Chapter 12Chapter 12

The Choice of Business Entity

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McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.

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This is a tax planning chapter - how to use rules related to Pass-through losses After-tax cash flows to individual investor Family income shifting Partnership versus S Corp characteristics Closely-held corporations

Constructive dividends limit corporate tax avoidance Accumulated earnings tax, personal holding company tax,

tax rates on members of a controlled group

ObjectivesObjectives

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Pass-Through EntitiesPass-Through Entities

Partnerships (includes LLCs) and S Corps are not taxed as entities; investors pay tax on their share of entity income

This treatment results in a single level of taxation Cash distributions are generally not taxable

The cash represents a return of investment and does not affect the income or loss reported by the owner

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Benefits of Pass-Through LossesBenefits of Pass-Through Losses

Pass-through losses are generally deductible in the year the loss is generated, producing a tax benefit at the individual’s marginal tax rate (i.e., immediate tax savings!)

For start-up corporations, loss must be carried forward and used to offset income in a taxable year where profits are reported NOL deduction provides a benefit at

the corporation’s tax rate in the year the NOL offsets profits

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ExampleExample

Investor A, a single individual, has $200,000 of taxable income in 2012, 2013 and 2014 before his investment in Entity X. Entity X has an end of year loss in 2012 and 2013 of ($50,000) per year and has profits in 2014 of $300,000

What is the net present value at 10% of the tax savings or tax costs on Entity X losses and profits if X is aa) Pass-through entity?

b) Corporation?

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Pass-Through ExamplePass-Through Example

2012 deduction = ($50,000) x 35% = ($17,500) savings 2013 deduction = ($50,000) x 35% = ($17,500) savings 2014 income = $300,000 x 35% = $105,000 tax cost NPV tax cost at 10% if END of year payments = $53,323

($17,500) + [($17,500) x .909) + [$105,000 x .826)

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Corporation ExampleCorporation Example

2014 net income = $200,000 ($300,000 – $50,000 - $50,000), corporate tax = $61,250; PV = $50,592 [$61,250 x .826) tax cost

The PV of tax costs for the corporation is lower even though the tax savings was delayed. Why? Lower corporate tax rates

BUT, if corporation pays a dividend equal to after-tax cash flows, then the owner is also taxed on $138,750 – which results in a tax cost of $48,562 ($138,750 x .35)

PV of total tax of $90,704 [$50,592 + ($48,562 x .826)], which is more than pass-through tax of $53,323

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Pass-Through Entities Only Pass-Through Entities Only Have a Single Level of TaxHave a Single Level of Tax

The preceding example illustrates the benefits of a pass-through entity Losses can be used immediately Earnings are subject to a single level of taxation

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Family Income ShiftingFamily Income Shifting

Goal - have income taxed at lower rates (e.g. children’s rates) or avoid estate tax

Remember, income shifting is the result of shifting property ownership - can’t assign income

If children or other relatives are made partners or co-shareholders, they own part of the business and are entitled to their share of any cash distributions from the business

The transfer of ownership may have gift tax consequences if relatives don’t pay FMV

Limits on Family Income ShiftingLimits on Family Income Shifting

Family members cannot be partners in a personal service business unless they can perform the services In contrast, a family member can be a partner in a

business in which property is a material income-producing factor

Family members providing services must first receive guaranteed payments that constitute reasonable compensation before net income is allocated

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Limits on Family Income ShiftingLimits on Family Income Shifting

Income of family partnerships is allocated according to proportionate interests in partnership capital

Income of all S corporations is allocated according to the proportionate shares of stock held by each shareholder

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Other ConsiderationsOther Considerations

The potential tax savings of operating a pass-through entity must be compared to the legal and accounting costs of creating and operating the business

The creation of a pass-through entity results in the dilution of parents’ wealth and control of the business Transfers must be complete and legally binding, irrevocable Buy-sell agreements are used to restrict family members

from selling their equity interests to an unrelated third party

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Other Considerations (continued)Other Considerations (continued)

To retain control, the entrepreneur (e.g., the parents) should consider A limited partnership with the entrepreneur as sole

general partner or An S corporation with voting

and nonvoting stock

Other Considerations (continued)Other Considerations (continued)

Gift tax may be assessed on the transfer of an equity interest in an established business to a family member

Example Mrs. Johnson is eager to create a family partnership to

generate income and cash flow for her three college-age children. Should she transfer ownership in a business established 15 years ago with $15 million FMV of assets or a business started 10 months ago with $300,000 FMV of assets?

