Chapter 13 Comparing Organizations Howard Godfrey Ph D

Chapter 13. Comparing Organizations. Howard Godfrey, Ph. D. , CPA Professor of Accounting Copyright 2009

Choice of Form of Business Entity • Many factors affect the choice of business entity – Both tax and nontax – Understanding the comparative tax consequences related to the different types of entities is important for effective tax planning

Forms of Doing Business • Sole Proprietorship • Partnership Limited liability co (LLC) • C corporation • S corporation

Limited Liability Company (LLC) Hybrid business form that combines the corporate characteristic of limited liability for owners with tax characteristics of a partnership

Filing Requirements Proprietorship Files Schedule C, Form 1040 Partnership & LLC File Form 1065 C Corporation Files S Corporation Form 1120 Files Form 1120 S

Nontax Factors—Capital Formation Proprietorship Limited ability to raise capital Partnership • Can raise funds through pooling of owner resources • Ltd. partnership can raise capital from investors C Corporation S Corporation • Greatest ease and potential for raising capital, raising capital but limited number of investors

Nontax Factors—Limited Liability Proprietorship Partnership Unlimited General partners are liability jointly and severally liable Ltd. Partner’s liability is limited to investment C Corporation S Corporation Generally have limited liability

Other Nontax Factors • Estimated life of business • Number of owners and their roles in management • Freedom of choice in transferring ownership interests • Organizational formality and related costs

Single vs. Double Taxation Proprietorship Single taxation Partnership Single taxation C Corporation Double taxation (unless you have policy of not paying dividends) S Corporation • Generally, single taxation • May be subject to built-in gains tax and passive investment income tax

Alternative Minimum Tax Proprietorship Directly subject to AMT Partnership • Indirectly subject to AMT • AMT adjustments & preferences flow through and partners subject to AMT C Corporation • Directly subject to AMT • May have advantage here since corp AMT rate is only 20% S Corporation • Indirectly subject to AMT • AMT adjustments & preferences flow through and S/H’s subject to AMT

Controlling the Entity Tax • Various techniques can be used to control the tax liability, whether imposed on the entity or owners, such as: – Distribution policy (dividends? ) – Recognizing the interaction between the regular tax liability and the AMT liability – Utilization of special allocations – Fringe benefits – Minimizing double taxation

Fringe Benefits (slide 1 of 2) • Generally produce the following tax consequences: –Deductible by entity (employer) providing the fringe benefit –Excludible from gross income of taxpayer (employee) who receives the fringe benefit

Fringe Benefits (slide 2 of 2) • Favorable tax treatment of fringe benefits is available only to employees – For owner of entity to be an employee, the entity must be a corporation • Partners in a partnership are not employees • Greater-than-2% shareholders in an S corp are treated as partners – If not an employee • Deduction of cost of fringe benefit is disallowed • Owner must include cost of fringe benefit in gross income

Min. Double Tax - C Corp (1 of 5) • Several techniques are available for reducing the double taxation of C corps including: – Making distributions to shareholders that are deductible by corporation – Retaining earnings at corp level – Making distributions treated as a return of capital – Making the S corp election

Min. Double Tax - C Corp (2 of 5) • Deductible distributions include: – Salary payments to shareholderemployees – Rental payments to shareholder-lessors – Interest payments to shareholdercreditors • IRS scrutinizes these types of transactions – Must be reasonable

Min. Double Tax - C Corp (3 of 5) • Retain earnings at corporate level – Double tax is avoided unless corp makes distributions (actual or deemed) to shareholders • Must watch out for accumulated earnings tax problems – For distributions made in 2003 and thereafter the 15%/0% rate for qualified dividends reduces the potential negative impact of double taxation

Min. Double Tax - C Corp (4 of 5) • Make return of capital distributions – For ongoing businesses, redemption provisions may help reduce gross income at the shareholder level – Corporate liquidation provisions can be used if business will cease to operate in corporate form

Min. Double Tax - C Corp (5 of 5) • Electing S corp status – Generally eliminates double taxation but other factors must be considered such as: • Will all shareholders consent to election? • Can qualification requirements be met currently and on an ongoing basis? • Are conditions favorable to an S corp election and how long will those conditions be favorable • Distribution policy may cause problems paying tax at shareholder level

Entity Formation (1 of 2) • Generally, owners make contributions of cash and property to entity in exchange for an ownership interest – Generally, tax-free to both the entity and the owner • In corporate setting, requirements of § 351 must be met – Owners and entities take a carryover basis in their ownership interest and in assets contributed, respectively

Entity Formation (2 of 2) • If FMV of property contributed > adjusted basis, may want to make special allocation –Required in partnerships –Not available for C corps or S corps

Basis Considerations Proprietorship Partnership N/A • Profits & losses affect partner’s basis • Partner’s basis is increased by share of entity debt C Corporation Shareholder’s basis is not affected by corporate profits & losses S Corporation Shareholder’s basis is increased by profits, decreased by losses, not by affected by corporate liabilities

