Chapter 13 Choice of Business Entity: General Tax and Nontax Factors Formation Kevin Murphy Mark Higgins ©2008 South-Western 1

Taxpayers must choose a form for a business entity Introduction Taxpayers must choose a form for a business entity Choice is based on tax and non-tax factors

Non-Tax Factors Is the number of owners restricted? Do owners have limited liability? Can ownership interest be freely transferred? Do owners have a large degree of management control? Does entity continue regardless of ownership changes? Is there a high cost of organizing the entity? Does the entity have an ability to raise additional capital? © 2008 South-Western Transparency 13-3

Let’s look at the non-tax factors and how they affect each entity. © 2008 South-Western Transparency 13-4

Sole Proprietorship A sole proprietorship is a business owned by one individual. The entity: Ceases to exist when ownership changes Has a low cost of formation Has a limited ability to raise capital The owner: Has unlimited liability Can easily transfer ownership interest Has full management control © 2008 South-Western Transparency 13-5

Partnership A partnership exists when two or more persons engage collectively in a profit making activity. The owners: Are fully liable (except for limited partners) Cannot easily transfer ownership interest Have full management control The entity: Ceases to exist if >50% ownership changes Has a moderate cost of formation Has a good ability to raise capital © 2008 South-Western Transparency 13-6

Corporation A corporation is an artificial entity created under the auspices of state law. The owners: Have limited liability Can easily transfer ownership interest Have no right to direct management Are not limited in number The entity: Continues to exist when ownership changes Has a relatively high cost of formation Has an excellent ability to raise capital © 2008 South-Western Transparency 13-7

S Corporation An S corporation is a regular corporation with special tax attributes. The owners: Have limited liability Can easily transfer ownership interest Have no right to direct management Are limited to a maximum number of 75 The entity: Continues to exist when ownership changes Has a relatively high cost of formation Has an excellent ability to raise capital © 2008 South-Western Transparency 13-8

S Corporation Election Requirements for electing S status No more than 100 shareholders Shareholders must be individuals, estates, tax-exempt organizations, or certain trusts Shareholders may not be nonresident aliens Only one class of outstanding stock is allowed All shareholders must consent to election

S Corporation Election Termination Terminating election May be voluntarily terminated by consent of >50% of shareholders Involuntary termination occurs when any requirements are violated Must wait 5 years before applying for S status again

Limited Liability Company The limited liability company (LLC) has corporate characteristics with the conduit tax treatment of partnerships. The owners: Have limited liability Cannot easily transfer ownership interest Have full management control Not limited to number of owners The entity: Ceases to exist when ownership changes Has a moderate cost of formation Has a good ability to raise capital © 2008 South-Western Transparency 13-11

Limited Liability Partnership The limited liability partnership (LLP) is a general partnership with limited liability for owners. The owners: Have liability only for their own acts Cannot easily transfer ownership interest Have full management control Must have at least 2 owners The entity: Ceases to exist when ownership changes Has a moderate cost of formation Has a good ability to raise capital © 2008 South-Western Transparency 13-12

Let’s look at the tax factors and how they affect each entity. © 2008 South-Western Transparency 13-13

General Income Tax Factors Three tax factors also influence choice of entity Incidence of Income Taxation Who pays the tax, the entity or the owner? Double Taxation Is the same income taxed to the entity and the owner? Employee versus Owner Can owners be treated as employees of the entity?

#1: Who Pays the Tax? Sole Proprietorship: conduit to owner Form 1040, Schedule C Partnership: conduit to partners Form 1065, Schedule K-1 Items that receive special tax treatment are reported separately from operations

#1: Who Pays the Tax? S Corporation: conduit to shareholders Form 1120S, Schedule K-1 Separable items like partnership C Corporation: Corporation pays Form 1120

#1: Who Pays the Tax? Personal Service Corporation A corporation is a personal service corporation (PSC) if The principal activity is performance of personal services The services are performed by owner-employees, those who own > 10% of the stock PSC’s pay tax on the income at a 35% rate Encourages payment of salary to owners

#2: Is Double Taxation a Problem? No Sole Proprietorships Partnerships S Corporations Yes C Corporations

#3: Owners Treated as Employees? Sole Proprietors - No Partners - No But may receive guaranteed payments and fringe benefits S Corporation shareholders - Yes Salary and fringe benefits are deductible by the corporation C Corporation shareholders - Yes All payments made to/for owner-employees allowable

apply to employees of each entity? How do fringe benefits and employment taxes apply to employees of each entity?

