CHAPTER15. Business Planning Choice of Entity. Learning Objectives. 15,001 Introduction

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1 CHAPTER15 Business Planning Choice of Entity Learning Objectives 1. Define a business entity, and distinguish taxable, conduit, and not-for-profit entities. 2. Explain the check the box regulations as they relate to the choice of entity decision. 3. Compare the payroll tax computations and tax payment procedures for a selfemployed individual and a corporate entity. 4. Distinguish the major tax and nontax advantages and disadvantages of the soleproprietorship as a business entity. 5. Distinguish the major tax and nontax advantages and disadvantages of the partnership as a business entity. 6. Describe the major characteristics of a limited liability company (LLC) and a limited liability partnership (LLP). 7. Distinguish the major tax and nontax advantages and disadvantages of the S corporation as a business entity. 8. Distinguish the major tax and nontax advantages and disadvantages of the regular C corporation as a business entity. 9. Explain the concept of double taxation as it relates to (1) corporate distributions and (2) corporate liquidations. 15,001 Introduction The choice of entity decision is one of the most important decisions facing tax professionals and their clients who own and operate businesses. There are several forms to choose from, each of which generates different legal and tax consequences. There is no

2 15 2 Contemporary Tax Practice: Research, Planning & Strategies single form of entity that is appropriate for every type of business owner or entity that a practitioner is likely to encounter. Choosing the appropriate form of entity in which to operate is a complex decision. It depends upon many non-tax factors, including the owners needs and desires and the particular characteristics and needs of the business in question. The federal tax consequences of each type of entity also play an important role, especially in closely held entities where the parties combined tax liabilities should be analyzed as part of the decision-making process. The purpose of this chapter is to review the key tax and non-tax factors involved in the choice of business entity. The major entity types reviewed are the sole proprietorship, the partnership (with special emphasis on limited liability entities), the S corporation, and the regular C corporation. A comprehensive case study is used to demonstrate the tax regime of each legal entity by using the same set of case facts. The discussion of each entity also includes a summary of the key non-tax factors that should be considered for each type of entity. The chapter concludes with an examination of the tax consequences associated with a disposition of each entity type; this analysis extends the case study for several years into the future and assumes a sale of the business entity five years after formation. 15,003 Business Entities: An Introduction.01 BUSINESS ENTITY DEFINED A business entity carries on a trade or business. In order to do that, it must have: one or more associates, assets, and engage in some business activity. In R.P. Groetzinger, the U.S. Supreme Court noted the Code s common-sense concept of what constitutes a trade or business, noting that all the facts of a particular situation must be examined. 1 Under Groetzinger, a taxpayer is engaged in a trade or business if the taxpayer is involved in the activity (1) with continuity and regularity, and (2) with the primary purpose of making income or a profit. A sporadic activity, a hobby, or an amusement diversion does not qualify as a business. Taxpayers who pursue an activity full-time, in good faith and with regularity, that produces income and that is not merely a hobby, are engaged in a trade or business..03 TYPES OF BUSINESS ENTITIES One of the first decisions a business owner must make in setting up a business is the legal or tax entity to operate the business enterprise (the atom or unit of taxability). This is an important decision that affects the tax treatment given to subsequent business transactions. The entity is responsible for keeping separate records and reporting the results of operations to the taxing authority. Under the current U.S. taxation system, an entity can be classified as taxable, conduit, or tax-exempt. Taxable entities are liable for the payment of tax on income. A taxable entity is any person as defined in Code Sec. 7701(a). Taxable business entities include the individual (doing business as a sole proprietorship), the regular C corporation, and some estates and trusts. We will limit our discussion of taxable business entities to individuals and corporations since these two are the dominant business entities. Conduit entities are nontaxable reporting entities. All conduit entities are owned by one or more taxable entities. The income, deductions, losses, credits, and other tax attributes of conduit entities flow through to the tax returns of its owners. The two principal conduit entities are: the S corporation and the partnership. Both of these types of entities are examined in this chapter. 1 Groetzinger, SCt, 87-1 USTC 9191, 480 US 23, 107 SCt ,003.01

3 Business Planning Choice of Entity 15 3 Not-For-Profit (NFP) entities are nontaxable reporting entities that have been organized to carry on a tax-exempt purpose. An NFP entity must apply for and receive tax-exempt status from the IRS. Most churches and civic associations are organized as NFPs. Many organizations organized for educational, scientific, or literary purposes apply for and are granted tax-exempt status. Some NFP entities also qualify as charitable organizations under Code Sec. 501(c)(3) so that donations to these organizations may be deductible as a charitable contribution. While NFP entities are occasionally taxed on their unrelated business income under the Unrelated Business Income Tax (UBIT), the taxation of NFPs is beyond the scope of this chapter and will not be discussed further. Refer to Chapter 8 for a brief introduction to tax-exempt entities and the UBIT in the discussion of U.S. vs. American College of Physicians. 2 Taxable Entities: A Few Statistics Based on IRS data, over 20 million businesses generate almost $13 trillion annually and report profits in excess of $500 billion. The most popular form of doing business is the sole proprietorship, followed by the regular C corporation, the S corporation, and lastly the partnership. As Limited Liability Companies (LLCs) become more popular, the number of partnerships is likely to surpass the S corporations. TYPE OF BUSINESS ENTITIES 12% 9% 7% 72% Sole Proprietorships C Corporations S Corporations Partnerships While sole proprietorships dominate the number of business entities, over one-half of the net business income is reported by regular C corporations, followed by partnerships, sole proprietorships, and lastly S corporations. Approximately four million corporate tax returns are filed annually, including over 1.7 million S corporations. Fewer than 67,000 consolidated returns are filed. Collectively, corporations own approximately $20 trillion in assets, generate almost $12 trillion in revenues and pay over $130 billion in federal income tax a year. 2 American College of Physicians, 86-1 USTC 9339, 475 US 834, 106 SCt ,003.03

