1. The Choice of Business Entity
Chapter 11
The Choice of Business Entity
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., All Rights Reserved.

2. Objectives
This is a tax planning chapter - HOW to use rules in relation to:
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.

3. Passthrough Entities
Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income.
This treatment results in a single level of taxation.
Cash distributions are generally NOT taxable.
The cash represents a return of
investment and does not affect
the income or loss reported by
the owner.

4. Benefits of Passthrough Losses
Passthrough loss is generally deductible in the year the loss is generated at the individual’s marginal tax rate (i.e., immediate tax savings!).
For start-up corporations, loss must be carried forward and used to offset income in a taxable year where profits are reported.
NOL deduction provides a benefit at
the corporation’s tax rate in the year
the NOL offsets profits.

5. Example:
Investor A has $200,000 of taxable wage income in 2002, 2003 and 2004 before his investment in Entity X. Entity X has an end of year loss in 2002 and 2003 of ($50,000) per year and has profits in 2004 of $300,000.
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?

6. Pass-through Example
2002 deduction = ($50,000) x 35% = ($17,500) refund
2003 deduction = ($50,000) x 35% = ($17,500) refund;
2004 income = $300,000 x 35% = $105,000 tax
NPV tax cost at 10% if END of year payments = $53,323
($17,500) + [($17,500) x .909) + [$105,000 x .826)

7. Corporation Example
2004 net income = $200,000 ($300,000 – $50,000 - $50,000), corporate tax = $61,250; PV = $50,592 [$61,250 x .826) tax cost.
The PV of tax costs for the corporation is lower even though the tax refund was delayed. Why?
lower corporate tax rates
BUT, if corporation pays a dividend equal to after-tax cash flows, then the owner is also taxed on $138,750 – which results in a tax of $48,562 ($138,750 x .35).
PV of total tax of $90,704 [$50,592 + ($48,562 x .826)], which is more than pass-through tax of $53,323.

8. Passthrough Entities Only Have a Single Level of Tax
The preceding example illustrates the benefits of a pass-through entity:
a) Losses can be used immediately.
b) Earnings are subject to a single level of taxation.

9. Family Income Shifting
Goal - have income taxed at lower rates (e.g. children’s rates) or avoid estate tax.
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 and are entitled to their share of any cash distributions from the business.
The transfer of ownership may have GIFT TAX consequences if relatives don’t pay FMV.

10. Limits on Family Income Shifting
Family members cannot be partners in a personal service business unless they can perform the services.
In contrast, a family member can be a partner in a business in which property is a material income-producing factor.
Family members providing services
must first receive guaranteed
payments that constitute reasonable
compensation before net income is
allocated.

11. Limits on Family Income Shifting
Income of family partnerships is allocated according to proportionate interests in partnership capital.
Income of all S corporations is
allocated according to the
proportionate shares of stock
held by each shareholder.

12. Other Considerations
The potential tax savings of operating a passthrough entity must be compared to the legal and accounting costs of creating and operating the business.
The creation of a passthrough entity results in the dilution of parents’ wealth and control of the business.
Transfers must be complete and legally binding, irrevocable.
Buy-sell agreements are used to restrict family members from selling their equity interests to an unrelated third party.

13. Other Considerations (continued)
To retain control, the entrepreneur (e.g., the parents) should consider:
A limited partnership with the entrepreneur as sole general partner, or
An S corporation with voting
and nonvoting stock.

14. Other Considerations (continued)
Gift tax may be assessed on the transfer of an equity interest in an established business to a family member.
Question 3:
Mrs. J is eager to create a family partnership to generate income and cash flow for her three college-age children. Should she transfer ownership in a business established 15 years ago with $15 million FMV of assets or a business started 10 months ago with $300,000 FMV of assets?

15. Partnership versus S Corporation
S Corps require an IRS election, incorporation documents, and possible corporate state tax payments. The IRS has eased some regulatory restrictions over the past few years.
Partnership agreements have more flexibility, but require more careful legal drafting.
Partners (but not S Corp shareholders) receive tax basis for liabilities of the partnership increasing the deductibility of losses.
S Corporation shares are transferable. Partnership interests are not - requires new partnership agreement.
Employee benefit planning favors S Corp.

16. Liability Associated with Types of Flow-Through Entities
Liability associated with different forms of ownership:
General partnership – full liability.
Limited liability partnership - general partners are not personally liable for malpractice-related claims of another general partner.
Limited partnership - at least one general partner with full liability, but other partners have no liability.

17. Liability Associated with Types of Flow-Through Entities (continued)
Limited liability partnership - partners not responsible for other partner’s malpractice.
Limited liability company (treated like partnership for tax, corporation legally).
S Corporation creates limited liability.

18. Closely-held Corporations
Biggest challenge is how investors can avoid double taxation of corporate earnings. One way is to have the investor assume an additional role with respect to the corporation.
If shareholders are also creditors, interest expense is deductible to corporation.
If shareholders are also employees, wage expense is deductible to corporation.
If shareholders are also landlords, rent expense is deductible to corporation.

19. Closely-held Corporations
IRS challenge turns “unreasonable” payments into constructive dividends.
How does the IRS decide what is an unreasonable payment for:
Wages
Rent
Interest?

20. Thin Capitalization
If the debt held by shareholders of a closely-held corporation is excessive, the IRS may contend that some or all of the interest payments are nondeductible dividends.
Accordingly, shareholders have taxable income – not a nontaxable return of investment.
Rule of thumb – a debt-to-equity ratio greater than 3 to 1 may appear “unreasonable”

21. Accumulating Corporate Profits as a Tax Shelter
Some corporations keep earnings in the corporation in order to avoid double taxation or they delay paying dividends.
If this practice results in an increase in stock price, it is possible for investors to convert ordinary dividends into capital gain by selling stock.

22. IRS Weapons Against Using Corporation as Tax Shelter
Accumulated earnings tax
Penalty is to assess tax on accumulated taxable income at highest individual tax rate - like forcing a deemed dividend.
Penalty = 15% of accumulated taxable income (taxable income less income tax less dividends paid less reasonable needs of business)
Common traits that IRS looks for investigating corporate tax shelters:
Little or no dividends paid,
Abundance of liquid assets not reinvested in production capacity, or
Especially substantial loans to shareholders.

23. IRS Weapons Against Using Corporation as Tax Shelter
Personal Holding Company tax
Similar penalty assesses tax on undistributed earnings at 15%
Applies to corporations whose income is principally dividends, interest, rents and royalties.
Application of Accum. Earn. Tax and PHC tax:
These rules prevent abuse, so assessment of these taxes is rare in practice.

24. Controlled Group Tax Rates
The corporate tax rates are progressive. Owners could reduce their overall tax by fragmenting their business into multiple corporate entities.

25. Controlled Group Tax Rates
The tax law requires that corporations aggregate the taxable income of all members of a controlled group before compute the tax. The tax is then allocated according to the entities’ proportion of taxable income.
Controlled groups include parent-subsidiaries and brother-sister groups.