1. Chapter 12 The Choice of Business Entity McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 12-2  This is a tax planning chapter - how to use rules related to  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 Objectives

3. 12-3 Pass-Through Entities  Partnerships (includes LLCs) and S Corps are not taxed as entities; investors pay tax on their share of entity income  This treatment results in a single level of taxation  Cash distributions are generally not taxable  The cash represents a return of investment and does not affect the income or loss reported by the owner

4. 12-4 Benefits of Pass-Through Losses  Pass-through losses are generally deductible in the year the loss is generated, producing a tax benefit at the individual’s marginal tax rate (i.e., immediate tax savings!)  For start-up corporations, loss must be carried 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

5. 12-5Example  Investor A, a single individual, has $200,000 of taxable income in 2011, 2012 and 2013 before his investment in Entity X. Entity X has an end of year loss in 2011 and 2012 of ($50,000) per year and has profits in 2013 of $300,000  What is the net present value at 10% of the tax savings or tax costs on Entity X losses and profits if X is a a) Pass-through entity? b) Corporation?

6. 12-6 Pass-Through Example  2011 deduction = ($50,000) x 35% = ($17,500) savings  2012 deduction = ($50,000) x 35% = ($17,500) savings  2013 income = $300,000 x 35% = $105,000 tax cost  NPV tax cost at 10% if END of year payments = $53,323  ($17,500) + [($17,500) x.909) + [$105,000 x.826)

7. 12-7 Corporation Example  2013 net income = $200,000 ($300,000 – $50,000 - $50,000), corporate tax = $61,250; PV = $50,592 [$61,250 x.826) tax cost  The PV of tax costs for the corporation is lower even though the tax savings was delayed. Why?  Lower corporate tax rates  BUT, if corporation pays a dividend equal to after-tax cash flows, then the owner is also taxed on $138,750 – which results in a tax cost of $48,562 ($138,750 x.35)  PV of total tax of $90,704 [$50,592 + ($48,562 x.826)], which is more than pass-through tax of $53,323

8. 12-8 Pass-Through Entities Only Have a Single Level of Tax  The preceding example illustrates the benefits of a pass-through entity  Losses can be used immediately  Earnings are subject to a single level of taxation

9. 12-9 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 children or other relatives are made partners or co- shareholders, they own part of the business and are entitled to their share of any cash distributions from the business  The transfer of ownership may have gift tax consequences if relatives don’t pay FMV

10. 12-10 Limits on Family Income Shifting  Family members cannot be partners in a personal service business unless they can perform the services  In contrast, a family member can be a partner in a business in which property is a material income- producing factor  Family members providing services must first receive guaranteed payments that constitute reasonable compensation before net income is allocated

11. 12-11 Limits on Family Income Shifting  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

12. 12-12 Other Considerations  The potential tax savings of operating a pass- through entity must be compared to the legal and accounting costs of creating and operating the business  The creation of a pass-through entity results in the dilution of parents’ wealth and control of the business  Transfers must be complete and legally binding, irrevocable  Buy-sell agreements are used to restrict family members from selling their equity interests to an unrelated third party

13. 12-13 Other Considerations (continued)  To retain control, the entrepreneur (e.g., the parents) should consider  A limited partnership with the entrepreneur as sole general partner or  An S corporation with voting and nonvoting stock

14. 12-14 Other Considerations (continued)  Gift tax may be assessed on the transfer of an equity interest in an established business to a family member  Example  Mrs. Johnson is eager to create a family partnership to generate income and cash flow for her three college-age children. Should she transfer ownership in a business established 15 years ago with $15 million FMV of assets or a business started 10 months ago with $300,000 FMV of assets?

15. 12-15 Partnership versus S Corporation  S corporations require an IRS election, incorporation documents, and possible corporate state tax payments; the IRS has eased some regulatory restrictions over the past few years  Partnership agreements have more flexibility, but require more careful legal drafting  Partners (but not S corporation shareholders) receive tax basis for liabilities of the partnership increasing the deductibility of losses  S corporation shares are transferable. Partnership interests are not - requires new partnership agreement  Employee benefit planning favors S corporation

16. 12-16 Liability Associated with Types of Flow-Through Entities  Liability associated with different forms of ownership  General partnership – full liability  Limited liability partnership - general partners are not personally liable for malpractice-related claims of another general partner  Limited partnership - at least one general partner with full liability, but other partners have no liability

17. 12-17 Liability Associated with Types of Flow- Through Entities (continued)  Limited liability partnership - partners not responsible for other partner’s malpractice  Limited liability company (treated like partnership for tax, corporation legally)  S corporation creates limited liability

18. 12-18 Closely-Held Corporations  Biggest challenge is how investors can avoid double taxation of corporate earnings; one way is to have the investor assume an additional role with respect to the corporation  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

19. 12-19 Closely-Held Corporations  IRS challenge turns “unreasonable” payments into constructive dividends  How does the IRS decide what is an unreasonable payment for  Wages  Rent  Interest?

20. 12-20 Thin Capitalization  If the debt held by shareholders of a closely-held corporation is excessive, the IRS may contend that some or all of the interest payments are nondeductible dividends  Accordingly, shareholders have taxable income, not a nontaxable return of investment  Rule of thumb – a debt-to-equity ratio greater than 3 to 1 may appear “unreasonable”

21. 12-21 Accumulating Corporate Profits as a Tax Shelter  Some corporations keep earnings in the corporation in order to avoid double taxation or they delay paying dividends  If this practice results in an increase in stock price, it is possible for investors to convert ordinary dividends into capital gain by selling stock

22. 12-22 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  Penalty = 20% of accumulated taxable income (taxable income less income tax less dividends paid less reasonable needs of business)  Common traits that IRS looks for when investigating corporate tax shelters:  Little or no dividends paid  Abundance of liquid assets not reinvested in production capacity, or  Especially substantial loans to shareholders

23. 12-23 IRS Weapons Against Using Corporation as Tax Shelter  Personal Holding Company tax  Similar penalty assesses tax on undistributed earnings at 20%  Applies to corporations whose income is principally dividends, interest, rents and royalties  Application of Accumulated Earnings Tax and PHC tax  These rules are intended to prevent abuse, so assessment of these taxes is rare in practice

24. 12-24 Controlled Group Tax Rates  The corporate tax rates are progressive; owners could reduce their overall tax by fragmenting their business into multiple corporate entities  The tax law requires that corporations aggregate the taxable income of all members of a controlled group before compute tax; the tax is then allocated according to the entities’ proportion of taxable income  Controlled groups include parent-subsidiary and brother-sister groups

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