© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Chapter 15 Choice of Business Entity: Other Considerations Murphy & Higgins, Concepts in Federal Taxation, 2010 edition

1-2 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Introduction There are two major areas in which tax issues play a major role in deciding the business form of an organization Employee compensation Pension plans Stock options Fringe benefits

1-3 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Tax liability Tax credits Alternative minimum tax International Considerations Introduction

1-4 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Deferred Compensation Plans Are designed to encourage employers to donate toward employees’ retirement funding General tax consequences are: Employers take a current deduction for the amounts contributed Employees may defer recognition of income

1-5 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Employee Pension Plans Contributory versus noncontributory Qualified versus nonqualified Contributions made to nonqualified may not be deferred or deducted To be qualified, a plan must Cover workers 21 or older Be in writing Be made to a trust Be made exclusively for the benefit of employees

1-6 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Not discriminate in favor of highly paid employees Limit the amount of allowed contributions and/or benefits Defined contribution versus defined benefit Defined contribution plans (money purchase plan or profit-sharing plan) have limits on the amount of contributions made Employee Pension Plans

1-7 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. limited to the lesser of $49,000 or 25% of taxable compensation Defined benefit plans have limits on the amount of retirement benefits paid Cannot exceed the smaller of $195,000 or 100% of average of the highest 3 years’ compensation Employee Pension Plans

1-8 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Other Pension Plans Keogh Designed for self-employed taxpayers not covered by an employer’s plan For self-employed or owner-partner Defined contribution plans Employees: lesser of $49,000 or 25% of compensation Owners: lesser of $49,000 or 20% of net SE income up to $245,000

1-9 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Defined benefit plans Maximum payment limited to $195,000 or 100% of average compensation for the highest 3 consecutive years Other Pension Plans Keogh

1-10 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Individual Retirement Accounts Open to all taxpayers Two kinds Conventional (Traditional) Roth Total contributions to all IRAs may not exceed $5,000 per person per year Taxpayers age 50 or older may contribute up to $6,000

1-11 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Traditional IRA Contributions limited to lesser of $5,000 ($6,000 if age 50 or older) or amount of earned income Married filing joint may contribute up to $10,000 ($12,000 if 50 or older) total Fully deductible if not covered by an employer’s plan

1-12 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Deductible IRA Phase-out Beginnings

1-13 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. If covered by employer’s plan: Maximum deduction for married equals: (Maximum contribution) x [1 - {(AGI - phase-out) / $20,000}] Maximum deduction for unmarried equals: (Maximum contribution) x [1 - {(AGI - phase-out) / $10,000}] Deductible IRA Phase-out Beginnings

1-14 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Roth IRA Contributions are not deductible Earnings distributions are tax-free if IRA has existed for 5 years, and Taxpayer is > 59 1/2 years old No age limit to begin distributions Contributions are phased-out Married, between $166,000 to $176,000 Single, between $105,000 to $120,000

1-15 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Converting IRAs to Roth IRAs May convert traditional IRAs to Roth IRAs If AGI < $100,000 Must pay tax due on amount distributed, but no penalty for early distribution If AGI > $100,000, must pay 10% penalty

1-16 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. IRA Withdrawals Traditional Must begin distributions by age 70 1/2 Distributions are taxable Both IRAs - penalty free withdrawals for Death or disability Medical Qualified higher education expenses First time home purchases

1-17 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Other Pension Plans Simplified Employee Pension (SEP) Open to any entity Must cover all employees who Are at least 21 years old Have worked during the year and for 3 of the last 5 years Have received at least $550 in compensation

1-18 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Other Pension Plans Simplified Employee Pension (SEP) Maximum contributions For owners: lesser of $49,000 or 20% of net SE income up to $245,000 For employees: lesser of $49,000 of 25% of compensation

1-19 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Savings Incentive Match Plan for Employees (SIMPLE) Designed to encourage small employers to establish retirement plans Do not have another qualified plan Fewer than 100 employees Not subject to discrimination rules regarding highly compensated employees All employees earning > $5,000 in the two previous years are eligible to contribute Maximum contribution is $11,500