Distributions • Distributions can be made to partners, LLC owners, or S corp. shareholders taxfree – Same distribution would produce dividend income treatment for C corp. shareholders • If appreciated property is distributed to S corp. shareholders, realized gain is recognized at the corporate level (same treatment as a C corp. ) – This corporate-level gain is passed-through to the S corp. shareholders

Passive Activity Losses (slide 1 of 2) • Loss limits apply to owners of partnerships, LLCs, and S corps – Passive losses are separately stated items that flow through to owners – Passive loss rules apply at the owner level

Passive Activity Losses (slide 2 of 2) • For corporations, only apply if a closely held corp or a personal service corp – Closely held corp—more than 50% of value of stock at any time during last half of year is owned by 5 or less individuals • Passive losses can offset active income but not portfolio income – Personal service corp—principal activity is performance of personal services by owner-employees who own more than 10% in value of corp’s stock • General passive loss rules apply

At-Risk Rules • At-risk rules apply to: – Partnerships – LLCs – S corps – Closely held C corps • May be more troublesome for partnerships and LLCs since liabilities are included in partner’s basis in partnership interest

Special Allocations • Partnership and LLCs have many opportunities to use special allocations – Not generally available in C corps and S corps • May be able to achieve the same results using payments to owners for services, rents and interest

Redemption of ownership interest by the entity • May generate no income for owner. • May generate ordinary income for owner. • May generate capital gain for owner.

Disposition of a Business or an Ownership Interest • Disposing of a business may be viewed as either: – A sale of an ownership interest, or – A sale of assets • Tax consequences are, in general, more favorable for a sale of an ownership interest

Sale of Assets by Entity —Seller’s Issues (slide 1 of 3) • Sole Proprietorship – Treated as a sale of separate assets – Gain or loss is calculated for each asset • Character of income or loss depends on nature of asset

Sale of Assets by Entity —Seller’s Issues (slide 2 of 3) • Partnership, LLC, or S Corp—Same as proprietorship – Gain/loss flows through to shareholders or partners • They report & pay tax on gain or loss • Distribution of cash proceeds does not cause double tax since basis is adjusted by gain/loss

Sale of Assets by Entity —Seller’s Issues (slide 3 of 3) • C Corp—double taxation occurs – Gain is determined for each asset and tax paid by corporation – Net cash is distributed • Taxed as dividend, return of capital or capital gain to shareholder

Liquidating Dist. of Assets to Owner’s Sells to Third Party. (1 of 3) • Partnership – Distribution rules determine partner’s basis in assets received from ptship – Partner has gain if cash received > basis – Partner has loss if cash, inventory and unrealized receivables are only assets rec’d and are < basis – Character of gain on asset sale depends on nature of assets received by partner – No double tax

Liquidating Dist. of Assets to Owner’s Sells to Third Party. (2 of 3) • S Corp – S Corp has gain if appreciated assets distributed to shareholders – No corporate level tax unless “built-in gain” – Shareholder has gain (tax) on receipt of assets > basis (after basis increase for gain) – Shareholder’s basis in assets = FMV, so no gain on later sale of assets

Liquidating Dist. of Assets to Owner’s Sells to Third Party. (3 of 3) • C Corp – Double tax – Gain on distribution and tax at entity level – Net (after tax) assets distributed at FMV & result in gain to shareholder

Purchase of Business Assets— Buyer’s Issues (slide 1 of 2) • Purchaser of individual assets is not generally affected by the type of entity through which the seller operates: – The buyer (whether individual, partnership, LLC, C corp or S corp) allocates the total amount paid to the individual assets acquired – Part of the cost may be allocated to intangible assets such as goodwill

Purchase of Business Assets— Buyer’s Issues (slide 2 of 2) • Asset cost is recovered through depreciation, amortization, sale of inventory, collection of accounts receivable, etc. . . • The buyer can contribute the assets to a partnership or C corp under § 721 or § 351 – If the C corp is qualified, an S corp election can be made

Sale of Bus -Seller’s Issues (1 of 3) • Sole Proprietorship – No distinction between sale of interest or assets • Partnership – Sale of partnership interest results in ordinary income to partner for share of partnership’s ordinary income assets; capital gain for remainder

Sale of Bus -Seller’s Issues (2 of 3) • S Corp – Sale treated as sale of stock • Results in capital gain or loss to shareholder – In general, no corporate-level consequences • However, if purchaser is not qualified shareholder, S election is automatically terminated

Sale of Bus -Seller’s Issues (3 of 3) • C Corp – Sale treated as sale of stock • Results in capital gain or loss to shareholder – No corporate level consequences

Purchase of Bus-Buyer’s Issues (1 of 3) • If the purchaser acquires an interest in one of these types of entities, he or she is treated as follows: • Sole Proprietorship – Purchaser is deemed to buy assets • Purchase price is allocated to assets • Assets are depreciated, amortized, etc. . .