4 15 4 Contemporary Tax Practice: Research, Planning & Strategies NET INCOME 14% 22% 12% 52% C Corporations Partnerships Sole Proprietorships S Corporations There are approximately 1.5 million partnerships in the United States. Over 80 percent are general partnerships and fewer than 20 percent are limited partnerships. The real estate industry dominates all industrial groups. Over 62 percent of the limited partnerships are real estate partnerships, and over 40 percent of the general partnership returns are real estate partnerships. Between 1980 and 2000, the number of businesses grew at an annualized rate of just under four percent. The largest annual growth rate occurred in the Communication industry (11 percent). However, the largest annual growth rates in net income occurred in the Finance and Banking industry (25 percent) as banks recovered from the Savings and Loan crisis. While the number of businesses in the Real Estate industry grew by over 2 percent, net income fell over 27 percent. The number of corporations has increased steadily over the past 10 years. However, the growth in S corporations has outpaced the growth of regular C corporations since This is attributed to significant tax law changes enacted by the Tax Reform Act of 1986 which taxed corporations less favorably than individuals. Recall that both S corporation and partnership income are taxed on the individual tax return. When the top corporate marginal tax rate is higher than the top individual rate, shifting of income from the corporate to the individual tax return will occur as taxpayers seek to minimize their total tax liabilities by shifting income between related entities. TYPES OF CORPORATIONS 37% S Corporations C Corporations 63% 15,003.03

5 Business Planning Choice of Entity ,005 Importance of the Choice of Entity Decision.01 TAX ENTITY POSSIBILITIES When a trade or business will be operated in a form other than the sole proprietorship, such as when there are two or more owners, the choice of entity decision requires a comparative assessment of these forms of business entities: Regular or C corporation; S corporation; Limited liability company; and General or limited partnership. Performing this assessment requires an understanding of not only the major tax and non-tax aspects of each form of business, but also of how the comparative advantages and disadvantages of each relate to the needs of a specific client. Often, the decision revolves around two basic questions: 1. To what extent do the owners want to limit their personal liability for the debts and liabilities of the business? 2. Do the owners want the business to be taxed as a separate legal entity, or do they want the items of income, deduction, loss, and credit to "pass through" to them? The following discussion examines the formation, operation, and liquidation of the four basic tax entities: sole proprietorship, partnership, S corporation, and C corporation. In general, limited liability companies and limited partnerships are taxed the same as regular partnerships, although a few differences exist. The limited liability company and limited liability partnership possibilities are discussed after the four basic forms..03 CHOICE OF ENTITY: THE CHECK THE BOX REGULATIONS Prior to 1997, there was much confusion as to the circumstances that would cause an entity to be classified as a corporation. A four-factor test was often used by the IRS, and controversies inevitably arose. This procedure was greatly simplified by the check the box regulations issued by the IRS in Under these rules, if an entity is a separate entity (carrying on an active business) and is an eligible entity (certain special company statuses, such as insurance companies, banks, and joint-stock companies do not qualify), the business may choose its status under these rules: If two or more owners. The entity may elect to be a corporation or a partnership. If one owner. The entity may elect to be a corporation or elect to disregard the entity (i.e., elect to be treated as a sole proprietor). If no election is made, the default election is specified in the Regulations as the entity offering the best federal income tax treatment. Thus, the default election for an entity with two or more owners is a partnership, and for one owner is a proprietorship..05 PAYROLL TAXES: AN IMPORTANT FACTOR IN ENTITY CHOICE Before examining the income tax regimes of each entity, it is important to understand how payroll tax obligations are met for each type of entity. For this reason, Figures 1 and 2 provide a review of the basic rules for the FICA taxes of employees and the selfemployed taxes of sole proprietors and general partners. In addition to these obligations for Social Security and Medicare taxes, an employer with more than one employee must also pay taxes under federal and state unemployment tax acts (usually refereed to as FUTA and SUTA taxes, respectively). This tax is imposed on the employer, and applies to the first $7,000 of wages earned by an employee during 15,005.05

6 15 6 Contemporary Tax Practice: Research, Planning & Strategies the year. Technically, the FUTA rate is 6.2 percent, but this can be reduced to.8 percent with a credit of up to 5.4 percent for state tax experience. For simplicity, the following discussion will assume that the employer pays a full 6.2-percent tax in combined FUTA and SUTA taxes on the first $7,000 of income earned by each employee. Note that in some entities, owners are not employees and in other entities they are employees. Figure 1 FICA Tax and the Self-Employment Tax FICA Tax Liability: The FICA tax liability is shared equally by the employer and the employee. The tax is composed of the following two components and rates: Social Security Tax: 6.2 percent on the first $102,000 of wages in 2008 Medicare Tax: 1.45 percent on all wages without limit Since both employer and the employee pay the tax, the total tax collected will be at a 12.4-percent rate for the Social Security tax (6.2% 2) and a 2.9-percent rate for the Medicare tax (1.45% 2). Example Tad Was, an employee of Wake Corporation, was paid a salary of $50,000 in The FICA taxes payable by Wake and Tad in 2008 are as follows: SS tax withheld from Tad s salary ($50, ) $ 3,100 MC tax withheld from Tad s salary ($50, ) 725 SS tax paid (matched) by Wake Corporation ($50, ) 3,100 * MC tax paid (matched) by Wake Corporation ($50, ) 725 * Total FICA taxes due $ 7,650 * Deductible as expenses by Wake Corporation Note that as long as the employee s salary is less than the FICA social security maximum for the year ($102,000 in 2008), both the employer and the employee will pay in a 7.65-percent share to the government (6.2% %), resulting in 15.3 percent (7.65% 2) of the gross salary being paid as FICA taxes. Example Assume the same facts as Example 15-1, except that Tad was paid a salary of $120,000 in The FICA taxes payable in 2008 is as follows: SS tax withheld from Tad s salary ($102, ) $ 6,324 MC tax withheld from Tad s salary ($120, ) 1,740 SS tax paid (matched) by Wake Corporation ($102, ) 6,324 * MC tax paid (matched) by Wake Corporation ($120, ) 1,740 * Total FICA taxes due $16,128 * Deductible as expenses by Wake Corporation 15,005.05

