Chapter 13 ©2009 South-Western, a part of Cengage Learning Kevin Murphy Mark Higgins Choice of Business Entity: General Tax and Nontax Factors Formation

13 -2 © 2009 South-Western, a part of Cengage Learning Introduction Taxpayers must choose a form for a business entity vChoice is based on tax and non-tax factors

Non-Tax Factors vIs the number of owners restricted? vDo owners have limited liability? vCan ownership interest be freely transferred? vDo owners have a large degree of management control? vDoes entity continue regardless of ownership changes? vIs there a high cost of organizing the entity? vDoes the entity have an ability to raise additional capital? © 2009 South-Western, a part of Cengage Learning 13 -3

Let’s look at the non-tax factors and how they affect each entity. © 2009 South-Western, a part of Cengage Learning 13 -4

Sole Proprietorship The owner: þHas unlimited liability þCan easily transfer ownership interest þHas full management control A sole proprietorship is a business owned by one individual. The entity : þ Ceases to exist when ownership changes þ Has a low cost of formation þ Has a limited ability to raise capital © 2009 South-Western, a part of Cengage Learning 13 -5

Partnership The owners: þAre fully liable (except for limited partners) þCannot easily transfer ownership interest þHave full management control The entity : þ Ceases to exist if >50% ownership changes þ Has a moderate cost of formation þ Has a good ability to raise capital A partnership exists when two or more persons engage collectively in a profit making activity. © 2009 South-Western, a part of Cengage Learning 13 -6

Corporation The owners: þHave limited liability þCan easily transfer ownership interest þHave no right to direct management þAre not limited in number A corporation is an artificial entity created under the auspices of state law. The entity : þ Continues to exist when ownership changes þ Has a relatively high cost of formation þ Has an excellent ability to raise capital © 2009 South-Western, a part of Cengage Learning 13 -7

S Corporation The owners: þHave limited liability þCan easily transfer ownership interest þHave no right to direct management þAre limited to a maximum number of 75 An S corporation is a regular corporation with special tax attributes. The entity : þ Continues to exist when ownership changes þ Has a relatively high cost of formation þ Has an excellent ability to raise capital © 2009 South-Western, a part of Cengage Learning 13 -8

13 -9 © 2009 South-Western, a part of Cengage Learning S Corporation Election vRequirements for electing S status FNo more than 100 shareholders FShareholders must be individuals, estates, tax-exempt organizations, or certain trusts FShareholders may not be nonresident aliens FOnly one class of outstanding stock is allowed FAll shareholders must consent to election

© 2009 South-Western, a part of Cengage Learning S Corporation Election Termination vTerminating election FMay be voluntarily terminated by consent of >50% of shareholders FInvoluntary termination occurs when any requirements are violated VMust wait 5 years before applying for S status again

Limited Liability Company The owners: þHave limited liability þCannot easily transfer ownership interest þHave full management control þNot limited to number of owners The limited liability company (LLC) has corporate characteristics with the conduit tax treatment of partnerships. The entity : þ Ceases to exist when ownership changes þ Has a moderate cost of formation þ Has a good ability to raise capital © 2009 South-Western, a part of Cengage Learning

Limited Liability Partnership The owners: þHave liability only for their own acts þCannot easily transfer ownership interest þHave full management control þMust have at least 2 owners The limited liability partnership (LLP) is a general partnership with limited liability for owners. The entity : þ Ceases to exist when ownership changes þ Has a moderate cost of formation þ Has a good ability to raise capital © 2009 South-Western, a part of Cengage Learning

Let’s look at the tax factors and how they affect each entity. © 2009 South-Western, a part of Cengage Learning

© 2009 South-Western, a part of Cengage Learning General Income Tax Factors vThree tax factors also influence choice of entity ¶Incidence of Income Taxation VWho pays the tax, the entity or the owner? ·Double Taxation VIs the same income taxed to the entity and the owner? ¸Employee versus Owner VCan owners be treated as employees of the entity?

© 2009 South-Western, a part of Cengage Learning #1: Who Pays the Tax? vSole Proprietorship: conduit to owner FForm 1040, Schedule C vPartnership: conduit to partners FForm 1065, Schedule K-1 FItems that receive special tax treatment are reported separately from operations

© 2009 South-Western, a part of Cengage Learning #1: Who Pays the Tax? vS Corporation: conduit to shareholders FForm 1120S, Schedule K-1 FSeparable items like partnership vC Corporation: Corporation pays FForm 1120

© 2009 South-Western, a part of Cengage Learning #1: Who Pays the Tax? Personal Service Corporation vA corporation is a personal service corporation (PSC) if FThe principal activity is performance of personal services FThe services are performed by owner- employees, those who own > 10% of the stock vPSC’s pay tax on the income at a 35% rate FEncourages payment of salary to owners

© 2009 South-Western, a part of Cengage Learning #2: Is Double Taxation a Problem? vNo FSole Proprietorships FPartnerships FS Corporations vYes FC Corporations

© 2009 South-Western, a part of Cengage Learning #3: Owners Treated as Employees? vSole Proprietors - No vPartners - No FBut may receive guaranteed payments and fringe benefits vS Corporation shareholders - Yes FSalary and fringe benefits are deductible by the corporation vC Corporation shareholders - Yes FAll payments made to/for owner-employees allowable

© 2009 South-Western, a part of Cengage Learning How do fringe benefits and employment taxes apply to employees of each entity?

