Essentials of taxation 2016 cengage chapter 18

Entity Formation slide 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 th

© 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

The Big Picture (slide 1 of 2)

• Bill and George are going to start a new business in which

they both will participate on an active basis

– They will use savings to finance the business.

• They have narrowed the choice of business forms to

– A C corporation,

– An S corporation, or

– An LLC.

• Limited liability is important in their choice of business

form, but minimizing taxes is also important

• They expect losses for the first 2 years of operations, but

after that they expect to earn $200,000 in before-tax profit.

– Any after-tax profit will be distributed to Bill and George

The Big Picture (slide 2 of 2)

• George also is considering investing $10,000 in a

limited partnership

– He provides you with information on projected partnership

profits and losses See Example 2

• As a way of leveraging the risks and rewards

associated with his investments, Bill earlier had

acquired a 30% interest in a boutique retail coffee franchise outlet.

– Bill now is considering selling this investment, which has

experienced rapid appreciation

– He needs to know the adjusted basis of his ownership

interest See Example 13

• Read the chapter and formulate your response.

Choice of Form of Business Entity

• Many factors affect the choice of business entity

related to the different types of entities is important for effective tax planning

Principal Forms of Doing Business

Limited Liability Company (LLC)

• Hybrid business form that combines the corporate

characteristic of limited liability for owners with tax characteristics of a partnership

The Big Picture – Example 2

• Return to the facts of The Big Picture on p 18-1

• George is considering investing $10,000 in a

limited partnership

• He projects that he will be able to deduct the

$10,000 capital contribution within the next 2

years (as his share of losses)

– Since George’s marginal tax rate is 28%, the deductions

will produce a positive cash-flow effect of $2,800 ($10,000

X 28%)

The Big Picture – Example 2

• However, there is a substantial risk that he will not

recover any of his original investment

– If this occurs, his negative cash flow from the investment

in the limited partnership is $7,200 ($10,000 - $2,800)

• George must decide if the investment makes

economic sense.

Nontax Factors—Capital Formation

• Greatest ease and potential

for raising capital

Nontax Factors—Limited Liability

Other Nontax Factors

• Estimated life of business

• Number of owners and their roles in management of the

business

• Freedom of choice in transferring ownership interests

• Organizational formality and related costs

Single vs Double Taxation

• Generally, single taxation

• May be subject to built-in gains tax and passive

investment income tax

Alternative Minimum Tax

Sole Proprietorship

• Directly subject to AMT

Partnership and LLC

• 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

tax liability and the AMT liability

– Utilization of special allocations

Minimizing Double Taxation

• Several techniques are available for reducing the double

taxation of C corps including:

– Making distributions to shareholders that are

deductible by corp

– Retaining earnings at corp level

– Making distributions treated as a return of capital

Minimizing Double Taxation

• Deductible distributions include:

– Interest payments to shareholder-creditors

• IRS scrutinizes these types of transactions

Minimizing Double Taxation

• Retain earnings at corporate level

distributions (actual or deemed) to shareholders

• Must watch out for accumulated earnings tax problems

reduces the potential negative impact of double taxation

Minimizing Double Taxation

• Make return of capital distributions

may help reduce gross income at the shareholder level

– Corporate liquidation provisions can be used if

business will cease to operate in corporate form

Minimizing Double Taxation

• 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

(slide 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

(slide 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

• Partner’s basis is increased

by share of p’ship liabilities

The Big Picture – Example 13

• Return to the facts of The Big Picture on p 18-1

entity for a 30% ownership interest in the franchise

$20,000 of this amount by the end of

the taxable year

The Big Picture – Example 13

• If the entity is a partnership or limited liability entity, Bill’s

basis at the end of the period is $136,000.

– $100,000 investment + $9,000 share of net liability

increase + $27,000 share of profits

• If Bill is a C corporation shareholder instead, his stock

• Distributions can be made to partners, LLC owners, or S

corp shareholders tax-free

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

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

• 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

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

• 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

• 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

• 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 Distribution of Assets to Owner Followed

by Owner’s Sale to Third Party (slide 1 of 3)

• Partnership

– Distribution rules determine partner’s basis in

assets received from partnership

– 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

• Limited Liability Company – Same as above.