7 Business Planning Choice of Entity 15 7 Figure 2 Self-Employment Tax Liability Self-employed individuals and general partners do not have an employer to withhold FICA taxes; thus, self-employed individuals must compute and pay their selfemployment tax liabilities when filing their individual tax returns. The computation is made on Schedule SE, and the tax is added to the regular income tax liability. The self-employed individual must pay both the Social Security and Medicare portions, and the same FICA ceiling of $102,000 applies in In order to provide approximately the same tax relief to self-employed individuals as corporations (who can deduct the 7.65-percent total share of FICA taxes that they pay), Congress enacted two special benefits: (1) self-employment income may be reduced by 7.65 percent (or, stated differently, only percent of the self-employment income is subject to the tax), and (2) in computing the regular income tax liability, a self-employed person may deduct one-half of the self-employment tax liability as a deduction for adjusted gross income. Thus, the self-employment tax in 2008 has two components: Social Security Tax: [Lesser of (a) $102,000 or (b) (SE income.9235)].124 Medicare Tax: SE income Example Tad Was is self-employed in 2008, and his Schedule C discloses $50,000 of self-employed income. His self-employment tax liability is as follows: SS portion: ($50, ).124 $ 5,726 MC portion: ($50, ).029 1,339 Total SE tax (added to income tax liability) $ 7,065 * * One-half of this amount, or $3,533, is deductible for AGI for income tax purposes. Example Assume the same facts as Example 15-3, except that Tad s 2008 selfemployment income is $120,000. His self-employment tax liability is as follows: SS portion: $102, $12,648 MC portion: ($120, ).029 3,214 Total SE tax (added to income tax liability) $15,862 * * One-half of this amount, or $7,931, is deductible for AGI for income tax purposes. If the self-employed individual also has salary from another source that was subject to FICA taxes, the $102,000 SS tax ceiling for purposes of the SE tax is reduced accordingly. For example, if Tad in Example 15-4 above also received $40,000 salary from another job, only $62,000 ($102,000 $40,000) would be subject to the SS tax. Case Study for Comparing the Tax Characteristics of Entities Appendix B-1 presents a Case Study for taxpayers Dave and Ellen Davidson, illustrating the appropriate tax computations for the same set of facts assuming four different entities: sole proprietorships, partnerships, S corporations and C corporations, each of which is discussed below. In the following discussion, this same set of facts will be recast according to the tax regimes of the particular entity being discussed. The reader should pay particular attention to the tax treatment (if any) of the $30,000 other payments to the owner in each case. 15,005.05

8 15 8 Contemporary Tax Practice: Research, Planning & Strategies In order to make the results roughly comparable, certain simplifying assumptions are made. For example, in the case of the partnership, an assumption is made that Dave Davidson is a 99.9-percent owner, with his wife Ellen owning the other.1 percent. And in the case of the S corporation and C corporation, an assumption is made that Dave is a 100-percent owner. Although the near 100-percent partnership ownership assumption may be somewhat unrealistic, it does provide a point of reference for comparisons to the other taxable entities. OBSERVATION Actually, the assumption that Ellen has a small partnership interest may be a realistic one (assuming that she contributed property or services for such interest). If her interest is limited, then her share of the income would not be subject to self-employment taxes and some tax savings would be generated. As discussed below, a limited partner is prohibited from participating in the affairs of the partnership, and thus does not have self-employment income. The next sections of the chapter examine the non-tax and tax characteristics of the four major types of tax entities. The discussion for each entity concludes with an examination of the computed tax results for that type of entity as based on the facts of the Case Study. The following factors are discussed for each type of entity: Formation of the entity Ability to raise capital Liability issues The tax regime Payroll taxes of the owner Payments to the owner Liquidation of the entity 15,007 The Sole Proprietorship as a Business Entity The sole proprietorship is the most common type of business entity in the United States. It also is the simplest to organize and to discontinue. No legal formalities are needed because the business and the individual are treated as one entity under tax law. The business owner has total control over all decisions. A sole proprietorship involves a lot less paperwork and expense in starting up the business; obtaining a license from the local government may be all that is required..01 FORMATION OF THE SOLE PROPRIETORSHIP The formation of a sole proprietorship is not a taxable event, as the sole proprietorship entity is not distinguishable from the sole proprietor for tax purposes. The sole proprietor merely acquires assets and starts business; no formal transfer is required. If the sole proprietor uses assets that he or she already owns, then his or her adjusted basis in those assets carries over to the proprietorship. OBSERVATION If the property is a depreciable asset, the adjusted basis for depreciation is the lesser of adjusted basis or fair market value on the date of the conversion to business use. This prevents an indirect deduction (through depreciation) for a decline in value that occurred when the property was held for personal use. 15,007

9 Business Planning Choice of Entity ABILITY TO RAISE CAPITAL Of all the possible tax entities, the sole proprietor may have the most difficult time in raising capital. A sole proprietor will have unlimited liability, as the business and the business owner are indistinguishable in this environment. The proprietor may be able to acquire some properties with non-recourse financing, but that will not normally be the case..05 LIABILITY ISSUES OF A SOLE PROPRIETORSHIP One of the major disadvantages of the proprietorship is the unlimited liability of the owner. Creditors of the business may attach the owner s personal assets since the owner is personally liable for the debts and liabilities of the business. However, this disadvantage can be overcome by electing single member LLC status, as discussed later..07 OPERATING A SOLE PROPRIETORSHIP: THE TAX REGIME Sole proprietors are responsible for tax on the net income from self-employment. A sole proprietorship business is not a separate taxable entity; rather, the business income and expenses of the entity are reported on the sole proprietor s individual income tax return on Form 1040, Schedule C, which in effect serves as a tax income statement for the sole proprietor. Since the self-employment income relates solely to business operating income and expenses, items such as capital gains and losses, dividend income, interest income, and charitable contributions deductions are never reported on Schedule C, even though such items may be run through the business checking accounts. The tax law does not distinguish the sole proprietor from the individual, and personal items such as charitable contributions should not be reported as a business expense..09 PAYROLL TAXES OF THE OWNER The net income on Schedule C is treated as self-employment income, and the tax on this income is computed on Form 1040, Schedule SE. As mentioned earlier, one-half of this amount is deductible for adjusted gross income by the self-employed individual..11 PAYMENTS TO THE OWNER Although sole proprietorships can hire employees and pay and deduct fringe benefits as proprietorship expenses, the owners cannot deduct any salary paid to themselves. Sole proprietors are allowed to withdraw cash from the business without tax, as though they were removing it from their own pockets. Sole proprietors can have retirement plans and may deduct wages or salary paid to a spouse or child, provided the family member actually works in the trade or business. There are no tax-free fringe benefits available to a sole proprietor, since he or she is an owner of the business and not an employee of the business..13 LIQUIDATION OF THE SOLE PROPRIETORSHIP If the sole proprietor decides to liquidate the business, generally there are no tax consequences unless some of the proprietorship assets are sold. If assets are sold, gain or loss must be computed on each separate asset, and the character of the gain or loss on such sale depends on the type of asset (e.g., ordinary income for inventory and depreciation recapture, Code Sec gain or loss for properties used in the business and held longer than one year, and capital gain or loss for investment properties). At most, there is a single layer of taxation at the individual level only. On the other hand, if the proprietor merely keeps all the assets used in the proprietorship, there is no gain or loss on this cessation of business; gain or loss would occur only if the sole proprietor sells the assets. 15,007.13