Purchase of Bus-Buyer’s Issues (2 of 3) • Partnership – Purchaser buys partnership interest – Purchaser may ask partnership to make § 754 election to step up inside basis in assets

Purchase Bus-Buyer’s Issues (2 of 3) S Corp or C Corp –Purchaser buys stock –There is no effect on underlying assets owned by the entity

Purchase Bus-Buyer’s Issues (3 of 3) S Corp or C Corp –Purchaser buys stock –There is no effect on underlying assets owned by the entity

Tax Attributes Max Tax Paid by 35% Owner Ptshp or LLC At least 2 35% Partner S Corp 35% Shareholder (Corp. may have built-in gains tax or PII tax Corp pays first, then owner pays on dividends Prop C Corp Max No. of owners One individual Max =100 individuals, estates and some trusts 35% corp, plus 15% max on dividends

Tax Attributes Tax Year allowed Prop Owner’s Yr Ptshp or LLC Timing of taxation Owner’s Year N/A – 1 owner end Majority or prin. End of Ptshp partners or least year aggregate def. S Corp Calendar year or End of corp business purpose tax year C Corp No restrictions (generally) Income Allocation Profit-loss ratio, or special allocation. Per share, Per day Corp reports N/A at Year End. Shareholders report div. received

Tax Attributes Contribute Prop. Character of income to Entity taxed to Owner Prop. Not taxable. Retains source characteristics. Ptshp Generally not Conduit-Retains or LLC taxable. source characteristics. S Corp Taxable unless Conduit-Retains transaction source characteristics. meets Sec. 351. C Corp Taxable unless Source characteristics transaction are lost when income meets Sec. 351. is distributed.

Tax Attributes Loss Allocation Limit on Loss to Owners Deduction of Owners Prop. Not applicable Amount invested plus liabilities of business Ptshp Profit and loss Ptr’s investment plus or LLC sharing ratios share of partnership liabilities S Corp Per share, S/H’s investment plus Per day loans from S/H to corp. C Corp Not Applicable

Tax Attributes At Risk Rules Applicable? Prop. Yes, at the owner, Ptshp. partner or LLC shareholder level. S Corp. Indefinite carryover of unused losses C Corp. Yes, for closely held C corps. Indefinite carryover of unused losses. Passive Loss Rules Applicable Yes, at the owner, partner or shareholder level. Indefinite carryover of unused losses Yes, for closely held C corps. Indefinite carryover of unused losses.

Tax Attributes Capital Gains Prop. Owner level 0/15% tax Capital Losses Up to $3, 000 against ord. income. Indefinite carryover of excess. Ptshp. Conduit-owners LLC report shares same S Corp. as Sole Prop. C Corp. Taxed at Corporate Carried back 3 yrs, level up to 35 %. forward 5. Can only offset capital gains.

Tax Attributes Retaining earnings Prop. Taxable when earned. Increases investment (basis) Ptshp. Same as proprietorship LLC S Corp. Same as proprietorship C Corp. Taxed to corp. as earned. Possible Accum. E Tax. Non-liquidating distributions rules Not taxable for sole proprietor Not taxable unless cash or debt relief > ptnr’s basis Generally not taxable unless distribution > AAA or stock basis. May be dividend if E & P from Sub C year. Taxed in yr received up to earned. Possible

Tax Attributes Sales of Ownership Interest Prop. Treated as a sale of each asset. Gain character depends on asset nature Ptshp. LLC Treated as sale of underlying ordinary income assets. Remainder treated as sale of partnership interest (capital gain). Treated as sale of corporate stock (capital gain). Loss may be ordinary if § 1244 applies, otherwise capital. S Corp. or C Corp.

Tax Attributes Fringe Benefits for Owners No Sec. 1244 available No N/A No No N/A S Corp Some if < 2% owner Yes Possible Corp. Level Tax C Corp Available. Limited by nondiscrimination rules. Yes Not Effect Prop Ptshp or LLC Built-in Gains Effect

Tax Attributes Sec. 1231 Gains and Losses Prop. Foreign Tax Credits Taxable or Owner level deductible by owner. 5 Yr. Lookback rule. Conduit—same as proprietorship Ptshp. LLC S Corp. C Corp. Taxable/deductible at corp. level. 5 yr. Corporate level lookback rule Available

Tax Attributes Prop Ptshp or LLC S Corp Alternative Minimum Tax Applies at owner level (26%, 28%) ACE Adjustment N/A Determined at owner level Applies at partner or shareholder level N/A Conduit-entity preferences pass through to owners for their AMT calculation C Corp Applies corprate level (20%) Tax Preference Items 75% X (ACE Subject to AMT at less AMTI) is Corporate Level added to AMTI (or subtracted)

The End