Taxation of Business Entities Copyright ©2010 Cengage Learning

Taxation of Business Entities Copyright ©2010 Cengage Learning
Chapter 9 Corporations: Organization, Capital Structure, and Operating Rules Taxation of Business Entities Copyright ©2010 Cengage Learning

Various Business Forms
Sole proprietorships Partnerships Trusts and estates S corporations Regular corporations (also called C corporations)

Sole Proprietorship Not a separate taxable entity
Income reported on owner’s Sch. C

Partnership Separate entity, but does not pay tax
Allocates partnership income to partners Partners report partnership income on personal tax returns Files information return (Form 1065)

S Corporation Separate entity, only pays special taxes (e.g., built-in gains) Allocates entity income to shareholders Shareholders report entity income on personal tax return Files information return (Form 1120S)

C Corporation Separate tax-paying entity
Reports income and expenses on Form 1120 Income taxed at corporate level and again at owner level when distributed as a dividend

Dividends Double taxation stems, in part, from the fact that dividend distributions are not deductible by the corporation To alleviate some of the double taxation effect, Congress reduced the tax rate applicable to dividend income of individuals for years after 2002 Generally, dividends are taxed at same marginal rate applicable to a net capital gain Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 0% tax on qualified dividends received Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends

Corporate Income Tax Rates

Nontax Issues in Selecting Entity Form (slide 1 of 3)
Liability Sole proprietors and some partners have unlimited liability for claims against the entity Capital-raising Corporations and partnerships to a lesser extent can raise large amounts of capital for entity ventures

Transferability Corporate stock is easily sold, but partners must approve partnership interest transfer Continuity of life Corporations exist indefinitely

Centralized management Corporate actions are governed by a board of directors Partnership operations may be conducted by each partner without approval by other partners

Limited Liability Companies (LLC)
LLCs have proliferated since 1988 when IRS ruled it would treat qualifying LLCs as partnerships Major nontax advantage Allows entity to avoid unlimited liability Major tax advantage Allows qualifying business to be treated as a partnership for tax purposes, thereby avoiding double taxation associated with C corporations

Entity Classification After 1996 (slide 1 of 2)
Check-the-box Regulations Allows taxpayer to choose tax status of entity without regard to corporate or noncorporate characteristics Entities with > 1 owner can elect to be classified as partnership or corporation Entities with only 1 owner can elect to be classified as sole proprietorship or as corporation

Entity Classification After 1996 (slide 2 of 2)
Check-the-box Regulations (cont’d) If no election is made, multi-owner entities treated as partnerships, single person businesses treated as sole proprietorships Election is not available to: Entities incorporated under state law, or Entities required to be corporations under federal law (e.g., certain publicly traded partnerships)

Consequences of §351 (slide 1 of 2)
In general, no gain or loss to transferors: On transfer of property to corporation In exchange for stock IF immediately after transfer, transferors are in control of corporation

Consequences of §351 (slide 2 of 2)
If boot (property other than stock) received by transferors Gain recognized up to lesser of: Boot received or Realized gain No loss is recognized

Formation Example Ron will incorporate his donut shop: Asset Fair Mkt
Tax Basis Value . Cash $10,000 $ 10,000 Furniture & Fixtures 20, ,000 Building 40, ,000 Total $70,000 $170,000 Without §351: gain of $100,000. With §351: no gain or loss. Ron’s economic status has not changed.

Issues re: Formation (slide 1 of 7)
Definition of property includes: Cash Secret processes and formulas Unrealized accounts receivable (for cash basis taxpayer) Installment obligations Code specifically excludes services from definition of property

Stock transferred Includes common and most preferred stock Does not include nonqualified preferred stock which possesses many attributes of debt Does not include stock rights or stock warrants Does not include corporate debt or securities (e.g., corporate bonds) Treated as boot

Transferors must be in control immediately after exchange to qualify for nontaxable treatment To have control, transferors must own: 80% of total combined voting power of all classes of stock entitled to vote, and 80% of total number of shares of all other classes of stock

“Immediately after” the transfer Does not require simultaneous transfers if more than one transferor Rights of parties should be outlined before first transfer Transfers should occur as close together as possible

After control is achieved, it is not necessarily lost upon the sale or gift of stock received in the transfer to others not party to the initial exchange But disposition might violate §351 if prearranged

Transfers for property and services May result in service provider being treated as a member of the 80% control group Taxed on value of stock issued for services Not taxed on value of stock received for property contributions Service provider should transfer property having more than “a relatively small value”

Subsequent transfers to existing corporation Tax-free treatment still applies as long as transferors in subsequent transfer own 80% following exchange

Assumption of Liabilities (slide 1 of 2)
Assumption of liabilities by corp DOES NOT result in boot to the transferor shareholder for gain recognition purposes Liabilities ARE treated as boot for determining basis in acquired stock Basis of stock received is reduced by amount of liabilities assumed by the corp

