Chapter 14 Choice of Business Entity: Operations and Distributions © 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

14-2 Taxation of Operations  The general formula for computing income tax is Gross Income less:Deductions Taxable Income times: Tax rate (for entity) Income tax less:Tax prepayments and Tax credits Tax (refund) due with return © 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.

14-3 Sole Proprietorship Exceptions to the General Formula  Many items are reported elsewhere on the owner’s return and not reported as part of the proprietorship’s income Investment income and expense Capital gains and losses Section 1231 gains and losses Passive activity items Charitable contributions Owner’s personal expenses Tax credits Net operating losses © 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.

14-4 Partnership Exceptions to the General Formula (slide 1 of 4)  Income and expenses are reported by the partners according to their ownership interest  Items which would receive special treatment on a partner’s return are reported separately All items listed separately for sole proprietorships Amounts expensed under Section 179 Alternative minimum tax items Nondeductible expenses © 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.

14-5  Losses are deductible subject to three limitations Limited to the amount of a partner’s basis (capital recovery concept) Limited to the partner’s at-risk amount Limited by passive activity 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. Partnership Exceptions to the General Formula (slide 2 of 4)

14-6  Partner’s basis is adjusted to reflect partnership income and losses reported Increased for income or gains  Designed to prevent double taxation Decreased for losses  Designed to prevent double benefit and reflect capital recovery © 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 Exceptions to the General Formula (slide 3 of 4)

14-7  Transactions between a partner and partnership are subject to related-party rules Partner who has > 50% interest in a partnership is a related party Losses on sales are disallowed © 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 Exceptions to the General Formula (slide 4 of 4)

14-8 Corporation Exception to the General Formula (Slide 1 of 5)  Taxable income is determined at the corporate level under the general formula  Exceptions: Net capital losses are not deductible Corporations must recapture additional depreciation for Sec property = 20% of straight-line depreciation taken © 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.

14-9 Dividends-Received deduction  Designed to relieve triple taxation  Corporation may deduct a % of the dividends received from other 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. Corporation Exception to the General Formula (slide 2 of 5) Percent Owned < 20% > 20% and < 80% > 80% Deduction % 70% 80% 100%

14-10  Passive activity losses Corporations are not subject to the passive activity rules  Personal service corporations must follow them  Closely-held corporations may use passive losses to offset active income but not portfolio income © 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. Corporation Exception to the General Formula (Slide 3 of 5)

14-11  Charitable contributions are limited to 10% of taxable income Before dividend-received deductions and any carrybacks Excess contributions may be carried forward 5 years © 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. Corporation Exception to the General Formula (Slide 4 of 5)

14-12  Net operating loss cannot be used in the current year or distributed to shareholders May be carried back 2 years and forward 20 until used May elect to forego the carry back © 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. Corporation Exception to the General Formula (Slide 5 of 5)

14-13 S Corporation Exception to the General Formula (slide 1 of 2)  Income and expenses are reported by the shareholders according to their ownership interest Items which would receive special treatment on a shareholder’s return are reported separately Losses are deductible subject to the three limitations faced by partnerships © 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.

14-14  S corporations are also subject to the corporate depreciation recapture rules for Section 1250 property  May not take the dividend-received deduction  NOLs are subject to three limitations Basis limitation At-risk limitation Passive activity loss limitation © 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 Exception to the General Formula (slide 2 of 2)

14-15 Entity Distributions  Tax treatment of distributions to an owner depends on the amount and kind of the distribution and the entity making the distribution  Distributions are either Non Liquidating Liquidating © 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.

14-16 Non Liquidating Distributions  What are the effects of Non Liquidating distributions on each 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.

14-17 Sole Proprietorship Effects of Non Liquidating Distributions  Distribute cash No tax consequences to owner/entity  Distribute property No gain or loss recognized until owner sells the property © 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.

14-18 Partnership Effects of Non Liquidating Distributions  Distribute cash Partner recognizes no gain unless amount exceeds partner’s basis; excess is capital gain No tax consequences to partnership  Distribute property Partner recognizes no gain or loss; Basis is the lesser of carryover basis or partner's basis No tax consequences to the partnership © 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.

14-19 C Corporation Effects of Non Liquidating Distributions (slide 1 of 2)  Distribute cash Shareholder reports  Dividend income to the extent of earnings and profits or corporation, then  Return of capital to the extent of basis, then  Capital gain No tax consequences to corporation © 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.

14-20  Distribute property Shareholder reports same as cash Corporation reports gain “as if the property was sold” for its FMV. No loss allowed © 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 Effects of Non Liquidating Distributions (slide 2 of 2)

14-21  Distribute cash Shareholder recognizes no gain unless amount exceeds basis; excess is capital gain No tax consequences to corporation  Distribute property Same as for cash Corporation reports gain “as if the property was sold” for its FMV. No loss allowed © 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 Effect of Non Liquidating distributions

14-22 Liquidating Distributions  What are the effects of Liquidating distributions on each 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.

14-23 Sole Proprietorship Effects of Liquidating Distributions  Distribute cash No tax consequences to owner/entity  Distribute property When property is sold; gain or loss = FMV less 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.

14-24 Partnership Effects of Liquidating Distributions  Distribute cash Partner recognizes  No gain unless amount exceeds partner’s basis; excess is capital gain  If only cash is distributed, loss may be recognized No tax consequences to partnership  Distribute property Partner recognizes no gain or loss; Basis is the lesser of carryover basis or partner's basis No tax consequences to the partnership © 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.

14-25 C Corporation Effects of Liquidating Distributions  Distribute cash Shareholder reports capital gain or loss = amount less basis No tax consequences to corporation  Distribute property Shareholder reports same as cash Corporation reports gain or loss “as if the property was sold” for its FMV © 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.

14-26 S Corporation Effects of Liquidating Distributions  Distribute cash Shareholder recognizes capital gain or loss equal to distribution amount less basis No tax consequences to corporation  Distribute property Shareholder reports same as for cash Corporation reports gain or loss “as if the property was sold” for its FMV © 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.

14-27 Tax Planning With proper tax planning, owners of entities can minimize their overall tax liability by taking full advantage of the progressive tax rate structure  Income splitting  Children as employees  Family entities © 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.