Chapter 10 Types of Businesses Taxpayer is owner(s) of flow-through type entities Sole proprietorship Partnerships Limited Liability Company (LLCs) S Corporations Taxpayer is corporation C Corporation is taxed first, then shareholders may be taxed on distributions, resulting in double taxationSole Proprietorship What is a sole proprietorship? Sole proprietorship is a single owner business by taxpayer Single or joint taxpayer (owner and spouse) Taxpayer owns assets (and liabilities) in personal name(s) All liabilities are recourse to the taxpayer there are no limits Business income and expenses are reported on Schedule C, filed with the individual form 1040 Net profit or loss on Schedule C is ordinary income or loss; combine this net amount with other items of gross income on page 1 of form 1040 More IRS scrutiny via individual income tax audits What is taxable income of the sole proprietorship? How is taxable income determined? What does IRC section 61 provide on definition of gross income? What does IRC section 162 provide with regard business expenses? How is the income and deductions reported? Schedule C reports revenues and expenses of the business Exhibits on pages 273 and 274 including exhibit 10.2 Revenues from the business less expenses including CGS Interest expense on business debt is deducted on schedule C Interest, dividends and rent income related to owners investments are not reported on Schedule C Schedules B and E of 1040 Dispositions of business assets are reported on Forms 4797 and Schedule D and capital assets on Schedule D Non-business related (personal) interest expense is deducted on schedule A. What about home office deductions? A portion of the taxpayers personal residence may be allowable as a Schedule C deduction if The office is exclusively used on a regular basis as:1) the principal place of business operated by the homeowner, OR2) a place to meet with patients, clients or customers A home office used exclusively for administrative or management activities qualifies if the taxpayer has no other fixed location where such activities are conducted If the home office qualifies Allocate expenses between business and personal use such as: Utilities, Home mortgage interest and taxes (*), Insurance, Repairs, Depreciation Home office deduction cannot exceed taxable income of the business before this deduction (*) Reduces the amount reported in schedule A What about employees of the sole proprietorship? Employees receive compensation for their services and employer withholds payroll taxes and income taxes: Employer portion: FICA = 6.2% Social Security tax on wages up to $117,000 (2014) + 1.45% Medicare tax on all wages Employee portion: FICA = 6.2% Social Security tax on wages up to $117,000 (2014) + 1.45% Medicare tax on all wages Employers withhold and remit: Income taxes on behalf of employees based on payroll exemptions Employees and employers share of FICA taxes Employers Federal and State Unemployment Taxes Any employee deferrals that need to be contributed to a 401k etc What about the owner (or taxpayer)? Owner or taxpayer reports the profit as income on 1040 SE Owner is treated as self-employed persons who will pay SE tax on net earnings from self employment Tax base = 92.35% of net profit reported on Schedule C Tax rates ( similar to employee and employer portion of FICA) Social security tax =12.4% of earnings up to $117,000 (2014) Medicare tax = 2.9% of earnings Self-employment tax is paid via estimated tax payments and your 1040 rather than through withholdings as for employees 50% of self-employment tax (2014) on Form 1040 as deduction or adjustment from gross income for AGI How does the sole proprietorship pay income tax? Reports profit (or loss) on 1040 and included part of overall taxable income of the owner-taxpayer. Taxed at ordinary income tax rates Owner-taxpayer must make estimated tax payments quarterly via 1040 ES due April 15, June 15, September 15, and January 15 to avoid underpayment penalties on their individual tax due to the profit from Schedule C business Estimated taxes need to include impact of self employment taxesChapter 11The Corporate Taxpayer What is a corporation (including an S corp.)? Entity formed & chartered under state law (not federal law) Artificial legal entity separate and distinct from its owners Corporations have shares of stock- authorized & outstanding Shares or ownership can be closely-held or widely-held like a publicly held corporation traded on one of the exchanges Articles of incorporation and bylaws Shareholders, board of directors, officers and employees Registration & annual fillings with state corporation commissions Examples: Regular C Corp., S Corp, & Associations Distinguish from the Limited Liability Company or LLC What are the legal characteristics of a corporation? Limited liability Unlimited life Free transferability Centralized management Big issue for IRS back in the late 70s and 80s with limited liability partnerships, LLCs and publicly traded LLPs whether they could be partnerships versus corporations matter largely resolved today by the check the box regulatory guidance. The States played a big role in creating greater options for choice of entities What is the big issue on corporations? Double taxation: Corporation pays income tax on its taxable income Shareholders in turn pay tax on the distributions (e.g. dividends) they receive from the corporation Mitigated by qualified