10 15 10 Contemporary Tax Practice: Research, Planning & Strategies Case Study: The Sole Proprietorship (Appendix B-2) In a sole proprietorship, the owner and the business are treated as one tax entity. The Schedule C net income includes only operating income and expenses; other business items such as dividend income, capital gains and losses on business investments, and charitable contributions are treated as items of an individual taxpayer and are not reflected on Schedule C. The reasonable salary withdrawn by Dave Davidson is not a business expense, but is merely treated as a nontaxable owner withdrawal (as is the $30,000 other payment ). Likewise, Dave is not an employee for purposes of employment taxes; instead, Dave must pay self-employment taxes. As a sole proprietor, Dave is able to deduct one-half of the self-employment tax and 100 percent of health insurance premiums for adjusted gross income. Finally, Dave may establish a SEP-IRA retirement plan and deduct contributions on his own behalf for AGI each year. 15,009 The Partnership as a Business Entity When two or more tax entities join together to operate a business for profit, they become partners. Although a partnership is an aggregate of other associates, it has a definite legal status and is treated as an entity separate from its partners under local law. A partnership is defined as a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation, or a trust or estate. An entity may be a partnership for federal tax purposes but not for state law purposes. A joint undertaking to share expenses is not necessarily a partnership for federal tax purposes. It is possible to co-own property and not be taxed as a partnership if no services are provided. For example, assume that two tenants in common of farm property lease it to a farmer for a cash rental or a share of the crops. Have they created a partnership? There is a distinction between co-ownership of improved realty and a partnership. Customary tenant services such as heat, air conditioning, hot and cold water, unattended parking, normal repairs, trash removal, and cleaning of public areas can be provided by two or more co-owners without them necessarily becoming partners. However, the furnishing of additional services such as attendant parking, cabanas, and gas, electricity, and other utilities by the owners will result in a finding of a partnership relationship whether these services are provided directly or through an agent. In many cases, it will make no difference whether persons are partners or not. If two persons share equally in the profits of a venture, each will be taxed on his or her share whether he or she is a partner or co-owner. It may, however, be beneficial for the parties to be taxed as a partnership. A partnership allows gains and losses to be specially allocated among partners. If there is only an employer-employee or creditor-debtor relationship, the employee or creditor is generally not allowed a deduction for any loss. The associates in a limited partnership include one or more general partners who are responsible for the ongoing operations of the business and at least one limited partner, who is only an investor and does not participate in management. As explained below, only the general partner(s) are fully liable for the debts of the partnership. In exchange for giving up the right to direct partnership activities, the limited partner s liability for partnership debts is limited to what that partner has invested in the partnership. The limited partnership has been a popular choice for investors in risky activities, such as real estate, oil and gas exploration, and mining. 15,009

11 Business Planning Choice of Entity FORMATION OF THE PARTNERSHIP Generally, Code Sec. 721 provides that no gain or loss is recognized when a partner transfers property to a partnership in return for an interest in the partnership. Unlike the tax treatment of corporate formations under Code Sec. 351 discussed below, there is no 80-percent ownership requirement for nontaxable treatment to apply to the contribution. The contributing partner s adjusted basis in the partnership interest is simply a carryover of the basis in the property transferred. This amount is also the basis of the property to the partnership. Example Sue Mason exchanges land ($20,000 adjusted basis, $30,000 fair market value) for a one-third interest in MNO Partnership worth $30,000. Sue has a realized accounting gain of $10,000, but since no liabilities are involved in the transfer, Sue has no taxable gain or loss on the contribution, and her basis in the partnership interest is $20,000. The partnership s basis in the property received is also $20,000. An exception to nontaxable treatment occurs in some cases when the partnership assumes liabilities on the property transferred. Specifically, if the share of the liabilities assumed by the other partners exceeds the basis of the property contributed, the contributing partner is taxed on the excess as boot received. This prevents a negative basis in the new partner s interest, which becomes $0 after the gain is recognized. Example Assume the same facts, except that the land is subject to a $36,000 liability which is assumed by MNO Partnership. In this case, Sue is being relieved of $24,000 liabilities ($36,000 ² ³, the amount assumed by N and O). Sue, as a one-third partner, is still liable for the remaining $12,000 of liabilities. Since the $24,000 liabilities assumed by N and O exceed Sue s $20,000 basis in the property, she must report a gain of $4,000. Her basis in her partnership interest will be $0 ($20,000 basis of property contributed + $4,000 gain recognized $24,000 boot received with liabilities assumed by other partners). The partnership s basis in the property will be $24,000. OBSERVATION Even though a contributing partner is not taxed on the appreciation in value of contributed property, Code Sec. 704(c) requires mandatory allocation of that built-in gain to the contributing partner on a later sale of the property by the partnership..03 ABILITY TO RAISE CAPITAL The unlimited liability aspect of a partnership interest may make it difficult for the partnership to raise capital. However, unlimited liability applies only to general partners, so the partnership may be able to raise additional funds by selling a few limited partnership interests. Although limited liability is assured with such interests, such a restriction prevents the limited partner from taking an active role in the business..05 LIABILITY ISSUES AS A PARTNERSHIP A major disadvantage of a general partnership is that the partners are jointly liable for the partnership s debt. This is not always a problem since personal liability may be mitigated by insurance or other means. However, when the liability of partners for the debts of the partnership is a problem, a limited partnership may be a solution, but at a cost. Limited partners are generally not liable for debts of the partnership, but they must restrict participation in management of the partnership or risk loss of limited liability. 15,009.05

