Chapter 13 Choice of Business Entity: General Tax and Nontax Factors Formation © 2014 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. Murphy & Higgins, Concepts in Federal Taxation, 2014 edition

13-2 Introduction  Taxpayers must choose a form for a business entity  Choice is based on tax and non-tax factors © 2014 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.

13-3 Non-Tax Factors (slide 1 of 2)  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? © 2014 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.

13-4 Non-Tax Factors (slide 2 of 2)  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? © 2014 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.

13-5 © 2014 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. How do non-tax factors affect each entity?

13-6 Sole Proprietorship The Owner : Has unlimited liability Can easily transfer ownership interest Has full management control The Entity: Ceases to exist when ownership changes Has a low cost of formation Has a limited ability to raise capital © 2014 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. a business owned by one individual

13-7 Partnership 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 © 2014 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. Exists when two or more persons engage collectively in a profit making activity

13-8 Corporation 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 © 2014 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. an artificial entity created under the auspices of state law

13-9 S Corporation The Owners : Have limited liability Can easily transfer ownership interest Have no right to direct management Are limited to a maximum number of 100 The Entity: Continues to exist when ownership changes Has a relatively high cost of formation Has an excellent ability to raise capital © 2014 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. a regular corporation with special tax attributes

13-10  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 © 2014 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. S Corporation Election

13-11 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 © 2014 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.

13-12 Limited Liability Company The Owners: Have limited liability Cannot easily transfer ownership interest Have full management control Not limited to number of owner s The Entity: Ceases to exist when ownership changes Has a moderate cost of formation Has a good ability to raise capital © 2014 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. Has corporate characteristics with the conduit tax treatment of partnerships

13-13 Limited Liability Partnership 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 © 2014 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. a general partnership with limited liability for owners

13-14 © 2014 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. How do tax factors affect each entity?

13-15 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? © 2014 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.

13-16 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 © 2014 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.

13-17  S Corporation: conduit to shareholders Form 1120S, Schedule K-1 Separable items like partnership  C Corporation: Corporation pays Form 1120 © 2014 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. Who Pays the Tax?

13-18 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 © 2014 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.

13-19 Is Double Taxation a Problem?  No Sole Proprietorships Partnerships S Corporations  Yes C Corporations © 2014 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.

13-20 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 © 2014 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.

13-21 © 2014 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. How do fringe benefits and employment taxes apply to employees of each entity?

13-22 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 © 2014 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.

13-23 Fringe Benefit Limitations  Sole proprietors are not employees No deduction allowed for salary or benefits © 2014 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.

13-24  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 © 2014 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. Fringe Benefit Limitations

13-25 Social Security Taxes  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 % OASDI Maximum amount subject to OASDI is $113,700 © 2014 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.

13-26  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 © 2014 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. Social Security Taxes

13-27 Issues at Formation 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? © 2014 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.

13-28 © 2014 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. How are property transfer issues treated by each entity?

13-29 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 © 2014 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.

13-30 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 © 2014 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.

13-31 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 © 2014 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.

13-32 © 2014 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. How are basis issues treated by each entity?

13-33 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 © 2014 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.

13-34 Sole Proprietorship Basis Determination  Ownership of property never changes  Owner’s basis remains unchanged © 2014 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.

13-35 Partnership Basis Determination  Basis determines the taxability of distributions from the entity to the partner  Initial basis = basis in property transferred and/or FMV of services contributed © 2014 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.

13-36 Increased by: Additional contributions Partner’s share of income Partner’s share of increases in entity debt Entity debt taken by partner Decreased by: Distributions received Partner’s share of losses Partner’s share of decreases in entity debt Partner’s debt taken by entity © 2014 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. Partnership Basis Determination

13-37 C Corporation Basis Determination  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 © 2014 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.

13-38  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 © 2014 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. C Corporation Basis Determination

13-39  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 © 2014 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. S Corporation Basis Determination

13-40  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 © 2014 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. S Corporation Basis Determination

13-41 © 2014 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. How are costs incurred prior to and during formation treated?

13-42 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 © 2014 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.

13-43  May elect to deduct first $5,000 currently Current deduction phased-out $1 for $1 if total costs exceed $50,000 No current deduction allowed if total costs exceed $55,000  Costs not currently deducted are amortized over 180 months © 2014 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. Organization and Start-up Costs

13-44 © 2014 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. What accounting period and method should be used?

13-45 Accounting Periods  The annual accounting period concept requires all entities to report operations on an annual basis © 2014 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.

13-46  Taxpayers are generally free to choose their accounting period But  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 owners (> 5%) if majority partners’ years do not agree © 2014 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. Accounting Periods

13-47 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 © 2014 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.