© 2009 South-Western, a part of Cengage Learning Fringe Benefits Legislative grace allows employers to deduct amounts paid as fringe benefits but does not require employees to report income. FOwner-employees VRelated party concerns VNondiscriminatory rules

© 2009 South-Western, a part of Cengage Learning Fringe Benefit Limitations vSole proprietors are not employees FNo deduction allowed for salary or benefits

© 2009 South-Western, a part of Cengage Learning Fringe Benefit Limitations vPartners and > 2% shareholders of S Corporations must include in income: FEmployer-provided group term life of $50,000 or less FEmployer sponsored accident and health- care plans VOwner/employee can deduct for AGI FCafeteria plans, and FMeals and lodging provided by employer

Social Security Taxes vTaxes are paid half by employee and half by employer FTotal rate is 15.3% = 2.9% Medicare % OASDI FMaximum amount subject to OASDI is $102,000 The social security tax is imposed on the wages of employees and the net self- employment income of self-employed individuals. © 2009 South-Western, a part of Cengage Learning

© 2009 South-Western, a part of Cengage Learning Social Security Taxes vSelf-employed taxpayers (sole proprietors and partners) pay both halves FBase is 92.35% of net self-employed income vCorporations and S corporations may deduct the half paid for shareholder- employees

© 2009 South-Western, a part of Cengage Learning Formation vAt the formation of a business entity, a number of tax issues arise FHow to treat transfers of cash and property to an entity in exchange for ownership? FHow to determine an owner’s initial and continuing basis? FHow to treat costs incurred prior to and during formation? FWhat accounting period and method to use?

© 2009 South-Western, a part of Cengage Learning How are property transfer issues treated by each entity?

© 2009 South-Western, a part of Cengage Learning Sole Proprietorship vNo tax effects arise FSole proprietorship is not an entity separate from the owner FNo realization under the realization concept Vno second party involved in the transfer

© 2009 South-Western, a part of Cengage Learning Partnership vNo gain or loss recognized when property transferred FRealized gain or loss is deferred FPartner and partnership take a carryover basis in the property vIncome is recognized if services are performed in exchange for ownership FAll-inclusive income concept applies FIncome = FMV of partnership interest

© 2009 South-Western, a part of Cengage Learning Corporations vNo gain or loss recognized if FProperty is exchanged solely for stock, and FThe shareholders control (> 80% ownership) the corporation after transfer vIncome is recognized if services are performed in exchange for stock

How are basis issues treated by each entity? © 2009 South-Western, a part of Cengage Learning

© 2009 South-Western, a part of Cengage Learning Basic Basis Considerations vOwners obtain an initial basis either through purchase or the transfer of property FIf by purchase, use the purchase cost FIf by transfer, use a carry-over basis and holding period vThe entity generally takes a carry-over basis for property transferred in

© 2009 South-Western, a part of Cengage Learning Sole Proprietorship vOwnership of property never changes vOwner’s basis remains unchanged

Partnership vBasis determines the taxability of distributions from the entity to the partner vInitial basis = basis in property transferred and/or FMV of services contributed Increased byDecreased by Additional contributionsDistributions received Partner’s share of incomePartner’s share of lossesPartner’s share of increases in entity debt decreases in entity debt Entity debt taken by partnerPartner’s debt taken by entity © 2009 South-Western, a part of Cengage Learning

© 2009 South-Western, a part of Cengage Learning C Corporation vInitial basis = basis in property transferred and/or FMV of services contributed vIf any boot is received in the transfer FShareholder has wherewithal-to-pay and must report gain FBasis includes the amount of gain recognized

© 2009 South-Western, a part of Cengage Learning C Corporation vShareholders adjust basis in individual shares for stock dividends and stock splits vShareholders who receive a distribution in excess of basis must report a capital gain FExcess over capital recovery

© 2009 South-Western, a part of Cengage Learning S Corporation vInitial basis = basis in property transferred and/or FMV of services contributed vIf any boot is received in the transfer FShareholder has wherewithal-to-pay and must report gain FBasis includes the amount of gain recognized

© 2009 South-Western, a part of Cengage Learning S Corporation vBasis is adjusted for items affecting the shareholder’s capital recovery FFollow the adjustments made for a partner with the exception of adjustments for debt

How are costs incurred prior to and during formation treated? © 2009 South-Western, a part of Cengage Learning

© 2009 South-Western, a part of Cengage Learning Organizational and Start-up Costs vExpenditures that have a life extending beyond the end of the tax year must be capitalized FOrganization costs pertain to getting the entity ready to operate FStart-up costs are incurred by an entity prior to beginning operations

© 2009 South-Western, a part of Cengage Learning Organizational and Start-up Costs vAmortize over 60 months, or vElect to deduct $5,000 currently FPhased-out $1 for $1 if total costs exceed $50,000 vCosts above $5,000 are amortized over 180 months

© 2009 South-Western, a part of Cengage Learning What accounting period and method should be used?

© 2009 South-Western, a part of Cengage Learning Accounting Periods The annual accounting period concept requires all entities to report operations on an annual basis.

© 2009 South-Western, a part of Cengage Learning Accounting Periods vTaxpayers are generally free to choose their accounting period vPartnerships and S Corporations must use the taxable year of owners with >50% interest FMay use natural business year FPartnerships may use year of principal (> 5%) owners if majority partners’ years do not agree

Accounting Methods Taxpayers must select an accounting method which properly characterizes income and deductions. vMay use one of three methods: cash, accrual, hybrid FCorporations are generally required to use the accrual method FPartnerships with a corporate partner are generally required to use the accrual method © 2009 South-Western, a part of Cengage Learning