Principles of Taxation Chapter 11 The Choice of Business Entity

Choice of Entity This is a tax planning chapter - HOW to use rules. Pass-through losses After-tax cash flows to individual investor Family income shifting Partnership versus S Corp characteristics Closely-held corporations Constructive dividends limit corporate tax avoidance. Accumulated earnings tax, personal holding company tax, tax rates on members of a controlled group.

Passthrough Entities Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income. Is there a single or double level of taxation? Are cash distributions are generally taxable?

Benefits of Passthrough Losses When are passthrough losses generally deductible? At what rates? Corporation loss must be carried (back) forward and used to offset income in a taxable year where profits are reported. Thus, when, and at what rates, is a benefit obtained?

Example: Investor A has $200,000 of taxable income in 1996, 1997 and 1998 before his investment in Entity X. Entity X has an end of year loss in 1996 and 1997 of (50,000) per year and has profits in 1998 of $200,000. What is the net present value at 10% of the tax refunds or payments due on Entity X losses and profits if X is a: a) pass-through entity? b) corporation?

Passthrough Example 1996 deduction = (50,000) x 36% = ( ) refund 1998 income = $200,000 x 36% = _________ tax NPV tax cost at 10% if END of year payments = ________________

Corporation Example 1998 net income = $100,000, corporate tax = _____________ NPV = ___________. Why is this better even though the tax refund was delayed? BUT, if corporation pays a dividend, then individual also taxed on 77,750 x 36% =___________. NPV of total tax = __________ Is this better or worse than passthrough?

Passthrough Entities Only Have a Single Level of Tax The preceding example illustrates the benefits of a pass-through entity. a) Use losses immediately b) Single level of taxation

Family Income Shifting What is the goal? Remember, income shifting is the RESULT of shifting property ownership - can’t assign income. If children or other relatives are made partners or co-shareholders, they own part of the business. The transfer of ownership may have GIFT TAX consequences if relatives don’t pay FMV.

Limits on Family Income Shifting Family members cannot be partners in a personal service business unless they can do what? Family members providing services must first receive ______________________before net income is allocated. How is income allocated if the entity is a family partnership? an S corporation?

Other Considerations Gift tax (See Q3). Legal and accounting costs of creating and operating business. Dilution of parents’ wealth - transfers must be complete and legally binding, irrevocable.

Partnership versus S Corporation What are some administrative requirements of S Corps? Partnership agreements have more flexibility, but require more careful legal drafting. Refresher (chapter 9) - which owners receive tax basis for liabilities of the entity? S Corporation shares are transferable. Partnership interests are not - requires new partnership agreement.

Type of Flow-Through Entity Liability (See Q6) In which case(s) is the owner liable for losses/debts of the entity: General partner Limited partner Partner in an LLP Partner in an LLC Shareholder in an S Corp Shareholder in a C Corp

Closely-Held Corporations Biggest challenge is how can the investors avoid double taxation of corporate earnings. If shareholders are also creditors, is interest expense deductible to corporation? If shareholders are also employees, is wage expense deductible to corporation? If shareholders are also landlords, is rent expense deductible to corporation?

Closely-Held Corporations IRS challenge turns “unreasonable” payments into constructive dividends. How does the IRS decide what is unreasonable? (AP6) interest wages rent

Accumulating Corporate Profits as a Tax Shelter The goal of the taxpayer: Keep earnings in corporation. Small corporations are taxed at low rates. Delay paying dividends. Possibly convert ordinary dividend to capital gain by selling stock.

IRS Weapons Against Using Corporation as Tax Shelter Accumulated earnings tax Penalty is to assess tax on accumulated taxable income at what rate? How is this like a deemed dividend? What are common traits that IRS looks for?

IRS Weapons Against Using Corporation as Tax Shelter Personal Holding Company tax Similar penalty assesses tax on undistributed earnings at _______% Applies to corporations whose income is principally what? Application of Accum. Earn Tax and PHC tax: rules prevent abuse, so practical assessment of these taxes is rare.

Controlled Group Tax Rates Aggregate the taxable income of all members of a controlled group (>= _______% common ownership). Compute tax. Allocate tax according to proportion of taxable income. These rules prevent disbursing corporate income into numerous units all taxed at 15%.