Liquidating Distribution of Assets to Owner Followed

by Owner’s Sale to Third Party (slide 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 Distribution of Assets to Owner Followed

by Owner’s Sale to Third Party (slide 3 of 3)

• C Corp

– 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

• The purchaser of individual assets is not generally affected

by the type of entity through which the seller operates:

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

• 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 Business Interest—Seller’s Issues

(slide 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 Business Interest—Seller’s Issues

(slide 2 of 3)

• S Corp

– Sale treated as sale of stock

• Results in capital gain or loss to shareholder

• However, if purchaser is not qualified shareholder,

S election is automatically terminated

Sale of Business Interest—

• C Corp

– Sale treated as sale of stock

• Results in capital gain or loss to shareholder

Purchase of Business Interest—Buyer’s

• 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 Business Interest—Buyer’s

• Partnership

– Purchaser buys partnership interest

election to step up inside basis in assets

Purchase of Business Interest—Buyer’s

• S Corp or C Corp

– There is no effect on underlying assets owned by

the entity

Refocus On The Big Picture (slide 1 of 6)

• Conducting their business as a C corp, an S corp, or an

LLC would meet Bill and George’s objectives of providing limited liability

• From a tax perspective, both the S corp and the LLC

would allow the early-year losses to be passed through to the owners

• The losses are trapped until future years when the

company is profitable

• Once the entity turns profitable, the tax consequences are

as follows.

Refocus On The Big Picture (slide 2 of 6)

• As a C corp, the entity would pay income tax of $61,250 on

taxable earnings of $200,000

– If the after-tax earnings of $138,750 are distributed

equally to Bill and George, they would

• Each receive a taxable dividend of $69,375,

• Each pay an additional income tax of $10,406 ($69,375

x 15%)

• The combined entity/owner tax liability is $82,062,

resulting in after-tax cash flows of $117,938

Refocus On The Big Picture (slide 3 of 6)

• If the entity is operated as an S corp or

an LLC, no tax is paid at the entity level.

• The entire $200,000 is taxed as ordinary

income at the owner level.

income tax

• The combined entity/owner tax liability

is $56,000, resulting in after-tax cash

flows of $144,000.

Refocus On The Big Picture (slide 4 of 6)

• Both the S corp and the LLC meet Bill and George’s

objectives of having limited liability and minimizing tax liability

• An LLC need not satisfy the numerous requirements to

elect and maintain S corporation status

– However, based on the facts in this situation, it is

unlikely that satisfying the requirements would create any difficulty for Bill and George.

Refocus On The Big Picture (slide 5 of 6)

• The results of George’s investing in a limited

partnership appear in Example 2.

– While beneficial tax results are expected to occur, George

needs to be aware of the economic risk of losing his

$10,000 investment

• For Bill, the recognized gain on the sale of his

investment in the retail coffee franchise outlet is dependent on the entity form

– If Bill uses a pass-through entity, the recognized gain

differs from that if the entity were a C corporation:

• Entity profits increase the owner’s interest basis in a pass-through entity,

• Entity profits have no effect on a shareholder’s basis in C corporation stock.

Refocus On The Big Picture (slide 6 of 6)

What If?

• What if Bill and George decide to expand the business and

reinvest the annual $200,000 before-tax earnings instead of paying out dividends to the owners?

• If the business is a C corp, it can accumulate the earnings

—as long as the company has reasonable business needs— and avoid the additional tax paid on dividend distributions.

– Although the entity-level tax of $61,250 must still be paid, after-tax cash flows increase to $138,750

• While the S corp or LLC with after-tax cash flows of

$144,000 still would be preferred, the double tax problem

of the C corp can be minimized with effective planning.

Tax Attributes of Different

# Owners Rate Paid By

(or LLC)

tax)

Tax Attributes of Different

# Owners Rate Paid By .

C Corp No max limit 35% corporate Corporation

(some States level plus pays first,

least two on qualifying pays if

Tax Attributes of Different

Tax Year Timing of Income Allowed Taxation Allocation .

yr end (1 owner)

Partnership Majority or End of p/ship Profit/loss

Ptrs or “least Some special

deferral” year

Tax Attributes of Different

Allowed Taxation Allocation

S Corp Calendar year or End of Corp Per share, business purpose tax year per day

C Corp No restrictions Corp reports at N/A

(generally) end of tax yr;

Shareholder reports dividends received

Tax Attributes of Different

Contribution of Character of Income Property to Entity Taxed to Owners .

characteristics

Partnership Generally not Conduit-retains

characteristics

Tax Attributes of Different

Contribution of Character of Income Property to Entity Taxed to Owners

S Corp Taxable unless Conduit-retains source