1-20 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. SIMPLE Plans: SIMPLE-IRA and SIMPLE-401(k) IRA has 3 funding options Match employee’s contribution up to 3% Elect to match a minimum of 1% Contribute 2% of employee’s compensation regardless of contribution 401(k) has 2 funding options Match employee’s contribution up to 3% Contribute 2% of employee’s compensation regardless of contribution Maximum compensation is $245,000

1-21 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Distributions From a qualified pension plan, Keogh, SEP, IRA, or SIMPLE May begin the year taxpayer reaches age 59 and 1/2, but must begin the year taxpayer reaches age 70 and 1/2 (except for Roth IRAs) Must be an annuity May elect lump-sum for Keogh

1-22 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Required minimum distribution based on taxpayer’s life expectancy Taxable amount depends on whether taxpayer has basis: capital recovery concept Distributions

1-23 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Penalties Three major penalty provisions exist to ensure proper compliance with the rules and requirements of pension plans Contributions made in excess of limits are subject to 10% penalty (6% for IRAs) Early withdrawals are subject to penalty of 10%

1-24 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. May be waived if distribution is due to death, disability, or certain medical, education or home purchase expenses A 50% penalty is imposed for failure to begin receiving required minimum distribution by age 70 and 1/2 from plans other than Roth IRAs Penalties

1-25 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Stock Options Right to buy a share of stock at a fixed price within a specified period of time or on a specified date All stock options have three important dates Grant date: date an employee gets the option Exercise date: date the employee trades the option for stock Sale date: date the employee sells the stock

1-26 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. There are two kinds of stock options Nonqualified stock options Tax treatment depends on whether the option has a readily ascertainable fair market value Incentive stock options No tax consequences until the sale date Stock Options

1-27 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Nonqualified Stock Options With Ascertainable FMV At the grant date Employee has ordinary income = FMV of option Corporation has deduction = income recognized At the exercise date Employee basis in the stock = exercise amount paid + income recognized Holding period begins At the sale date Employee has capital gain = sales price less basis

1-28 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Nonqualified Stock Options With No Ascertainable FMV At the grant date No tax consequences At the exercise date Employee has Ordinary income = FMV of stock - exercise price paid, and Basis in stock = exercise price paid + income Holding period begins

1-29 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Nonqualified Stock Options With No Ascertainable FMV Employer has deduction = income recognized At the sale date Employee has capital gain = sales price less basis

1-30 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Nonqualified Stock Options Substantially Restricted At the grant date No consequences At the exercise date When restrictions lapse, employee has Ordinary income = FMV - exercise price Basis in the stock = exercise amount paid + income Holding period begins

1-31 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Employer has deduction = income At the sale date Employee has capital gain = sales price less basis Consequences of grant and exercise date may be reversed with Sec. 83(b) election Nonqualified Stock Options Substantially Restricted

1-32 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Incentive Stock Options (ISO) Requirements for ISO treatment Must be part of a qualified stock plan Option must be exercised within ten years of date of grant Option price must be > FMV of the stock at date of grant Option cannot be transferable FMV of the ISOs granted in a year cannot exceed $100,000

1-33 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Tax consequences No consequences on the grant or exercise dates At the exercise date Employee has basis in stock = amount paid At the sale date Employee has capital gain = sales price less basis Employer never has deduction Incentive Stock Options (ISO)

1-34 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Reasonableness of Compensation To be deductible, compensation must be Reasonable in amount Paid for actual employee services Unreasonable compensation of shareholder-employees may be reclassified as dividends

1-35 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Tax Credits A tax credit is a direct reduction in the tax liability of a taxpayer Most are nonrefundable They exist to provide specific tax relief Business credits are available to all entities

1-36 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Business Tax Credits Research and Experimental Credit* Encourages research in new technology Credit = 20% of incremental expenditures less base amount * this is under review by Congress; check the website for updated information