dividends for individuals and dividend received deduction for corporations receiving dividends What is a single corporation? Affiliated Group? Single corporate entity Corporation with shareholders who are individuals and/or corporations who are not significantly related Multiple corporation entities connected through ownership Controlled corporations, affiliated corporations, or affiliated group Parent Subsidiary-Parent owns a subsidiary (e.g. 80% or more) Consolidated Group with Parent Subsidiary (i.e. elects to file consolidated) Brother-Sister Corporations- ownership among common owners Corporate tax rate structure with affiliated group Single corporate tax bracket and other limitations Parent-Sub (1563 (a)(1)): Common parent owns > 80% of at least 1 other corporation Other corps own together > 80% of other corps May elect to file consolidated tax return Brother-Sister Controlled Group (1563(a)(2)) Old law: two tests 5 or fewer persons own 80% of the stock of two or more corps and these persons common or identical ownership exceeds 50% New Law No more 80% test 5 or fewer persons owned the stock of two or more corporations and these persons have common or identical ownership that exceeds 50% How do you determine taxable income of a corporation? Start with book net income or financial statements Determine the financial or book to tax differences so called M-1 items or M-3 items found on schedule M-1 or M-3 of 1120 Represent differences between the financial statements and tax return Arriving at taxable income using a tax trial balance: Financial Net Income Accounting Guidance (e.g. US GAAP- accrual basis) Journal entries, general ledger accounts, trial balances and financials Corporate Taxable Income Internal Revenue Code and Regulatory guidance (e.g. methods-accrual or cash) Book to tax differences, tax trial balance & tax liability calculations Arriving at taxable income by separate set of books Concept of book to tax differences is a movement from accounting (economic) net income to taxable income as compared to building up the taxable income from the statues of the Internal Revenue Code: Start: Gross Income- Section 61 Less: Exclusions-Sections 102-140 Equal: Net Gross Income Less: Deductions-Sections 162-199 & 241-249 Equal: Taxable Income- Section 63 Items not deductible by corporations are from sections 261-280 of the Code Reconcile book income to taxable income Schedule M-1 What is the dividend received deduction? General rule: Corporations receiving dividends from other domestic corporations are entitled to the following deductions: 70% of the dividends if the recipient owns less than 20% of the stock, 80% of the dividends if the recipient owns at least 20% and less than 80% of the stock, or 100% of the dividends if the recipient owns at 80% or more of the stock Exception: If the recipient corporations taxable income before the dividend received deduction is less than the respective percentage of taxable income; the deduction is limited to: 70% of taxable income limit 80% of taxable income limit Exception: If the dividend received deduction increases or creates an net operating loss, taxable income limitation does not apply. What is the limitations on charitable contributions? General Rule: The annual deduction limit is 10% of the corporations taxable income before certain deductions. Taxable income is computed without regard to certain deductions including: Charitable contributions Dividends received deduction Net operating loss carrybacks Capital loss carrybacks Taxable income is computed with regard to NOL and capital loss carryovers (forward) Charitable contributions in excess of the limitation may be carried forward 5 years and deducted as long as contributions do not exceed 10% of taxable income What is the domestic production activities deduction? Congress wanted to reduce the tax burden for domestic production activities to incent business to invest in US based production activities. Domestic production activities deduction is available for US taxpayers who derived: Income from qualified activities of leasing, selling, licensing, etc of tangible property, computer software and sound recordings From manufacturing, producing, growing or extracting activities within the US The deduction equals the lesser of 9% times: The corporations net income from the qualified activity or Taxable income computed before the deduction. This is an additional deduction over and above the ordinary and necessary expenses used in computing the net income from the qualified activity or taxable income What is the M-1, M-2 and M-3 of the Form 1120? M-1 reconciles net income or loss for book purposes and taxable income before NOLs and dividend received deduction M-2 reconciles beginning and ending retained earnings from the schedule L on the 1120 M-3 is detailed book to tax differences for large corporations with 10 Million and more in assets 10 Million to 50 Million of assets can choose to file M-1. Four primary parts. Detailed book to tax differences and disclosures How do you determine the corporate tax liability? Taxable income comes from 1120 line 30. Schedule J of the 1120 walks through the tax computation Utilize the corporate tax rate schedule on page 318 or Appendix C. Graduated progressive tax rates Surtax recaptures the 15% and 25% rate in the 100K to 335K bracket Impact of affiliated corporations What about tax credits? There are 26 business tax credits.1. Investment