Download - How to choose the best entity
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How to Choose the Best Business Entity
by
Alan D. Campbell
Ph.D., CPA, CMA, CFP®
Author of the forthcoming book
Tax Savings Prescriptions
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Objectives• Explain how to
choose the best business entity:– Sole proprietorship– Partnership– Limited liability
company– S Corporation– C Corporation
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Sole Proprietorship
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Characteristics
• Easy to form and operate
• The owner has unlimited liability
• The owner has limited ability to raise capital
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Formation• The owner may
operate under a fictitious name (a d/b/a)
• The owner may have to file a fictitious name registration with the county or parish
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Formation
• The individual owner owns the assets
• No owner recognizes any gain or loss on the transfer of personal use assets to the business
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Income Tax Treatment
• Only one level of income tax
• Income and expenses retain their character
• The net income is taxed at the owner’s marginal tax rate
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Income Tax Treatment
• The owner reports income and expenses on Form 1040, Schedule C
• Losses (except passive losses) are deductible against the owner’s other income
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More Than One Business• Income and expenses
from each different business are reported on separate Schedules C
• A net loss from one active business may offset net income from other businesses
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Self-Employment Tax • Reported on Form
1040, Schedule SE
• The net income is multiplied by 92.35%
• The resulting amount is multiplied by the SE tax rate of 15.3%
• Half of the SE tax is deductible for AGI
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Passive Losses• A passive loss may be
deducted only against passive income for both income tax and self-employment tax purposes
• Unused passive losses are carried forward
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Employing One’s Children
• Can reduce income taxes and the self-employment tax
• Wages paid to one’s children under age 18 are exempt from employment taxes
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Employing One’s Spouse
• Salaries are subject to income taxes and employment taxes
• Can be useful in saving self-employment tax on health insurance premiums and income tax and SE tax on medical expense reimbursement plans
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Employing One’s Spouse
• Can make business travel costs for the accompanying spouse deductible
• Can provide the spouse with earnings that can be tax sheltered with pension plans such as a SIMPLE plan
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Section 179 Deduction
• The Section 179 deduction reduces income tax and the self-employment tax
• Wages count as business income for purpose of the income limitation
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Net Operating Losses
• May generally be carried back two years and forward for up to 20 years for income tax purposes
• Are not deductible for self-employment tax purposes
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Transferring the Business
The owner cannot transfer a part of the equity in the business without first changing it to another type of entity
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Sale of the Business
• A sale of a sole proprietorship is treated as a sale of its assets
• Part of any gain will be ordinary income
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Transferring the Business to Reduce Estate Taxes• Bequeath the
business to the surviving spouse
• Sell the business outright and make annual gifts from the proceeds
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Transferring the Business to Reduce Estate Taxes• Sell the business
for a private annuity
• Sell the business for a self-canceling installment note
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Partnership
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Characteristics
• General partners have unlimited liability
• Partnerships have a greater ability to raise capital than do sole proprietorships
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Characteristics• Partnerships have
relatively simple administration and filing requirements compared to corporations
• Partnerships are often much more complex for tax purposes than are other entities
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Formation• Transfers of property to a
partnership in exchange for an interest in the partnership are generally tax deferred
• The receipt of a partnership interest for services is taxable as determined under Section 83
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Tax Year
• The partnership must use the same tax year as used by partners that own more than 50% of the interest in the partnership
• If not possible, use the tax year of all the principal partners
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Tax Year
• If not possible, use the tax year with the least amount of income deferral
• The IRS may approve a different tax year if a business purpose exists
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Tax Year
The partnership may elect a different tax year if the partnership makes the required payment and the deferral period is three months or less
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Income Tax Treatment
• Partnerships have a great deal of flexibility in allocating income between or among the partners
• Single level of taxation• Partners, not the
partnership, pay taxes
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Income Tax Treatment
Income is taxed to the partners even if the partnership makes no distributions of cash or other assets
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Employment Tax Treatment
For general partners, the distributive share of ordinary income and any guaranteed payments are subject to the self-employment tax
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Reporting Partnership Income
• The partnership must file Form 1065
• Income is reported to each partner on Schedule K-1
• Ordinary income or (loss)
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Reporting Partnership Income
• Separately reported items include portfolio income, capital gain/loss, and the Section 179 deduction
• Net earnings from self-employment
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Losses• Losses flow through to
the partners to the extent of each partner’s– Amount at risk– Adjusted basis in the
partnership interest, which includes the partner’s share of the partnership’s debts
