© 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 13 Choice of Business Entity: General Tax and Nontax Factors Formation Murphy & Higgins, Concepts in Federal Taxation, 2010 edition

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

13-3 © 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. 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?

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

13-5 © 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. Sole Proprietorship The Owners : 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 Is a business owned by one individual

13-6 © 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. 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 Exists when two or more persons engage collectively in a profit making activity

13-7 © 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. 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 Is an artificial entity created under the auspices of state law

13-8 © 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. 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 75 The Entity: Continues to exist when ownership changes Has a relatively high cost of formation Has an excellent ability to raise capital Is a regular corporation with special tax attributes

13-9 © 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. 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

13-10 © 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. 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

13-11 © 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. Limited Liability Company 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 Has corporate characteristics with the conduit tax treatment of partnerships

13-12 © 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. 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 Is a general partnership with limited liability for owners

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

13-14 © 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. 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?

13-15 © 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. 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

13-16 © 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. S Corporation: conduit to shareholders Form 1120S, Schedule K-1 Separable items like partnership C Corporation: Corporation pays Form 1120 Who Pays the Tax?

13-17 © 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. 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

13-18 © 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. Is Double Taxation a Problem? No Sole Proprietorships Partnerships S Corporations Yes C Corporations

13-19 © 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. 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

13-20 © 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. How do fringe benefits and employment taxes apply to employees of each entity?

13-21 © 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. 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

13-22 © 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. Fringe Benefit Limitations Sole proprietors are not employees No deduction allowed for salary or benefits

13-23 © 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. 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 Fringe Benefit Limitations

13-24 © 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. 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 $106,800

13-25 © 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. 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 Social Security Taxes

13-26 © 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. 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?

13-27 © 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. How are property transfer issues treated by each entity?

13-28 © 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. 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

13-29 © 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. 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

13-30 © 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. 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

13-31 © 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. How are basis issues treated by each entity?

13-32 © 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. 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

13-33 © 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. Sole Proprietorship Ownership of property never changes Owner’s basis remains unchanged

13-34 © 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. 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

13-35 © 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. 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 Partnership

13-36 © 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. 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

13-37 © 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. 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 C Corporation

13-38 © 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. 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

13-39 © 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. 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 S Corporation

13-40 © 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. How are costs incurred prior to and during formation treated?

13-41 © 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. 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

13-42 © 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. 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 Organizational and Start-up Costs

13-43 © 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. What accounting period and method should be used?

13-44 © 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. Accounting Periods The annual accounting period concept requires all entities to report operations on an annual basis Taxpayers are generally free to choose their accounting period

13-45 © 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. 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 Periods

13-46 © 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. 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