interest be freely transferred?
Do owners have a large degree of management control?
Does entity continue regardless of ownership changes?
Is there a high cost of organizing the entity?
Does the entity have an ability to raise additional capital?
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4. Let’s look at the non-tax factors and how they affect each entity.
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5. Sole Proprietorship
A sole proprietorship is a business owned by one individual.
The entity:
Ceases to exist when ownership changes
Has a low cost of formation
Has a limited ability to raise capital
The owner:
Has unlimited liability
Can easily transfer ownership interest
Has full management control
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6. Partnership
A partnership exists when two or more persons engage collectively in a profit making activity.
The owners:
Are fully liable (except for limited partners)
Cannot easily transfer ownership interest
Have full management control
The entity:
Ceases to exist if >50% ownership changes
Has a moderate cost of formation
Has a good ability to raise capital
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7. Corporation
A corporation is an artificial entity created under the auspices of state law.
The owners:
Have limited liability
Can easily transfer ownership interest
Have no right to direct management
Are not limited in number
The entity:
Continues to exist when ownership changes
Has a relatively high cost of formation
Has an excellent ability to raise capital
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8. S Corporation
An S corporation is a regular corporation with special tax attributes.
The owners:
Have limited liability
Can easily transfer ownership interest
Have no right to direct management
Are limited to a maximum number of 75
The entity:
Continues to exist when ownership changes
Has a relatively high cost of formation
Has an excellent ability to raise capital
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9. S Corporation Election
Requirements for electing S status
No more than 100 shareholders
Shareholders must be individuals, estates, tax-exempt organizations, or certain trusts
Shareholders may not be nonresident aliens
Only one class of outstanding stock is allowed
All shareholders must consent to election

10. S Corporation Election Termination
Terminating election
May be voluntarily terminated by consent of >50% of shareholders
Involuntary termination occurs when any requirements are violated
Must wait 5 years before applying for S status again

11. Limited Liability Company
The limited liability company (LLC) has corporate characteristics with the conduit tax treatment of partnerships.
The owners:
Have limited liability
Cannot easily transfer ownership interest
Have full management control
Not limited to number of owners
The entity:
Ceases to exist when ownership changes
Has a moderate cost of formation
Has a good ability to raise capital
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12. Limited Liability Partnership
The limited liability partnership (LLP) is a general partnership with limited liability for owners.
The owners:
Have liability only for their own acts
Cannot easily transfer ownership interest
Have full management control
Must have at least 2 owners
The entity:
Ceases to exist when ownership changes
Has a moderate cost of formation
Has a good ability to raise capital
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13. Let’s look at the tax factors and how they affect each entity.
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14. General Income Tax Factors
Three tax factors also influence choice of entity
Incidence of Income Taxation
Who pays the tax, the entity or the owner?
Double Taxation
Is the same income taxed to the entity and the owner?
Employee versus Owner
Can owners be treated as employees of the entity?

15. #1: Who Pays the Tax? Sole Proprietorship: conduit to owner
Form 1040, Schedule C
Partnership: conduit to partners
Form 1065, Schedule K-1
Items that receive special tax treatment are reported separately from operations

16. #1: Who Pays the Tax? S Corporation: conduit to shareholders
Form 1120S, Schedule K-1
Separable items like partnership
C Corporation: Corporation pays
Form 1120

17. #1: Who Pays the Tax? Personal Service Corporation
A corporation is a personal service corporation (PSC) if
The principal activity is performance of personal services
The services are performed by owner-employees, those who own > 10% of the stock
PSC’s pay tax on the income at a 35% rate
Encourages payment of salary to owners

18. #2: Is Double Taxation a Problem?No
Sole Proprietorships
Partnerships
S Corporations
Yes
C Corporations

19. #3: Owners Treated as Employees?
Sole Proprietors - No
Partners - No
But may receive guaranteed payments and fringe benefits
S Corporation shareholders - Yes
Salary and fringe benefits are deductible by the corporation
C Corporation shareholders - Yes
All payments made to/for owner-employees allowable

20. apply to employees of each entity?
How do fringe benefits
and employment taxes
apply to employees of each entity?