Fringe Benefits Legislative grace allows employers to deduct amounts paid as fringe benefits but does not require employees to report income. Owner-employees Related party concerns Nondiscriminatory rules

Fringe Benefit Limitations Sole proprietors are not employees No deduction allowed for salary or benefits

Fringe Benefit Limitations Partners and > 2% shareholders of S Corporations must include in income: Employer-provided group term life of $50,000 or less Employer sponsored accident and health-care plans Owner/employee can deduct for AGI Cafeteria plans, and Meals and lodging provided by employer

Social Security Taxes The social security tax is imposed on the wages of employees and the net self-employment income of self-employed individuals. Taxes are paid half by employee and half by employer Total rate is 15.3% = 2.9% Medicare + 12.4% OASDI Maximum amount subject to OASDI is $94,200 © 2008 South-Western Transparency 13-24

Social Security Taxes Self-employed taxpayers (sole proprietors and partners) pay both halves Base is 92.35% of net self-employed income Corporations and S corporations may deduct the half paid for shareholder-employees

Formation At the formation of a business entity, a number of tax issues arise How to treat transfers of cash and property to an entity in exchange for ownership? How to determine an owner’s initial and continuing basis? How to treat costs incurred prior to and during formation? What accounting period and method to use?

How are property transfer issues treated by each entity?

Sole Proprietorship No tax effects arise Sole proprietorship is not an entity separate from the owner No realization under the realization concept no second party involved in the transfer

Partnership No gain or loss recognized when property transferred Realized gain or loss is deferred Partner and partnership take a carryover basis in the property Income is recognized if services are performed in exchange for ownership All-inclusive income concept applies Income = FMV of partnership interest

Corporations No gain or loss recognized if Property is exchanged solely for stock, and The shareholders control (> 80% ownership) the corporation after transfer Income is recognized if services are performed in exchange for stock

How are basis issues treated by each entity? © 2008 South-Western Transparency 13 -31

Basic Basis Considerations Owners obtain an initial basis either through purchase or the transfer of property If by purchase, use the purchase cost If by transfer, use a carry-over basis and holding period The entity generally takes a carry-over basis for property transferred in

Sole Proprietorship Ownership of property never changes Owner’s basis remains unchanged

Partnership Basis determines the taxability of distributions from the entity to the partner Initial basis = basis in property transferred and/or FMV of services contributed Increased by Decreased by Additional contributions Distributions received Partner’s share of income Partner’s share of losses Partner’s share of Partner’s share of increases in entity debt decreases in entity debt Entity debt taken by partner Partner’s debt taken by entity © 2008 South-Western Transparency 13-34

C Corporation Initial basis = basis in property transferred and/or FMV of services contributed If any boot is received in the transfer Shareholder has wherewithal-to-pay and must report gain Basis includes the amount of gain recognized

C Corporation Shareholders adjust basis in individual shares for stock dividends and stock splits Shareholders who receive a distribution in excess of basis must report a capital gain Excess over capital recovery

S Corporation Initial basis = basis in property transferred and/or FMV of services contributed If any boot is received in the transfer Shareholder has wherewithal-to-pay and must report gain Basis includes the amount of gain recognized

S Corporation Basis is adjusted for items affecting the shareholder’s capital recovery Follow the adjustments made for a partner with the exception of adjustments for debt

How are costs incurred prior to and during formation treated? © 2008 South-Western Transparency 13 -39

Organizational and Start-up Costs Expenditures that have a life extending beyond the end of the tax year must be capitalized Organization costs pertain to getting the entity ready to operate Start-up costs are incurred by an entity prior to beginning operations

Organizational and Start-up Costs Costs incurred prior to 10/23/04 are amortized over 60 months Costs incurred after 10/22/04 Amortize over 60 months, or Elect to deduct $5,000 currently Phased-out $1 for $1 if total costs exceed $50,000 Costs above $5,000 are amortized over 180 months

What accounting period and method should be used?

Accounting Periods The annual accounting period concept requires all entities to report operations on an annual basis.

Accounting Periods Taxpayers are generally free to choose their accounting period Partnerships and S Corporations must use the taxable year of owners with >50% interest May use natural business year Partnerships 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. May use one of three methods: cash, accrual, hybrid Corporations are generally required to use the accrual method Partnerships with a corporate partner are generally required to use the accrual method © 2008 South-Western Transparency 13-45