Assumption of Liabilities (slide 2 of 2)
Liabilities are NOT treated as boot for gain recognition unless: Liabilities incurred for no business purpose or as tax avoidance mechanism Boot = Entire amount of liability Liabilities > basis in assets transferred Gain recognized = Excess amount (liabilities - basis)

Formation with Liabilities Example (slide 1 of 2)
Property transferred has: Fair market value = $150,000 Basis = ,000 Realized Gain = $ 50,000

Formation with Liabilities Example (slide 2 of 2)
Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $80, $120,000 $120,000 Boot None $ 20,000 $120,000 Gain Recognized None $20,000 $ 50,000* *(Gain is lesser of $50,000 realized gain or boot)

Basis Computation for §351 Exchange (slide 1 of 2)
Shareholder’s basis in stock: Adjusted basis of transferred assets + Gain recognized on exchange - Boot received Liabilities transferred to corporation Minus: Adjustment for loss property (if elected) = Basis of stock received by shareholder

Basis Computation for §351 Exchange (slide 2 of 2)
Corporation’s basis in assets: Adjusted basis of transferred assets + Gain recognized by transferor shareholder - Adjustment for loss property (if required) = Basis of assets to corporation

Basis in Stock in Last Example
Adjusted Basis of transferred assets: $100,000 Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose . Liability: $ 80, $120, $120,000 Basis in assets Transferred $100, $ 100, $100,000 + Gain recognized None , ,000 - Liab. Transferred (80,000) (120,000) (120,000) Basis in stock $ 20, $ 30,000

Corporation’s Basis in Assets Received in Last Example
Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $ 80, $120, $120,000 Basis of transferred assets: $100, $100, $100,000 Gain recognized by shareholder None , ,000 Basis to Corp $100, $120, $150,000

Basis Adjustment for Loss Property (slide 1 of 2)
When built-in loss property is contributed to a corporation Aggregate basis in property may have to be stepped down so basis does not exceed the F.M.V. of property transferred Necessary to prevent parties from obtaining double benefit from losses involved

Basis Adjustment for Loss Property (slide 2 of 2)
Step-down in basis is allocated among assets with built-in loss Alternatively, if shareholder and corporation both elect, the basis reduction can be made to the shareholder’s stock Built-in loss adjustment places loss with either the shareholder or the corporation but not both

Stock Issued for Services Rendered
Corporation may be able to deduct the fair market value of stock issued in exchange for services as a business expense e.g., Performance of management services May claim a compensation expense deduction under § 162 If the services are such that the payment is characterized as a capital expenditure (e.g., legal services in organizing the corporation) Must capitalize the amount as an organizational expenditure

Holding Period Holding period of stock received
For capital assets or §1231 property, includes holding period of property transferred to corporation For other property, begins on day after exchange Corp’s holding period for property acquired in the transfer is holding period of transferor

Recapture Considerations
In a § 351 transfer where no gain is recognized, the depreciation recapture rules do not apply Recapture potential associated with the property carries over to the corporation

Capital Contributions (slide 1 of 3)
No gain or loss is recognized by corp on receipt of money or property in exchange for its stock Also applies to additional voluntary pro rata contributions of money or property to a corp even though no additional shares are issued

Capital contributions of property by nonshareholders Not taxable to corporation Basis of property received from nonshareholder is -0-

Capital contributions of cash by nonshareholder Must reduce basis of assets acquired during 12 month period following contribution Any remaining amount reduces basis of other property owned by the corp Applied in the following order to depreciable property, amortizable property, assets subject to depletion, and other remaining assets

Debt vs. Equity (slide 1 of 2)
Corporation pays interest to debt holder which is deductible by corporation Interest paid is taxable as ordinary income to individual or corporate recipient Loan repayments are not taxable to investors unless repayments exceed basis

Debt vs. Equity (slide 2 of 2)
Corporation pays dividends which are not deductible Taxable to individuals at low capital gain rates to extent corp has E & P Corporate shareholder may receive dividends received deduction

Reclassification of Debt as Equity
If corp is “thinly capitalized,” i.e., has too much debt and too little equity IRS may argue that debt is really equity and deny tax advantages of debt financing If debt has too many features of stock, principal and interest payments may be treated as dividends

Thin Capitalization Factors (slide 1 of 2)
Debt instrument documentation Debt terms (e.g., reasonable rate of interest and definite maturity date) Timeliness of repayment of debt Whether payments are contingent on earnings

Thin Capitalization Factors (slide 2 of 2)
Subordination of debt to other liabilities Whether debt and stock holdings are proportionate Use of funds (if used to finance initial operations or to acquire capital assets, looks like equity) Debt to equity ratio

Dividends Received Deduction (slide 1 of 3)
If corporation owns stock in another corporation and receives dividends, a portion of dividends may be deducted from income: % owned Deduction Percent Less than 20% %  20% but < 80% % 80% or more, and affiliated %

The dividends received deduction is limited to a percentage of the taxable income of a corporation For this purpose, taxable income is computed without regard to The NOL The domestic production activities deduction The dividends received deduction, and Any capital loss carryback to the current tax year The percentage of taxable income limitation corresponds to the deduction percentage

The following steps are useful in calculating the dividends received deduction 1. Multiply dividends received by deduction percentage 2. Multiply taxable income by deduction percentage 3. Subtract 1. from taxable income - If entity has income before DRD, but DRD creates NOL, amount in 1. is DRD -If DRD does not create NOL, deduction is limited to lesser of 1. or 2.