12 15 12 Contemporary Tax Practice: Research, Planning & Strategies A limited partnership requires at least one general partner. Use of a corporate general partner provides a solution to these problems, but it also introduces complexity..07 OPERATING A PARTNERSHIP: THE TAX REGIME Partners in a partnership are not employees of the partnership; thus, they do not qualify for any of the special fringe benefit rules (described below) that may be available to employees of C corporations. The partnership offers the principal tax advantage of being a conduit. Profits and losses of the partnership are not taxed at the entity level, although such amounts are reported to the IRS on Form 1065; rather, such items flow through to the individual owners, and only a single level of tax is paid. Each partner includes in income his or her share of (1) guaranteed payments (payments such as salary that are guaranteed without reference to the profitability of the partnership) and (2) the partnership s ordinary income or loss (after deducting any guaranteed payments as salary expenses). These amounts are identified on a Schedule K-1 that is furnished to each partner to disclose his or her share of the various partnership items. The totals of the K-1s must match the Schedule K that is part of the partnership tax return, Form Any guaranteed payments are deducted in determining partnership ordinary income and then allocated directly to the partner receiving them. The partnership s ordinary income includes only those items of income and expense that could not vary in treatment across the individual partner s tax returns (i.e., sales revenue, cost of goods sold, advertising expense, etc.). Items that could vary across the tax returns are reported separately on Schedule K-1 as specially allocated items ; these include such items as capital gains and losses and contribution expenses. See Figure 3 for an explanation of ordinary income and specially allocated items. Non-guaranteed payments, such as withdrawals, are generally nontaxable distributions. Example During the current year, XY Partnership (owned equally by X and Y) had $150,000 ordinary business revenues, a $2,000 capital gain, $70,000 ordinary business expenses, and a $10,000 charitable deduction. In addition, XY made a guaranteed salary payment of $30,000 to X, and each partner withdrew $10,000 of non-guaranteed payments. The ordinary income of the partnership is $50,000 ($150,000 $70,000 30,000), and each partner will report half of this amount, or $25,000, as income on his or her individual tax return. In addition, X must also report the $30,000 guaranteed payment as income. Each partner will also report one-half of the capital gain and one-half of the charitable contributions on their individual returns as separately reported items (from the K-1). This is because these two items can vary in treatment on the individual partner s return. Finally, as explained below, the $10,000 withdrawals by each partner are ignored for tax purposes, since these payments were not guaranteed. Partnerships also offer the advantage of passing any losses through to the owners for immediate tax benefits. As explained below, this is not the case with a C corporation, where such losses stay in the separate corporate legal entity and can be used only as net operating loss carryovers. A major advantage of a partnership is that it can specially allocate items of income, deductions, and losses among partners non-pro rata. A contributor of money or property to a partnership can be allocated a disproportionate amount of the losses that the contribution has financed. However, the allocation must have substantial economic effect in order for it to be respected for tax purposes. 15,009.07

13 Business Planning Choice of Entity Figure 3 Treatment of Specially Allocated Items for Flow-Through Entities Partnership (or S corporation) items of income and expense that could never vary in treatment on the individual owners tax returns are included as part of the ordinary income divided among the partners. An example of ordinary income would be sales revenue (always taxable) or advertising expense (always deductible). On the other hand, items that may end up being treated differently by partners (or S shareholders) are not part of ordinary income, but instead are allocated separately to each partner. Three such items are capital losses, charitable deductions, and dividend income. The rationale for each may be explained in terms of the following examples involving two equal partners in the AB Partnership. Capital Losses Tax Treatment. Capital losses may be deducted against any capital gains, and up to $3,000 of such losses may be offset against ordinary income (e.g., non-capital gains income) in a tax year. Example Partner A has $6,000 capital gains during the year, and Partner B has no capital gains. If the ABC Partnership has $10,000 capital losses during the year, Partner A may deduct her entire $5,000 share against the $6,000 of capital gains; however, Partner B may only deduct $3,000 of his $5,000 share against ordinary income. Since the capital losses can be treated differently across each partner s return, the losses must be reported as separately stated items. Charitable Contributions Tax Treatment. Contributions to recognized charities are itemized deductions, limited in total in any one year to 50 percent of the taxpayer s adjusted gross income (AGI). Example Partners A and B each have $60,000 AGI for the year. Partner A s charitable contributions for the year total $22,000, and Partner B s contributions total $29,000. If the AB Partnership has charitable contributions of $10,000 during the year, Partner A can deduct her full $5,000 share (since total contributions of $27,000 are less than 50 percent of AGI). On the other hand, Partner B can deduct only $1,000 of his $5,000 share, since his overall deduction is limited to $30,000 (50 percent of AGI). Since the charitable contributions can be treated differently across each partner s return, the contributions must be reported as separately stated items. Dividend Income Tax Treatment. Included in gross income and included in the definition of investment income that forms the upper limit on the amount of investment interest expense deductible in one year. Example Partner A has no investment income or expenses during the year, while Partner B has $40,000 investment income and $48,000 investment interest expense (thus limiting Partner B s investment interest deduction to $8,000 this year). If the AB partnership has $20,000 dividends during the year, Partner A will simply increase her gross income by $10,000. However, Partner B can increase gross income by $10,000 and at the same time deduct $8,000 more investment interest expense, since the $10,000 is included in investment income. If the dividends were buried in partnership ordinary income, this would not be possible; they must be separately stated. 15,009.07