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Losses• Passive losses are
deductible only to the extent of passive income
• Losses from a limited partnership interest are generally passive losses
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Distributions from the Partnership
• Distributions include distributions of cash and other assets
• A net decrease in a partner’s share of the liabilities is treated as a cash distribution
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Distributions from the Partnership
• Distributions are deemed to occur at the end of the year
• All other items that affect basis are taken into account before distributions
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Distributions from the Partnership
Distributions of property reduce the basis in the partnership interest by the adjusted basis of the property to the partnership
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Distributions from the Partnership
• Distributions of cash are a reduction in the basis of the partner’s interest in the partnership
• Distributions of cash in excess of basis result in a recognized gain
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Sale of a Partnership Interest
A sale of a partnership interest is treated as a sale of a capital asset except to the extent of “hot assets”
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Optional Basis Adjustment• The partnership may
elect to adjust a partner’s outside basis when – A partner acquires the
interest of another partner or
– The partnership distributes property to a partner
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Sale of the Assets of the Business
• The partnership can sell the assets of the business
• The gain or loss on each asset must be calculated and characterized
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Termination of a Partnership
A partnership terminates for legal purposes on the death, withdrawal, or bankruptcy of any partner
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Termination of a Partnership
• A partnership terminates for tax purposes – When at least 50% of the
interest in the partnership is transferred in any 12-month period or
– When no business activity is carried on by any partner
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Transferring the Business to Reduce Estate Taxes
• Form a family limited partnership
• Make a lifetime gift of the general partnership interest or sell it
• A corporation or LLC could be formed to be the general partner
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Transferring the Business to Reduce Estate
Taxes• Retain a limited
partnership interest
• The value of the retained interest will receive discounts for – Lack of marketability
and– Lack of control
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Four Types of Entities May Be Taxed as Partnerships
• General partnership
• Limited liability partnership (LLP)
• Limited partnership
• Limited liability company (LLC)
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General Partnership
• All partners have unlimited liability
• Each partner is taxed on the partner’s distributive share of– The partnership’s
ordinary income– The separately stated
items
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Limited Liability Partnership
• Used by professional services firms
• All partners have unlimited liability for the normal business debts of the partnership
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Limited Liability Partnership
Partners are not liable for the professional negligence of another partner unless the other partner is under their direct supervision
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Limited Partnership
• Limited partners have limited liability
• Limited partners cannot take part in management
• Limited partners are often a source of a large amount of capital
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Limited Partnership
• Must have at least one general partner
• The general partner is often a corporation or LLC
• Limited partners pay self-employment tax on guaranteed payments only
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Limited Liability Company (LLC)
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Characteristics
• None of the members is personally liable for the debts of the LLC
• All members have the legal right to participate in management
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Characteristics
• LLCs may have an unlimited number of members
• Any taxpayer can be a member of an LLC (corporations, non-resident aliens, trusts, partnerships)
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State Law
• Little established case law exists to interpret the various state statutes
• Uncertainty exists for LLCs that operate in more than one state as to which state’s law will prevail
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Formation• Transfer of property
to an LLC in exchange for an ownership interest is – Generally governed by
the partnership tax provisions (Subchapter K)
– Generally tax deferred
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Income Tax Treatment
• One member LLC is taxed as
– A disregarded entity (sole proprietorship)
– A corporation if the LLC so elects
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Income Tax Treatment
• LLC in the USA with two or more members is taxed as
– A partnership– A corporation if the
LLC so elects
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Employment Tax Treatment
If the LLC elects to be taxed as a corporation, the salaries of the members who work for the LLC will be subject to FICA tax and income tax withholding
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Employment Tax Treatment
If the LLC elects to be taxed as a corporation, the LLC will be subject to FICA tax and unemployment taxes
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Employment Tax Treatment
If an LLC owned by one individual is taxed as a disregarded entity, all of the net income will be subject to self-employment tax
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Employment Tax Treatment
If an LLC is taxed as a partnership, the members who are equivalent to general partners will be subject to self-employment tax on their distributive share and on any guaranteed payments
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Employment Tax Treatment
Members who are equivalent to limited partners will be subject to self-employment tax only on their guaranteed payments
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LLCs Taxed as Partnerships
• The flexibility of a partnership
• The limited liability of a corporation
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LLCs vs. S Corporations
• LLCs are NOT subject to the taxes on built-in gains and excessive passive income
• LLCs are NOT limited as to the number of members