tax credit-Rehab, energy, reforestation credits2. R&D tax credit3. Work opportunity tax credit4. Disabled access credit5. Renewable electricity, refined coal What about alternative minimum tax? Just like individuals, corporations have the alternative tax system, which is called AMT. Starts with: Taxable income for regular tax purposes Plus/minus: AMT adjustments (like depreciation and ACE) Plus: AMT preferences Equals: Alternative minimum taxable income ACE is comparison of Adjusted Current Earnings to AMTI What about distributions by the corporation? Distributions of cash or property to Shareholders on their stock: General Rule: Distributions are taxable to Shareholders Role of Earnings and Profits (E&P) of the corporation Taxable to the extent of current and accumulated E&P Distribution of current and accumulated E&P is called a dividend Dividends to individuals are taxable and subject to preferential rates Dividends to a domestic corporate shareholder is subject to dividend received deduction Distribution in excess of current and accumulated E&P Return of Capital to the extent of basis in your stock Capital gains on excess over basis in your stock Distribution of cash No gain or loss to the corporation on distribution of cash dividend No tax deduction for dividends paid by the corporation Amount of cash is taxable to the extent of current and accumulated E&P (E&P) Distributions of property Potential gain but not a loss on appreciated property Fair Market value of property is taxable to the extent of E&P Distribution of Stock of the Company Stock dividends are not taxable Basis of stock is spread over all shares Distributions to Shareholders on their stock: Double taxation issue as discussed earlier Mitigated by the preferential tax rate on qualified dividends Unearned income tax of 3.8% on net investment income Existence of alternative choices of entity in some cases Dividends are part of the total return After tax return would reflect dividends (net of tax) After tax return would reflect capital gains on disposition (net of tax) Growth stocks typically do not pay dividends Total return is tied to growth in stock value After tax return would reflect capital gains on disposition (net of tax) Distributions to corporate debt holders on debt instruments: Public corporate bond market Debt holders or creditors receive interest income and principal payments Interest payments are part of the return to credit/debt holders Interest payments are deductible and taxable to the debt holder or creditor Principal payments are a payment of debt and not deductible while the payments are return of debt to the holder and not taxable Sale of bonds may appreciate or depreciate based on interest environmentChapter 13 What about businesses who span multiple jurisdictions? State and local income taxes and other indirect taxes (e.g. property taxes) Foreign taxes where jurisdictions are outside the US borders The potential issue is that a business can be: Taxed more than once by multiple jurisdictions Hopefully through a series of tax credits for taxes paid and apportionment or allocation of income there is not to much overlap Multi-jurisdictional tax structures, compliance and related matters is very complicated and represents a sub specialty of knowledge What about state and local tax issues? Covers areas of: State and local income taxes, Real property taxes, Personal property taxes, State unemployment taxes, Sales and use taxes or gross receipts taxes, Franchise taxes One good thing: State and local taxes are deductible in arriving at Federal taxable income States are limited: States have a right to tax all individuals and corporations who reside in their state Federal government can regulate interstate commerce within the US States cannot discriminate interstate commerce- its unconstitutional to have a 3% tax for residence and 5% for others. The matter of NEXUS for business determines the degree of residency for activity and contact in a state and jurisdiction over the state income tax What is nexus for a corporation for state income taxes? Corporations physical presence in a particular state: Formed and protected under state law Commercially licensed in the state Employees residing in the state Owns or rents property in the state Commercial activity may establish nexus Not a mere sale of tangible personal goods that are sold and distributed to customers in another state Services and intangible property Internet sales of goods and services is particular uncertain What about the allocation of income to the states? The so- called apportionment of income among states: Uniform state income tax apportionment factors Average of three equally weighted factors: Sales factor: Gross receipts from sales in the state divided total gross receipts Payroll factor: Compensation paid to employees in the state divided by total compensation paid Property factor: Cost of real and personal property in the state divided by the total cost of property Should equal 100%- correct? Double weighted factor for sales and divided by four Apportionment base may vary by state- not taxable income What else? Some states use a gross receipts tax levied on the corporation: Total gross receipts in the state (not a sales or use tax) Net gross receipts (reduced for CGS or compensation) Business and occupation tax Using different rates by industry and no reduction for expenses Tax planning for state income involves: High