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Partnership versus S CorporationPartnership versus S Corporation

S corporations require an IRS election, incorporation documents, and possible corporate state tax payments; the IRS has eased some regulatory restrictions over the past few years

Partnership agreements have more flexibility, but require more careful legal drafting

Partners (but not S corporation shareholders) receive tax basis for liabilities of the partnership increasing the deductibility of losses

S corporation shares are transferable. Partnership interests are not - requires new partnership agreement

Employee benefit planning favors S corporation

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Liability Associated with Types of Flow-Through EntitiesLiability Associated with Types of Flow-Through Entities

Liability associated with different forms of ownership General partnership – full liability Limited liability partnership - general partners are not

personally liable for malpractice-related claims of another general partner

Limited partnership - at least one general partner with full liability, but other partners have no liability

Liability Associated with Types of Flow-Liability Associated with Types of Flow-Through Entities (continued)Through Entities (continued) Limited liability partnership - partners not

responsible for other partner’s malpractice Limited liability company (treated like partnership

for tax, corporation legally) S corporation creates limited liability

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Closely-Held CorporationsClosely-Held Corporations

Biggest challenge is how investors can avoid double taxation of corporate earnings; one way is to have the investor assume an additional role with respect to the corporation If shareholders are also creditors, interest expense is

deductible to corporation If shareholders are also employees, wage expense

is deductible to corporation If shareholders are also landlords, rent expense

is deductible to corporation

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Closely-Held CorporationsClosely-Held Corporations

IRS challenge turns “unreasonable” payments into constructive dividends

How does the IRS decide what is an unreasonable payment for Wages Rent Interest?

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Thin CapitalizationThin Capitalization

If the debt held by shareholders of a closely-held corporation is excessive, the IRS may contend that some or all of the interest payments are nondeductible dividends

Accordingly, shareholders have taxable income, not a nontaxable return of investment

Rule of thumb – a debt-to-equity ratio greater than 3 to 1 may appear “unreasonable”

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Accumulating Corporate Profits Accumulating Corporate Profits as a Tax Shelteras a Tax Shelter Some corporations keep earnings in the corporation

in order to avoid double taxation or they delay paying dividends

If this practice results in an increase in stock price, it is possible for investors to convert ordinary dividends into capital gain by selling stock

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IRS Weapons Against Using Corporation as IRS Weapons Against Using Corporation as Tax ShelterTax Shelter Accumulated earnings tax

Penalty is to assess tax on accumulated taxable income at highest individual tax rate - like forcing a deemed dividend

Penalty = 20% of accumulated taxable income (taxable income less income tax less dividends paid less reasonable needs of business)

Common traits that IRS looks for when investigating corporate tax shelters: Little or no dividends paid Abundance of liquid assets not reinvested in production

capacity, or Especially substantial loans to shareholders

IRS Weapons Against Using Corporation as IRS Weapons Against Using Corporation as Tax Shelter Tax Shelter Personal Holding Company tax

Similar penalty assesses tax on undistributed earnings at 20%

Applies to corporations whose income is principally dividends, interest, rents and royalties

Application of Accumulated Earnings Tax and PHC tax These rules are intended to prevent

abuse, so assessment of these taxes is rare in practice

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Controlled Group Tax RatesControlled Group Tax Rates

The corporate tax rates are progressive; owners could reduce their overall tax by fragmenting their business into multiple corporate entities

The tax law requires that corporations aggregate the taxable income of all members of a controlled group before compute tax; the tax is then allocated according to the entities’ proportion of taxable income Controlled groups include

parent-subsidiary and brother-sister groups

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