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Selling the Assets of the Business and Liquidating the LLC• The gain or loss on each
asset must be calculated and characterized
• The treatment of liquidating distributions depends on how the LLC is taxed
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Sale of a Membership in the LLC
• If the LLC is taxed as a partnership, the interest in the LLC is a capital asset
• Capital gain or loss results, except to the extent of the sale of “hot assets”
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Sale of a Membership in the LLC
A loss on the sale of a membership in an LLC taxed as a partnership or disregarded entity cannot qualify for ordinary loss treatment under Section 1244
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Sale of a Membership in the LLC
• If the LLC is taxed as a corporation, the sale of the LLC membership should result in capital gain or loss
• Possible limited ordinary loss treatment under Section 1244
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S Corporation
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Eligibility Requirements
• Must be a domestic (USA) corporation
• Must be eligible to elect S status (not an insurance company or non-qualifying bank)
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Eligibility Requirements
• Shareholders are only– Individuals – Estates – Tax-exempt organizations,
and – Seven kinds of trusts
• No more than 100 shareholders
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Eligibility Requirements
• A husband and wife count as one shareholder
• Certain family members may elect to be treated as one shareholder, up to six generations
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Eligibility Requirements
• Only one class of stock
• Stock with different voting rights is allowed
• Disproportionate distributions can be deemed to indicate that the corporation has more than one class of stock
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Eligibility Requirements
• Generally, nonresident alien shareholders are NOT allowed
• An exception applies if the nonresident alien is married to a U.S. citizen or resident alien and elects to be taxed as a resident alien
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Trusts That Can Own S Corporation Stock
• Grantor trusts• Voting trusts• Testamentary trusts• Qualified Subchapter S trusts• Qualified retirement plan
trusts• Small business trusts• Beneficiary-controlled trusts
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Characteristics
• Limited liability
• Unlimited life
• Centralized management
• Limited transferability of interests without losing the S election
• Subject to more government regulation
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Formation• The transfer of assets in
exchange for the corporation’s stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer
• The transfer of assets for the debt of the corporation is taxable
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Formation• The receipt of stock in
exchange for services is taxable as determined under Section 83
• Service provider may make election under Section 83(b) if stock is restricted
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Making the S Election
• File Form 2553 with the IRS
• All shareholders must consent
• The election must be timely and properly filed
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Deadline for the S Election• The corporation may make
the S election at any time in the year before it is to become effective
• The corporation may make the S election on or before the 15th day of the third month of the tax year of the year it is to be effective
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Deadline for the S Election• A new corporation may
make the S election on or before the 15th day of the third month of its first tax year
• The first tax year begins on the day the corporation has assets, shareholders, or begins business
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Deadline for the S ElectionIf the corporation makes the S election late, the IRS may treat the election as timely if the corporation had reasonable cause
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Deadline for the S Election• The election is faulty if
the corporation failed to qualify or did not obtain shareholder consents
• However, the IRS may honor the election if the corporation corrects the problem within a reasonable time
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Tax Year• An S corporation generally
must use the calendar year
• A fiscal year is allowed if it has a business purpose
• The corporation may also use the same year as used by shareholders who own more than 50% of its stock
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Tax Year
• The S corporation may also elect to use a different tax year
• The maximum deferral of income is three months
• Requires payments to the IRS to compensate for the deferral
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Ownership of C Corporations• A C corporation may
NOT own stock in an S corporation
• However, an S corporation may own stock in a C corporation
• No consolidated return allowed with a C corporation
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QSubs
• An S corporation may have qualified S corporation subsidiaries (QSubs)
• The QSubs are disregarded for tax purposes
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QSub Criteria
• Must qualify as an S corporation
• The S corporation parent must own all of its stock
• The parent elects to treat it as a QSub
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Income Tax Treatment
• No corporate income tax except for– Built-in gains– Excessive net passive
income– LIFO recapture tax– Recapture of
investment tax credit
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Penalty Taxes
• An S corporation Is NOT subject to– The accumulated
earnings tax or– The personal
holding company tax
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Income Tax Treatment
• The S corporation must file Form 1120S by March 15th
• Income is allocated to the shareholders on Schedule K-1
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Income Tax Treatment
• Income is taxed to the shareholders at their marginal tax rates
• Capital gains, tax-exempt income, and other separately stated items retain their character
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Income Tax Treatment
• Income is taxed to the shareholders on a per share per day basis
• Therefore, S corporations are not as flexible as partnerships
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Splitting Income• S corporation stock can be
given to family members to split income among the family members
• However, the S corporation must pay reasonable compensation to family members who provide services or capital to the corporation
