1. 1 Chapter 13 Choice of Entity- General Fall, 2009 Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2009, Dr. Howard Godfrey Edited November 18, 2009. T9-Chp-13-1-Entity-Choice-General-2009

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5. 5 Non-Tax Factors- choice of a form for a business entity 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?

6. 6 Sole Proprietorship: A business owned by one individual. The owner: þ Has unlimited liability þ Can easily transfer ownership interest þ Has full management control The entity: þCeases to exist when ownership changes þ Has a low cost of formation þ Has a limited ability to raise capital

7. 7 Partnership -two or more persons engage collectively in a profit making activity. The owners: þAre fully liable (except for limited partners) þ Cannot easily transfer ownership interest þ Have full management control The entity: þCeases to exist if >50% ownership changes þ Has a moderate cost of formation þ Has a good ability to raise capital

8. 8 Corporation: an artificial entity created under the auspices of state law. The owners: þ Have limited liability þ Can easily transfer ownership interest þ Have no right to direct management þ No limit on number of shareholders The entity: þ Continues to exist when ownership changes þ Has a relatively high cost of formation þ Has an excellent ability to raise capital

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

10. S Corporation Election 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

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

12. Limited Liability Company: corporate characteristics with the conduit tax treatment of partnerships. The owners: þ Have limited liability þ Cannot easily transfer ownership interest þ Have full management control þ No limit on number of owners The entity: þ Ceases to exist when ownership changes þ Has a moderate cost of formation þ Has a good ability to raise capital

13. Limited Liability Partnership is a general partnership with limited liability for owners. The owners: þ Have liability only for their own acts þ Cannot easily transfer ownership interest þ Have full management control þ Must have at least 2 owners The entity: þ Ceases to exist when ownership changes þ Has a moderate cost of formation þ Has a good ability to raise capital

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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 ?

16. #1: 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

17. #1: Who Pays the Tax? S Corporation: conduit to shareholders – Form 1120S, Schedule K-1 – Separable items like partnership C Corporation: Corporation pays – Form 1120 – Owners pay income tax on div.

20. #1: 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 – How will Jan’s computer repair company tax differ if it is a PSC? (2 slides forward)

21. #2: Is Double Taxation a Problem? No – Sole Proprietorships – Partnerships – S Corporations Yes – C Corporations

26. #3: 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

27. 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 Sole proprietors are not employees – No deduction allowed for salary or benefits

28. Fringe Benefit Limitations 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

29. Willie is the director of golf for Rooney Corp. Willie owns a 20% interest in Rooney. He receives a salary of $60,000 and fringe benefits costing $6,000. Rooney's taxable income before considering the payments to and on behalf of Willie is $250,000. Rooney distributes a $50,000 dividend to its shareholders. How much income does Willie have from Rooney? a. $ 60,000 b. $ 70,000 c. $ 76,000 d. $ 96,800 e. $102,800 Ans: B (Suppose Rooney is an S Corp or Ptshp.)

30. Social Security Taxes The social security tax is 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% = 12.4% OASDI + 2.9% Medicare –Maximum amount subject to OASDI is $106,800 for 2009

31. Social Security Taxes 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

32. Mary’s salary is $120,000 per year. She has federal income tax of $20,000 withheld. There is no state income tax. What is her take-home pay for the year? See following slide.

34. Self-Employment Taxes. Pg. __. Self-employed individuals must pay both the employer’s and the employee’s share of FICA taxes for a combined rate of 15.3% – 12.4 % (6.2% x 2) for Social Security on income up to $106,800 in 2009 – 2.9% (1.45% x 2) for Medicare – no income limit Deduction for employer portion simulated by multiplying net income from self-employment by 92.35% (100% - 7.65%) before calculating SE tax

35. Self-Employment Taxes Tax computed on Schedule SE Self-employed individuals are also allowed a deduction for AGI for the employer’s half of self-employment taxes – Calculated by multiplying net income from self-employment by 92.35% (100% - 7.65%) before calculating SE tax There is no deduction for the employee’s half of the taxes

36. Self-Employment Tax Carrie owns a business that she operates as a sole proprietorship. The business had a net profit of $25,000. This is Carrie’s only earned income. a. How much self-employment taxes will she pay? b. How much can she deduct on her tax return? c. If the business had a net loss of $10,000 (instead of a $25,000 profit), how much in self-employment taxes must Carrie pay?

39. Self-Employment Tax – George -1 George has net income from self- employment of $43,000 (from his week-end tax practice). He has a salary of $72,000, earned as a VP of a local corporation. What is his self-employment tax? What amount may he deduct?

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43. 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?

44. 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

45. 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

46. 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

47. Tinker incorporates his proprietorship by transferring his land to the Big Tinker Corp. in exchange for all its stock, which has a basis of $800,000 and a value of $1,200,000. The land is subject to a $40,000 liability that the corporation assumes. Tinker receives Big Tinker stock worth $1,160,000. What is Tinker’s gain on receipt of the stock? What is his basis in the stock received from the corporation?

52. The following slide illustrates the unique impact of debt for partners in a partnership as explained in the text on page ____. Please ignore recourse and non-recourse debt material.

58. (CPAM95#27-Mod) Strom acquired a 25 percent interest in Ace Partnership by contributing land with a basis of $20,000 and FMV of $50,000. The land was subject to a $24,000 debt, which was assumed by Ace. No other debt existed at the time of the contribution. What was Strom's basis in Ace? a. $0 b. $2,000 c. $26,000 d. $32.000

59. (CPAM95#27-Mod) Strom acquired a 25 percent interest in Ace Partnership by contributing land with a basis of $20,000 and FMV of $50,000. The land was subject to a $24,000 debt, which was assumed by Ace. No other debt existed at the time of the contribution. What was Strom's basis in Ace? a. $0 b. $2,000 c. $26,000 d. $32.000

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61. 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

62. Sole Proprietorship Ownership of property never changes Owner’s basis remains unchanged

63. 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

65. 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

66. C Corporation Shareholders do not adjust their stock basis for corporate earnings. 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

67. S 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

68. S Corporation 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

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70. 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

71. Organizational and Start-up Costs Amortize over 180 months, or Elect to deduct $5,000 currently – Phased-out $1 for $1 if total costs exceed $50,000 Costs (above write-off of up to $5,000) are amortized over 180 months.

72. Big Corp. -1 On 1-1-10, Big Corp. was organized. On that date, Big paid $90,000 for startup costs for the corporation. What is the total amount of start-up cost deduction for 2010 (including first year write-off and amortization)?

74. Blue Corp. -1 On 1-1-10, Blue Corp. was organized. On that date, Blue paid $51,000 for startup costs for the corporation. What is the total amount of start-up cost deduction for 2010 (including first year write-off and amortization)?

76. 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 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

79. 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

82. The End