14 15 14 Contemporary Tax Practice: Research, Planning & Strategies One unique aspect of a partnership interest is that the adjusted basis of such interest includes the partner s share of any partnership liabilities. This adjustment is made because the partner is liable for his or her share of partnership liabilities, and is thus permitted to include this in basis. This in turn increases the potential loss deduction of a partner. Appendix B-3 recasts the facts of the Davidson Case Study in the form of a partnership entity. Once again, a simplifying assumption is made that Dave is a 99.9-percent partner (and Ellen owns the other.1 percent), so in effect all items of income and expense are allocated to Dave. This produces results that may be compared with the other types of entities. Note specifically in Appendix B-3 the treatment of the dividends, capital gains, and contributions from the business. These items, though related to the business entity, must be reported as separately stated items, for the reasons explained earlier. And even though these items are from the business, they flow through to the Davidsons Form 1040 as separately stated items that are not included in the ordinary partnership income that is reported on Schedule E of Form PARTNERSHIP: PAYROLL TAXES OF THE OWNER General partners must pay self-employment taxes on their share of the ordinary income of the partnership, as well as any guaranteed payment received. Limited partners are not required to pay self-employment tax on their share of the ordinary income of the partnership, since by definition they cannot be active in the day to day management of the entity..11 NONLIQUIDATING CASH DISTRIBUTIONS TO THE OWNER As a general rule, as long as nonliquidating cash distributions to a partner are less than the partner s basis in the partnership interest, no gain or loss is recognized. If the distributions do exceed basis, the gain is usually capital gain unless the partnership has certain Code Sec. 751 recapture properties known as hot assets. With this exception, nonliquidating distributions are not income, since the net income of the partnership is reported when it is earned and not when it is distributed. Income shares increase a partner s adjusted basis in the interest, and distributions decrease that basis..13 LIQUIDATION OF THE PARTNERSHIP A partnership may be liquidated by either distributing the partnership assets directly to the partners or by first selling the assets and then distributing the cash to the partners. In either case, there is a single layer of tax, recognized at the partner level. If the partnership distributes the assets directly to the partners, gain is recognized only to the extent that money (e.g., cash and marketable securities) distributed exceed the partner s basis in the partnership interest. If the money received is less than basis, the money reduces basis dollar for dollar, then basis is allocated first to unrealized receivables and inventory, and then any remaining assets received. Although gain is not recognized, it may be postponed because the basis allocation to some properties may be lower than the partnership relative basis. If the partner receives cash from the partnership exceeding basis, then the excess is taxed as capital gain in most cases (subject to the existence of hot assets ). But recall that if the partnership sold the assets first at a gain and then distributed the cash to the partners, the partners would not likely recognize gain because the gain on the sale by the partnership is taxed to the partners, which increases their adjusted bases in the partnership interests. Finally, a retiring partner may be required to report some payments as ordinary income if such payments are for other than the partner s relative interest in partnership properties. These above-market payments are treated like compensation. 15,009.09

15 Business Planning Choice of Entity Case Study: The Partnership (Appendix B-3) When assuming that Dave Davidson is essentially a 100-percent partner, the total tax liabilities under the sole proprietorship and partnership entities are the same. This is because all business items flow through to the individual return and retain their character. Items included in the computation of partnership ordinary income are those items of operating income and expense that cannot vary in treatment across the individual partners returns. The $55,000 reasonable salary, the $3,000 health insurance premium payment, and the $5,500 contribution to the SEP-IRA by the Partnership on Dave s behalf are all treated as guaranteed payments and are deducted in determining partnership ordinary income. The dividend income, the capital loss on the sale of the business investment, and the partnership charitable contributions are all reported as separate items. Dave, a general partner, is subject to the self-employment tax liability. 15,011 The S Corporation as a Business Entity An S corporation is a special-status corporation for tax purposes, in that it is essentially treated as a partnership for federal tax purposes (a conduit, thus avoiding the double taxation problem of a C corporation). But since the entity is a corporation in all other respects, the entity offers limited liability for its owners. The Internal Revenue Code specifies a number of requirements for electing S status. For example, an S corporation may have no more than 100 shareholders; for these purposes, certain family members are counted as one shareholder. An S corporation may generally also have only one class of outstanding stock. S status must be affirmatively elected by all shareholders in order to be valid. An S corporation gives shareholders the benefits of a pass-through entity for tax purposes (earnings are taxed only once) and the corporate advantage of limited liability. Although publicly held corporations cannot qualify for a Subchapter S election, there are no limits with regard to the size of an eligible corporation. Thus, very large closely held corporations may qualify as S corporations. An S corporation is created under state law in the same manner as a regular or C corporation. A corporation qualifies as an S corporation if a valid election (Form 2553) is filed with the IRS. This election may be made during the year in which it is to become effective, but must be made on or before the fifteenth day of the third month of such year (e.g., March 15, for calendar year corporations that were in existence on January 1). Alternatively, the election may be made during the year preceding the year for which it is to be effective. All current shareholders and the corporation itself must consent to the election. If the election is filed during the taxable year for which it is to become effective, any persons who are not currently shareholders, but who owned stock during that year, must also consent to the election..01 FORMATION OF THE S CORPORATION When an S corporation is formed, it is treated as a regular corporation and is thus subject to the special rules of the Internal Revenue Code and state law. As a separate business entity, corporations must follow certain business formalities when forming; these include articles of incorporation, bylaws, and electing directors. This can be quite time-consuming and costly. As for tax consequences on formation, Code Sec. 351 states that no gain or loss is recognized by either the contributing shareholder or the recipient corporation if three conditions are satisfied: (1) there is a transfer of property (and not services), (2) solely in exchange for corporate stock, and (3) after the exchange the contributing shareholder(s) is (are) in control of the corporation (e.g., own at least 80 percent of the voting and 80 percent of the outstanding stock). 15,011.01

16 15 16 Contemporary Tax Practice: Research, Planning & Strategies If all conditions are met, no gain is taxed, and the basis of the shares to the shareholder equals the basis of the property transferred to the corporation (and the corporation has the same basis in the property). In essence, the transaction is treated as if nothing has changed. Example In exchange for 70 percent of the stock of Hamilton Corporation (an S corporation) valued at $70,000, James contributed land with an adjusted basis to him of $36,000 and a fair market value of $70,000. The other 30 percent of the stock was issued to Jane for property that she contributed to the corporation at the same time. Since the combined transfers for property provided at least 80-percent control, James will not recognize gain or loss on the transfer, his basis in the shares is $36,000 (a carryover basis), and the corporation s basis in the land is also the $36,000 carryover basis. If the 80-percent control test is not met, the exchange will be fully taxable. In such a case the fair market value of the stock received is compared with the tax (adjusted) basis of the property contributed to the corporation. Any excess is reported as capital gain under the normal gain recognition rules, and there is no tacking of holding periods. Example Assume the same facts as the previous example, except that the 30-percent stock interest received by Jane was for services she performed for the corporation, and not for property. In this case, James has a $34,000 realized accounting gain ($70,000 $36,000), and this must be recognized for tax purposes since only 70 percent of the stock was received for property. His basis in the shares will be $70,000; since the exchange was fully taxable, he receives fair market value as the basis of his shares. Likewise, the S corporation s basis in the land received is also $70,000. OBSERVATION In the above example, if Jane had also contributed some property with her services, would the transaction qualify for nonrecognition under Code Sec. 351? According to the Regulations, the answer is yes, but only if the value of the property contributed was worth at least 10 percent of the value of the services Jane contributed. As was true with partnerships, a corporation will sometimes assume outstanding liabilities of the shareholder on contributed property. To prevent this from being a tax barrier to incorporation, Code Sec. 357 states that liabilities assumed by the corporation are not treated as boot received for purposes of determining gain on the contributing transfer. However, if the liabilities assumed exceed the tax basis of the property, such excess must be recognized as taxable gain; this prevents a negative basis in the stock received. Example Assume the same facts as Example 15-11, except that Hamilton stock was worth $40,000 and the land was subject to a $30,000 mortgage, to be assumed by Hamilton Corporation. In this case, the $4,000 excess of the mortgage assumed by the corporation ($40,000) over the adjusted basis of the property contributed ($36,000) must be reported as gain by James. James s adjusted basis in the stock is zero ($36,000 basis of the old + $4,000 gain $40,000 liabilities assumed that are treated as boot received). The corporation s basis in the property is $40,000 ($36,000 basis to James + $4,000 gain recognized by James on the transfer). 15,011.01