1-37 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Rehabilitation Tax Credit Incentive for restoring and saving older buildings Must hold buildings for 5 years Credit is 10% or 20% of cost depending on type of building Business Tax Credits

1-38 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Child Care Cost Credit Encourages companies to provide child care for employees Credit = 25%(Qualified child care expenses) + 10%(Qualified child care resources) Qualified child care expenses = amounts used to acquire, construct, or expand property + costs of training care givers Business Tax Credits

1-39 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Limited to $150,000 per year General Business Credit Overall limit on group of business credits Business Tax Credits

1-40 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Reporting Tax Credits Reduces tax liability dollar for dollar Reported: at the corporate level by owners of flow-through entities on the individual return of a sole- proprietor

1-41 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Alternative Minimum Tax (AMT) Is designed to impose a minimum amount of tax that a taxpayer must pay Taxpayer must pay at least the minimum amount of tax Figured separately from regular income tax Requires keeping a separate set of records Not required for small corporations with average gross receipts of less than $5,000,000

1-42 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Basic AMT Computation Regular taxable income +/-Adjustments +Preferences Tentative alternative minimum taxable income -Allowable exemption amount Alternative minimum taxable income (AMTI) timesTax rate (20% Corporate; 26% or 28% individual) Tentative minimum tax before credits

1-43 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. AMT Adjustments Purpose is to account for effect of special alternative rates or calculations Most reverse due to timing differences Examples: Required use of completed contract method No gain deferral for installment sales Recalculation of NOL; limited NOL deduction Depreciation under ADS versus MACRS

1-44 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Not all apply to all entities Corporations must compute Adjusted Current Earnings (ACE) Individuals must limit itemized deductions, delete personal exemption, report income from ISOs AMT Adjustments

1-45 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. AMT Preferences Apply to all taxpayers Always added in the computation of AMTI Are permanent differences and do not reverse Add back: Percentage depletion in excess of basis Limitation of intangible drilling costs Tax-exempt interest from private activity bonds

1-46 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Excess depreciation over straight-line for property acquired before % of gain exclusion on small business stock Reserves for bad debts of financial institutions AMT Preferences

1-47 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. AMT Exemptions Designed to eliminate taxpayers with relatively moderate income and small amounts of adjustments and/or preferences Phased-out at rate of 25 cents for every dollar of AMTI over base Entity Initial exemption Base Corporation $40,000 $150,000 Single & HoH 46, ,500 Married, joint 69, ,000 Married, separate 34,975 75,000

1-48 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. AMT Minimum Tax Credit Calculated each year in which AMT applies Designed to avoid double jeopardy caused by timing differences Deducted from regular tax Amount is the difference between actual AMT and what AMT would be without the reversal adjustments

1-49 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. International Tax U.S. citizens, resident aliens, and domestic corporations pay U.S. tax on worldwide income Non-resident aliens and non-domestic corporations pay U.S. tax only on income earned in the U.S.

1-50 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Tax Treaties U.S. government makes tax treaties with most foreign governments Determine how citizens and non- citizens are taxed Try to prevent double taxation

1-51 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Organizational Structures for Foreign Operations Foreign subsidiary U.S. parent owns > 50% Parent usually not taxed until income brought into the U.S. Subpart F income is taxed as earned like conduit entity interest, dividends, rent, royalties

1-52 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Foreign Tax Credit Credit is limited to amount of U.S. tax that would have been paid on foreign income Excess may be carried back 1 years, forward 10

1-53 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Other International Issues If appreciated property is transferred to foreign entities, must report income = gain “as if sold” Transfer pricing methods are used to set the price allowed

1-54 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Taxation of Non-resident Aliens and Foreign Corporations Income is U.S. trade or business income if two tests are met Asset use test: Income is derived from assets used in active conduct of business in the U.S. Business activities test: U.S. business is a material part of income Non-business income is taxed at a flat 30% rate