chapter 13 choice of business entity: general tax and nontax factors formation © 2014 cengage...

Chapter 13 Choice of Business Entity: General Tax and Nontax Factors Formation

© 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

13-2

Introduction

Taxpayers must choose a form for a business entity

Choice is based on tax and non-tax factors

© 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.

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Non-Tax Factors(slide 1 of 2)

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?


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Non-Tax Factors(slide 2 of 2)

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?

© 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.

13-5© 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.

How do non-tax factors affect each entity?

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Sole Proprietorship

The Owner: 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

© 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.

a business owned by one individual

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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


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Exists when two or more persons engage collectively in a profit making activity

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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


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an artificial entity created under the auspices of state law

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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 100

The Entity: Continues to exist when

ownership changes Has a relatively high

cost of formation Has an excellent ability

to raise capital


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a regular corporation with special tax attributes

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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


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S Corporation Election

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S Corporation ElectionTermination

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


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Limited Liability Company

The Owners: Have limited liability Cannot easily transfer

ownership interest Have full management

control Not limited to number

of owners


ownership changes Has a moderate cost

of formation Has a good ability to

raise capital


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Has corporate characteristics with the conduit tax treatment of partnerships

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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


ownership changes Has a moderate cost

of formation Has a good ability to

raise capital


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a general partnership with limited liability for owners



How do tax factors affect each entity?

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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?


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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


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S Corporation: conduit to shareholders Form 1120S, Schedule K-1 Separable items like partnership

C Corporation: Corporation pays Form 1120


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Who Pays the Tax?

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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


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Is Double Taxation a Problem?

No Sole Proprietorships Partnerships S Corporations

Yes C Corporations


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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


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How do fringe benefits and employment taxes

apply to employees of each entity?

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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


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Fringe Benefit Limitations

Sole proprietors are not employees

No deduction allowed for salary or benefits


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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


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Fringe Benefit Limitations

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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 +

12.4% OASDI Maximum amount subject to OASDI is

$113,700


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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


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Social Security Taxes

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Issues at Formation 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?


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How are property transfer issuestreated by each entity?

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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


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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


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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


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How are basis issues treated by each entity?

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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


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Sole ProprietorshipBasis Determination

Ownership of property never changes

Owner’s basis remains unchanged


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PartnershipBasis Determination

Basis determines the taxability of distributions from the entity to the partner

Initial basis = basis in property transferred and/or FMV of services contributed


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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


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PartnershipBasis Determination

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C CorporationBasis Determination


If any boot is received in the transfer Shareholder has wherewithal-to-pay and must report

gain Basis includes the amount of gain recognized


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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


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C CorporationBasis Determination

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If any boot is received in the transfer Shareholder has wherewithal-to-pay and must report

gain Basis includes the amount of gain recognized


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S CorporationBasis Determination

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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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S CorporationBasis Determination



How are costs incurred prior to and during formation treated?

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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

© 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.

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May elect to deduct first $5,000 currently Current deduction phased-out $1 for $1 if

total costs exceed $50,000 No current deduction allowed if total costs

exceed $55,000

Costs not currently deducted are amortized over 180 months


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Organization and Start-up Costs



What accounting period and method should be used?

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Accounting Periods

The annual accounting period concept requires all entities to report operations on an annual basis


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Taxpayers are generally free to choose their accounting period

But 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

owners (> 5%) if majority partners’ years do not agree


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Accounting Periods

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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


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chapter 13 choice of business entity: general tax and nontax factors formation © 2014 cengage...

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