17 Business Planning Choice of Entity ABILITY TO RAISE CAPITAL Normally, the corporate form is the best entity type for raising capital, since the company can potentially raise such capital by selling additional shares of stock. However, if an S election is in effect, this potential may be more limited due to the 100-shareholder limit on such entities. A family corporation is not likely to bring in outside owners in this case. Also, the S corporation can issue only one class of stock, and this can affect the flexibility of the company in raising capital as well..05 LIABILITY ISSUES OF AN S CORPORATION One of the major nontax advantages of an S corporation is the limited liability of its owners. Creditors may only seek repayment from the S corporation itself; they may not pierce the corporate shell and attach the personal assets of the owners. OBSERVATION As a practical matter, the advantage of limited liability may have very little value to a new S corporation. Because such a company has little or no credit history when it is formed, it may be impossible for the owners of the business to obtain a business loan without cosigning the note or guaranteeing the note as shareholders. As a result, the limited liability trait effectively becomes unlimited liability until a credit history and solid corporate asset base is established..07 OPERATING AN S CORPORATION: THE TAX REGIME After legislative changes in 1982, an S corporation is taxed in a manner similar to a partnership. All items of S corporation income, deduction, gain and loss are separated into ordinary income and specially allocated items. Each shareholder will pick up his or her share of S corporation income at the end of the year based on their weighted stock ownership percentage for the year. Although this allocation is similar to a partnership, there are no special allocations of profit or loss with an S corporation. Like a partnership, the S corporation passes losses through immediately to shareholders. However, unlike partners in a partnership, an S corporation shareholder s basis in the ownership interest (stock in this case) does not include a share of the corporate liabilities. Recall that an S corporation shareholder is not liable for corporation debts, so such liabilities may not be included in basis of the stock. OBSERVATION If an S corporation shareholder s share of a loss exceeds his or her basis, such excess loss may be used to offset any loans from the shareholder to the S corporation. But this is technically not basis in the stock; the offset simply recognizes that the shareholder has a recoverable tax basis in such loans. Appendix B-4 recasts the facts of the Davidson Case Study in the form of an S corporation entity. In this case, a simplifying assumption is made that Dave is a 100-percent shareholder so that the results may be compared to other entities. As was true with the partnership, all items of income and expense are allocated to Dave. One key difference should be noted in Appendix B-4. Since the S corporation is treated as a regular C corporation in most respects other than federal taxation, Dave is considered to be an employee of this separate entity. Thus, the reasonable salary payments of $55,000 are treated as salary income, and Dave is treated as an employee in the company pension plan. 15,011.07

18 15 18 Contemporary Tax Practice: Research, Planning & Strategies.09 S CORPORATION: PAYROLL TAXES OF THE OWNER Generally, the income shares allocated to S corporation shareholders are not subject to the self-employment tax, since investor/shareholders would are not treated as selfemployed persons. But what if a shareholder is also an employee, a typical situation for a family business organized as an S corporation? In this case, any wages paid to a shareholder/employee are subject to the normal FICA rules whereby the corporation matches the amounts withheld from the employee s salary. This is because the S corporation is a separate legal entity, apart from its owners..11 PAYMENTS TO THE OWNER As was true with the partnership entity, no gain or loss is generally recognized on nonliquidating distributions to S shareholders. Such distributions are not income, since the net income of the S corporation, like a partnership, is reported when it is earned and not when it is distributed. Income shares increase an S shareholder s adjusted basis in the interest, and distributions decrease that basis. An S corporation employee can exclude from tax the value of fringe benefits provided by the corporation only if the employee owns less than two percent of the outstanding stock. Thus, owner/employees in most small S corporations cannot exclude the value of the fringe benefits, since they own two percent or more of the outstanding stock..13 LIQUIDATION OF THE S CORPORATION An S corporation is treated just like a regular C corporation when liquidated. If the S corporation sells the assets and then distributes the proceeds to the shareholders, any gain recognized by the company on the asset sales is allocated to the shareholders as taxable gain, which increases their adjusted basis in their stock. As a result, the eventual distribution of cash to the shareholder usually produces no gain, thus resulting in a single layer of taxation at liquidation. If the S corporation distributes property directly to the shareholders in liquidation of their interests, the result is basically the same. That is because the S corporation must recognize gain on any appreciation in value of such properties distributed, this gain is passed through and taxed to the shareholders, and there is no other gain from the liquidating distribution at the shareholder level. Once again, there is only a single layer of tax. Case Study: The S Corporation (Appendix B-4) The total tax liability under the S corporation is different, since Dave Davidson is an employee for federal tax purposes and subject to withholding. Because Dave s reasonable salary is assumed to be only $55,000, this results in some payroll tax savings. Recall that with a sole proprietorship, the lesser of $102,000 or percent of Schedule C earnings are subject to the self-employment tax. Otherwise, the reporting for an S corporation is similar to a partnership, in that both apply a conduit approach. 15,013 The C Corporation as a Business Entity A C ( regular ) corporation is a separate legal and taxable entity, subject to a graduated income tax schedule from 15 to 35 percent. If such a corporation pays dividends to its owners, these amounts are also subject to taxation at the individual shareholder level. This is the primary disadvantage of a corporation the same amount of income is taxed twice (the double taxation dilemma). However, as part of the 2003 Act, the tax rate applicable to most sources of dividend income is limited to a maximum tax rate of 15 percent, the same rate applicable to long-term gains. This relief is temporary, however, 15,011.09