and low state tax rates: choice of property, location of plants with employees Location of management of the company and divisions What are the tax consequences of doing business abroad? Observation: Our economy is more global than ever. companies expanding into markets outside their home is extremely common. Multi-jurisdictional governance creates huge challenges. What does this mean to business? Inbound business Outbound business Mobility of employees and associates Growth through joint ventures, mergers and acquisitions How do businesses navigate the complex jurisdictions? Tax implications are big part of doing business among others (e.g. legal) Like the UDITPA for the states; where the multi-state compact recommended states create the concepts of apportionment factors; so do income tax treaties create bilateral agreements between countries and some level of uniformity. Home country (resident: individuals & business), Host country, and Permanent establishment Typically, you are taxed only by your home country unless you create permanent establishment through your physical presence and activities Existence of a permanent establishment in a foreign country: Income attributable to the permanent establishment is taxable in the foreign country under based on the jurisdictions individual laws The existence of a bilateral treaty provides guidance on the existence of permanent establishment and other potential implications of doing business. The nonexistence of a bilateral treaty creates more uncertainty to the implications of doing business and is highly subjective (e.g. presence of employees) There are guides produced on doing business in X, Y and Z countries The legal implications and protections are as important Management oversight is a big issue too What are the US jurisdictional rules on global business? US maintains a global tax system for its citizens, permanent residents and domestic corporations. US companies, citizens and permanent residents are taxed on their worldwide income Regardless of where it is earned including foreign sourced income Creates potential for double tax but for the tax effect of the deduction of foreign taxes US companies, citizens, and residents can elect to take a foreign tax credit annually Foreign tax credit is in lieu of the foreign tax deduction What are the US jurisdictional rules on global business? Foreign tax credits are available for only income taxes paid or accrued during the year Determination to deduct or take a credit is made annually Example: 1,000,000 taxable income with foreign taxes of 22% or 220,000 and 35% for US (1M-220K) or 273K for total tax of 493,000.US Tax without the deduction: 350,000Foreign tax credit:(220,000)Net US Tax 130,000 Total tax with a credit is 350,000 (Similar for individuals) What are the US jurisdictional rules on global business? Foreign tax credits are subject to limitation.. Imagine that? Foreign tax credit cannot exceed the following limitation: Foreign sourced income / Worldwide taxable income Relative % times the US pre-credit tax liability Arrives at the portion of foreign sourced income doubled taxed at the US tax rate typical tax credit approach A good summary: The U.S. will only grant a credit up to the amount of [U.S. tax rate x foreign source taxable income] FTC limit = U.S. tax x (foreign income / worldwide income) If the firm has paid more foreign tax than the FTC limit, the firm is allowed 1 year carryback, 10 year carryforward Carryovers are limited to the annual FTC limit discussed above Similar calculation for foreign tax credit for individuals What are the forms of businesses abroad? Branch offices: Not a separate legal entity but it establishes a legal presence in the country. Branches pay US and foreign taxes (potential withholding tax) Foreign Partnerships: Separate legal entity with legal presence in the country Partnerships pay US and foreign tax on share of income Separate US domestic subsidiary: Separate legal entity in US with legal presence in the country Subsidiary pays US and foreign taxes Foreign subsidiary: Pays only foreign taxes and not a party to the US consolidated return- traps earnings until tax on repatriation (dividends to US subject to foreign tax withholding)Chapter 12 What are the type of businesses? Taxpayer is owner(s) of flow-through type entities Sole proprietorship Partnerships Limited Liability Company (LLCs) that elect to be treated: Partnerships, S corporations, or single member sole proprietors S Corporations Taxpayer is corporation C Corporation is taxed first, then shareholders may be taxed on distributions, resulting in double taxation What are the key issues of choice of entity? Tax benefit of losses in early years? Avoiding double taxation of business earnings? Income shifting with or spreading among family members? Cost of formation? Cost of operations? Flexibility? Business and owner liabilities? Disposition of a business? Exit strategy? What are some of other issues for closely held businesses? Dividends (distributions) or salary Excessive Salaries & constructive dividends Family members- constructive dividends and gifts S corporate Shareholders reverse logic due to no SE tax and FICA issue Thinly capitalized businesses Debt to equity Interest on debt versus dividends on stock Transfer taxes on lifetime gifts or significant estate taxes Gift Taxes on any transfers of property & other planning Sell interests in the business over time