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Splitting IncomeThe IRS may ignore gifts of stock to family members if the IRS determines that the donor retains the economic benefits and control of the stock
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Dividends Received Deduction
Unlike a C corporation, an S corporation is NOT entitled to the dividends received deduction
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Treatment of Certain Fringe Benefits
• Statutory fringe benefits are included in the gross income of more than 2% shareholders
• The S corporation may deduct the fringe benefits as business expenses
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Employment Tax Treatment
• Shareholders who work for the corporation are employees
• Salaries are subject to FICA tax and income tax withholding
• The corporation Is subject to FICA tax and unemployment taxes
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Reducing Employment Taxes
The S corporation can reduce employment taxes by paying the lowest amount of a range of reasonable salaries to shareholder-employees
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Treatment of Losses• Losses flow through
to the shareholders to extent of each shareholder’s:
– Basis in stock
– Basis in loans to the S corporation
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Tax Planning for Loss Deductibility
The shareholder can loan money to the S corporation or make a contribution to capital before the end of the year if necessary to deduct the loss currently
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Treatment of Losses• The treatment of losses
is favorable for new businesses that are likely to incur losses
• When the corporation becomes very profitable, the shareholders can revoke the S election
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Treatment of Losses
• Losses subject to
– Amount at risk rules
– Passive activity loss rules
– Hobby loss rules
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Treatment of Losses• Losses of an S
corporation are often more limited than are losses of a partnership
• The basis in a partnership interest includes the partner’s share of the debts of the partnership
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Treatment of Distributions
• Distributions are a tax free recovery of basis to the extent of the shareholder’s basis in the stock
• The basis in debt does NOT absorb distributions
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Treatment of Distributions
Distributions in excess of the basis of a shareholder’s stock result in gain recognition to the shareholder
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Treatment of Distributions of Property
• Distributions of appreciated property result in gain recognition by the corporation
• However, no losses may be recognized
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Treatment of Distributions of Property
• The amount of the distribution of property is its – Fair market value– Minus any debts
assumed or taken subject to by the shareholder
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Former C Corporations• Former C corporations
with accumulated earnings and profits (E&P) keep an accumulated adjustments account (AAA)
• AAA is the total of income and loss from the S period (except tax-exempt income and related expenses)
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Former C Corporations
• Distributions come first from the AAA and reduce the basis in the shareholder’s stock
• Distributions come next from E&P and are taxable
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S Election Remains Until Revoked or Lost
• Voluntary revocation is easy and requires the approval of a majority of the shareholders
• Involuntary revocation occurs when– A new shareholder with over one half of the stock
refuses to consent to the election– The corporation no longer qualifies as a small business
corporation– The corporation does not meet the passive investment
income limitation
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Termination of the S Election for Excessive Passive Income
• Passive income greater than 25% of its gross receipts for three consecutive years and
• C corporation earnings and profits exist for each of the three years
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Preserving the S Election
• Management and shareholders should know the factors that affect S status
• Avoid passive investment income limitation violations
• Restrict transfer of stock to avoid loss of S status
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Inadvertent Terminations
• The IRS may continue to allow the S election if – The termination is
inadvertent and – The corporation takes
the necessary steps to meet the eligibility criteria within a reasonable time
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New Election
• If the S election is terminated, the corporation must – Wait five years to
make a new election or
– Obtain the consent of the IRS
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Sale of the Business
• You can structure the sale of the business as – A sale of stock or– A sale of assets
followed by a corporate liquidation
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Sale of the Business
• A sale of the stock should result in capital gain or loss
• Possible limited ordinary loss treatment under Section 1244
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Liquidation
• Liquidation of an S corporation is governed by the provisions of Subchapter C
• No double tax occurs except to the extent of built-in gains
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C Corporation
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Characteristics• Limited liability• Unlimited life• Centralized
management• Free transferability of
interests• Subject to more
government regulation
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Characteristics
• Unlimited number of shareholders allowed
• Often used for a growing business that is reinvesting its profits in the business
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Formation
The transfer of assets to the corporation in exchange for its stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer
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Formation
• The transfer of services to the corporation in exchange for its stock is taxable as determined under Section 83
• The transfer of property in exchange for the corporation’s debt is taxable
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Fringe Benefits
• Many fringe benefits are deductible by the corporation
• They are often tax free or tax deferred to the shareholders-employees
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Passive Activity Loss Rules
• Apply only to
– Personal service corporations
– Closely held corporations
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Net Operating Losses
• Do NOT flow through to the shareholders
• Can generally be carried back two years and then forward for up to 20 years