19 Business Planning Choice of Entity as it is scheduled to expire on December 31, 2010, following a controversial extension of the lower rates in FORMATION OF THE CORPORATION When a C corporation is formed, it is treated as a separate legal entity and is thus subject to the special rules of the Internal Revenue Code and state law. As a separate and distinct legal entity, corporations must follow certain business formalities, such as drafting articles of incorporation, bylaws, and electing directors. As is true with an S corporation, this process can be quite time-consuming and costly. The C corporation is subject to the same tax rules of Code Sec. 351 that are applicable to an S corporation upon formation (see the discussion above). Thus, no gain or loss is recognized when property is transferred solely in exchange for corporate stock and after the exchange the transferor is in control of the corporation (e.g., at least an 80 percent interest in voting and outstanding stock). Control can also be established by being part of a group of contributing shareholders who obtain at least an 80-percent controlling interest. As illustrated earlier, the receipt of boot or the assumption of liabilities exceeding basis by the corporation can create taxable gain to the contributing shareholder..03 ABILITY TO RAISE CAPITAL The C corporation offers maximum flexibility in terms of the ability to raise capital. Different types of stock and securities may be offered as a means to raise such capital, and there are no limitations on the size or type of ownership interest offered. Corporations may also issue bonds, with the added benefit of being able to deduct the interest expense (recall that dividends paid on stock are not deductible by the corporation). There is, however, a possible danger of having some debt reclassified as stock because the corporation is thinly capitalized, i.e., the bondholders are also stockholders in the same relative proportions. In such a case, the IRS may argue that the bondholders are really stockholders, and that the classification as a debtor was solely for purposes of deducting interest expense. Two other special tax-related provisions may assist the corporation in raising capital. First, Code Sec allows a corporation to designate the first $1 million of original issue capital stock as Code Sec stock. With this designation, any individual or partner owner(s) may deduct the first $50,000 of losses each year ($100,000 on a joint return) as ordinary losses; any excess losses on such stock each year are capital loss for the Sec stock treatment. Under Code Sec. 1202, a noncorporate taxpayer can exclude from gross income 50 percent of any gain from the sale or exchange of qualified small business stock held for more than five years. Qualifying corporations must have aggregate gross assets not exceeding $50 million at the time of the issue. Corporations engaging in personal services do not qualify..05 LIABILITY ISSUES AS A C CORPORATION The primary nontax advantage of a C corporation is the limited liability of the owners; creditors may only look to the corporate entity for payment. However, a C corporation without a credit history is likely to find that the only way they can borrow money is to cosign or guarantee the loans as individuals, so this advantage may be somewhat illusionary early in the life of the entity..07 OPERATING THE C CORPORATION: THE TAX REGIME The C corporation is a separate legal and tax entity, and the tax scheme applicable to corporations is different from that of individuals in several important respects. These include the following: 15,013.07

20 15 20 Contemporary Tax Practice: Research, Planning & Strategies 15, The corporate tax rates range from 15 to 35 percent, and may temporarily apply at a 38-percent tax rate (see Appendix A) There is no distinction between deductions for AGI and from AGI ; all legitimate expenses of the corporation are deductible There is no preferential rate for long-term capital gains, and capital losses can only offset capital gains and not regular income (unused capital losses can be carried back three years and forward five years as short-term capital losses) Charitable contribution deductions are limited to 10 percent of taxable income before considering the contribution itself, any dividends received deduction, and any capital loss or net operating loss carryback (but not carryforward) Any dividend income received by the corporation qualifies for a 70-percent (if ownership interest is less than 20 percent) or 80-percent (ownership interest of 20 percent or more) dividends received deduction One of the key tax differences between a C corporation and the other entities is the treatment of operating losses and capital losses. Since the C corporation is a separate taxable entity, these losses remain in the corporate entity and can only be used by the corporate entity; they do not flow through to the owners of the business. This can be a distinct disadvantage of the C corporation in early years when losses are likely..09 CORPORATION: PAYROLL TAXES OF THE OWNER As a separate taxable entity, the C corporation must withhold payroll taxes from all employees salaries, including shareholder-employees. The C corporation will then match the amounts withheld (only this portion of the FICA taxes forwarded to the IRS is deductible by the corporation). Any shareholder who also works for the corporation is treated the same as other employees. There are no self-employment tax issues for a C corporation, since the corporation is a separate legal entity..11 PAYMENTS TO THE OWNER Historically, the primary tax disadvantage associated with the C corporation is the double taxation of income. When the corporation earns an income, it pays an income tax, and when such earnings are distributed to the owners, they pay a second layer of income tax. The reduction in tax rates applicable to dividends to a maximum rate of 15 percent lessens but does not completely eliminate this double taxation. Some closely held businesses can mitigate the double taxation problem by paying salaries, interest, or rents to their owners; such amounts would be deductible by the corporation and would thus eliminate the first layer of taxation. However, such payments must be reasonable based on the facts and circumstances of the case; otherwise, excessive amounts may be reclassified by the IRS as dividends, which are not deductible by the corporation but are nonetheless still taxable to the shareholders. One of the primary advantages of a C corporation is that the Code provides for a number of fringe benefits that are not taxable to employees (who frequently are the owners of the business, if it is a small family corporation), even though they are deductible by the corporation. These include employer payments for health insurance coverage, medical reimbursement plans, childcare (up to $5,000), and group-term life insurance coverage (up to $50,000)..13 LIQUIDATION OF THE CORPORATION The specter of double taxation raises its head once again upon liquidation of the corporate entity. If the corporation sells its assets and distributes the proceeds to the owners, any gain recognized on the sale is taxable to the corporation. And when the cash is distributed to the shareholders, any amounts received in excess of the shareholder s basis in the stock are taxable gain. Thus, double taxation occurs upon the liquidation of a corporation.