21. Fringe Benefits
Legislative grace allows employers to deduct amounts paid as fringe benefits but does not require employees to report income.
Owner-employees
Related party concerns
Nondiscriminatory rules

22. Fringe Benefit Limitations
Sole proprietors are not employees
No deduction allowed for salary or benefits

23. Fringe Benefit Limitations
Partners and > 2% shareholders of S Corporations must include in income:
Employer-provided group term life of $50,000 or less
Employer sponsored accident and health-care plans
Owner/employee can deduct for AGI
Cafeteria plans, and
Meals and lodging provided by employer

24. Social Security Taxes
The social security tax is imposed on the wages of employees and the net self-employment income of self-employed individuals.
Taxes are paid half by employee and half by employer
Total rate is 15.3% = 2.9% Medicare % OASDI
Maximum amount subject to OASDI is $94,200
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25. Social Security Taxes
Self-employed taxpayers (sole proprietors and partners) pay both halves
Base is 92.35% of net self-employed income
Corporations and S corporations may deduct the half paid for shareholder-employees

26. Formation
At the formation of a business entity, a number of tax issues arise
How to treat transfers of cash and property to an entity in exchange for ownership?
How to determine an owner’s initial and continuing basis?
How to treat costs incurred prior to and during formation?
What accounting period and method to use?

27. How are property transfer issues
treated by each entity?

28. Sole Proprietorship No tax effects arise
Sole proprietorship is not an entity separate from the owner
No realization under the realization concept
no second party involved in the transfer

29. Partnership No gain or loss recognized when property transferred
Realized gain or loss is deferred
Partner and partnership take a carryover basis in the property
Income is recognized if services are performed in exchange for ownership
All-inclusive income concept applies
Income = FMV of partnership interest

30. Corporations No gain or loss recognized if
Property is exchanged solely for stock, and
The shareholders control (> 80% ownership) the corporation after transfer
Income is recognized if services are performed in exchange for stock

31. How are basis issues treated by each entity?
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32. Basic Basis Considerations
Owners obtain an initial basis either through purchase or the transfer of property
If by purchase, use the purchase cost
If by transfer, use a carry-over basis and holding period
The entity generally takes a carry-over basis for property transferred in

33. Sole Proprietorship Ownership of property never changes
Owner’s basis remains unchanged

34. Partnership
Basis determines the taxability of distributions from the entity to the partner
Initial basis = basis in property transferred and/or FMV of services contributed
Increased by Decreased by
Additional contributions Distributions received
Partner’s share of income Partner’s share of losses
Partner’s share of Partner’s share of
increases in entity debt decreases in entity debt
Entity debt taken by partner Partner’s debt taken by entity
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35. C Corporation
Initial basis = basis in property transferred and/or FMV of services contributed
If any boot is received in the transfer
Shareholder has wherewithal-to-pay and must report gain
Basis includes the amount of gain recognized

36. C Corporation
Shareholders adjust basis in individual shares for stock dividends and stock splits
Shareholders who receive a distribution in excess of basis must report a capital gain
Excess over capital recovery

37. S Corporation
Initial basis = basis in property transferred and/or FMV of services contributed
If any boot is received in the transfer
Shareholder has wherewithal-to-pay and must report gain
Basis includes the amount of gain recognized

38. S Corporation
Basis is adjusted for items affecting the shareholder’s capital recovery
Follow the adjustments made for a partner with the exception of adjustments for debt

39. How are costs incurred prior to and during formation treated?
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40. Organizational and Start-up Costs
Expenditures that have a life extending beyond the end of the tax year must be capitalized
Organization costs pertain to getting the entity ready to operate
Start-up costs are incurred by an entity prior to beginning operations

41. Organizational and Start-up Costs
Costs incurred prior to 10/23/04 are amortized over 60 months
Costs incurred after 10/22/04
Amortize over 60 months, or
Elect to deduct $5,000 currently
Phased-out $1 for $1 if total costs exceed $50,000
Costs above $5,000 are amortized over 180 months

42. What accounting period and method should be used?

43. Accounting Periods
The annual accounting period concept requires all entities to report operations on an annual basis.

44. Accounting Periods
Taxpayers are generally free to choose their accounting period
Partnerships and S Corporations must use the taxable year of owners with >50% interest
May use natural business year
Partnerships may use year of principal (> 5%) owners if majority partners’ years do not agree

45. Accounting Methods
Taxpayers must select an accounting method which properly characterizes income and deductions.
May use one of three methods: cash, accrual, hybrid
Corporations are generally required to use the accrual method
Partnerships with a corporate partner are generally required to use the accrual method
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