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Capital Losses
• Are deductible only to the extent of capital gains
• Are carried back three years and then carried forward for up to five years
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Special Deductions
• Organization costs
• Dividends received deduction
• Charitable contributions
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Sale of the Business
• Sale of stock – No corporate tax– Shareholder
realizes capital gain or capital loss
– Possible limited ordinary loss treatment under Section 1244
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Sale of the Business• Sale of assets
– Corporation recognizes gain or loss on sale of each asset
– Distributions are taxed to the shareholders as capital gain or capital loss
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Double Taxation
• Income is taxed at the corporate level
• Dividends are taxed to shareholders when distributed
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Reducing Double Taxation
• Avoid distributing dividends
• Make cash payments to the shareholders that are deductible by the corporation
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Reducing Double Taxation
• Make cash payments to the shareholder that are a tax free recovery of basis
• Make the S election
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Deductible Cash Payments
• Lease payments
• Reasonable compensation
• Interest
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Cash Payments That Are a Tax Free Recovery of
Basis• Principal payments
on debt
• Stock redemptions treated as a sale
• Liquidating distributions
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Penalty Taxes
• Accumulated earnings tax
• Personal holding company tax
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Double Tax on the Sale of the Assets of the Business
• The corporation recognizes gain or loss on the sale of the assets
• The shareholders recognize capital gain on the distribution of the proceeds
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Conclusion• The best entity for a
your business depends on many factors, including state income tax rules
• You should make the decision with guidance from your attorney and tax professional
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Bonus Material
11 Reasons You May
NOT Want to Incorporate
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1. Banks Require Cosigners
• Banks will usually require major shareholder(s) to consign any corporate loans
• Thus, there would be no limited liability for bank loans
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2. Piercing the Corporate Veil
• Most corporations keep poor records such as minutes and resolutions
• Many stockholders of small corporations commingle personal and corporate assets
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Shareholders Become Liable
• A plaintiff’s attorney may be able to pierce the corporate veil
• If so, the shareholders could be personally liable for any corporate debt
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3. Defending a Lawsuit Is Expensive
• Even if a corporation keeps good records and does not commingle assets
• The corporation would have to pay to defend a lawsuit, except to the extent that an insurance company will pay
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4. Breach of Fiduciary Duty
• Even if the corporation keeps good records and does not commingle assets
• You can be sued individually for breach of fiduciary duty as a director or officer of the corporation
• You can insure such risk, but it can be expensive
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5. Foreign Corporation Fees
• A corporation is an artificial person that has received a charter from a particular state
• To do business in another state, the corporation must register with that state and pay a fee as a “foreign corporation”
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6. Few Additional Deductions
• Section 162 authorizes deductions for business expenses
• It applies to all types of businesses
• There are few deductions a corporation may claim that are not allowed to other types of business entities
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7. Employment Taxes for Children Under Age 18
• If your children are under age 18 and they work for your sole proprietorship, their wages are not subject to employment taxes
• If your children work for your corporation, their wages are subject to employment taxes
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8. More Government Forms to File
• If you operate as a corporation, you have to file more forms and pay more fees to federal and state governments
• Complying with all the rules takes additional time and money away from your business
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9. Can Lose Stock to Personal Judgments
• A court may not force a creditor to be a partner with someone
• If someone gets a judgment against an LLC member or partner, usually all the creditor gets is a charging order
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Judgment Creditor Can Seize Stock to Satisfy Judgment
• A personal judgment creditor of a shareholder may be able to take the stock to satisfy the judgment
• You can buy personal umbrella liability insurance to hedge against this risk
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10. Payroll Tax Penalties on Your Own Salary
• If your corporation pays you a salary and does not deposit the payroll taxes timely, the corporation could be subject to large penalties
• And you as an individual could be subject to the trust fund recovery penalty
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11. Possible Tax on Transfer of Appreciated Assets
• If you transfer appreciated assets to a corporation that you control and if you do not comply with Section 351
• You could owe income tax just for placing the assets in a corporation
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Conclusion
• Think carefully and get excellent advice before you form a corporation
• Corporations do have some benefits
• But many of the alleged benefits are myths and half truths
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Credits
This presentation was created using PowerPoint® presentation graphics program, a Microsoft® software. PowerPoint® is a Windows®-based and Mac®-based application. All clip art is used with permission from Microsoft®. Microsoft®, Windows®, and PowerPoint® are either registered trademarks or trademarks of Microsoft Corporation in the United States and/or other countries.
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Disclaimers
Alan D. Campbell (d/b/a Campbell Education) is an independent entity and is not affiliated with, nor has he been authorized, sponsored, or otherwise approved by Microsoft Corporation.
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