DRD Examples Z Corp owns 60% of X Corp’s stock in years 1, 2 & 3. Dividend of $200 is received each year. Limit (Step 1) is 80% × $200 = $160. _ Income Dividend rec’d Expenses (340) (340) (340) Income before DRD 80% of income Year #1 $208 > $160, so $160 DRD Year #2 $129 < $160, so $129 DRD Year #3 DRD causes NOL ($159-$160), so $160 DRD is used. $2 less income results in $31 more DRD.

Organizational Expenditures (slide 1 of 2)
A corporation may elect to amortize organizational expenses over a period of 15 years or more A special exception allows the corporation to immediately expense the first $5,000 of these costs Phased out on a dollar-for-dollar basis when these expenses exceed $50,000

Organizational Expenditures (slide 2 of 2)
Organizational expenditures include the following: Legal services incident to organization Necessary accounting services Expenses of temporary directors and of organizational meetings of directors and shareholders Fees paid to the state of incorporation Expenditures connected with issuing or selling shares of stock or other securities or with the transfer of assets to a corporation do not qualify Such expenditures reduce the amount of capital raised and are not deductible at all

Start-up Expenditures (slide 1 of 2)
Start-up expenditures include: Various investigation expenses involved in entering a new business e.g., Travel, market surveys, financial audits, legal fees Also includes operating expenses, such as rent and payroll, that are incurred by a corporation before it actually begins to produce any gross income

Start-up Expenditures (slide 2 of 2)
At the election of the taxpayer, such expenditures can be treated in the same manner as organizational expenditures Up to $5,000 can be immediately expensed (subject to the dollar cap and excess-of-$50,000 phaseout) Any remaining amounts are amortized over a period of 180 months or longer

Corporate Tax Formula Gross income
Less: Deductions (except charitable, Div. Rec’d, NOL carryback, STCL carryback) Taxable income for charitable limitation Less: Charitable contributions (< = 10% of above) Taxable income for div. rec’d deduction Less: Dividends received deduction Taxable income before carrybacks Less: NOL carryback and STCL carryback TAXABLE INCOME

Tax Liability of Related Corporations
Subject to special rules for computing income tax Limits controlled group’s taxable income in tax brackets below 35% to amount corporations in group would have if they were one corporation Controlled group includes: Parent-subsidiary groups Brother-sister groups Combined groups

Parent-Subsidiary Controlled Group
Consists of one or more chains of corporations connected through stock ownership with a common parent Ownership is established through either: Voting power test: requires ownership of stock with at least 80% of total voting power of all classes of stock entitled to vote Value test: requires ownership of at least 80% of total value of all classes of stock

Parent-Subsidiary Controlled Group

Application of §482 §482 permits IRS to reallocate income, deductions, and credits between two or more businesses owned or controlled by the same interests Used to prevent avoidance of taxes or to reflect income properly Controlled groups of corps are especially vulnerable to §482

Corporate Filing Requirements (slide 1 of 2)
Must file Form 1120 on or before the 15th day of 3rd month following close of tax year even if it has no taxable income Automatic 6 month extensions are available by filing Form 7004

Corporate Filing Requirements (slide 2 of 2)
Must make estimated tax payments equal to lesser of: 100% of corporation’s final tax, or 100% of tax for preceding year No estimated tax payments required if tax liability expected to be less than $500

Schedule M-1 Corporations must reconcile financial accounting income with taxable income on Sch M-1, Form 1120 Common reconciling items include: Federal tax liability Net capital losses Income reported for tax but not book income (e.g., prepaid income) and vice versa Expenses deducted for book income but not tax (e.g., excess charitable contributions) and vice versa

Schedule M-2 Corporations must reconcile retained earnings at beginning of year with retained earnings at end of year using Sch M-2, Form 1120

Schedule M-3 Corporate taxpayers with total assets of $10 million or more are now required to report much greater detail regarding differences in financial accounting income (loss) and taxable income (loss) Reported on Schedule M–3 Schedule M–3 should Create greater transparency between corporate financial statements and tax returns Help the IRS identify corporations that engage in aggressive tax practices

Dr. Donald R. Trippeer, CPA
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta

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