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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.
13-3
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?
© 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.
13-4
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?
13-6
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
13-7
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
© 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.
Exists when two or more persons engage collectively in a profit making activity
13-8
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
© 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.
an artificial entity created under the auspices of state law
13-9
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
© 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 regular corporation with special tax attributes
13-10
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
© 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.
S Corporation Election
13-11
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
© 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.
13-12
Limited Liability Company
The Owners: Have limited liability Cannot easily transfer
ownership interest Have full management
control Not limited to number
of owners
The Entity: Ceases to exist when
ownership changes Has a moderate cost
of formation Has a good 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.
Has corporate characteristics with the conduit tax treatment of partnerships
13-13
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
The Entity: Ceases to exist when
ownership changes Has a moderate cost
of formation Has a good 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 general partnership with limited liability for owners
13-14© 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 tax factors affect each entity?
13-15
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?
© 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.
13-16
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
© 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.
13-17
S Corporation: conduit to shareholders Form 1120S, Schedule K-1 Separable items like partnership
C Corporation: Corporation pays Form 1120
© 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.
Who Pays the Tax?
13-18
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
© 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.
13-19
Is Double Taxation a Problem?
No Sole Proprietorships Partnerships S Corporations
Yes C Corporations
© 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.
13-20
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
© 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.
13-21© 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 fringe benefits and employment taxes
apply to employees of each entity?
13-22
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
© 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.
13-23
Fringe Benefit Limitations
Sole proprietors are not employees
No deduction allowed for salary or benefits
© 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.
13-24
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
© 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.
Fringe Benefit Limitations
13-25
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
© 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.
13-26
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
© 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.
Social Security Taxes
13-27
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?
© 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.
13-28© 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 are property transfer issuestreated by each entity?
13-29
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
© 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.
13-30
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
© 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.
13-31
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
© 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.
13-32© 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 are basis issues treated by each entity?
13-33
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
© 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.
13-34
Sole ProprietorshipBasis Determination
Ownership of property never changes
Owner’s basis remains unchanged
© 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.
13-35
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
© 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.
13-36
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
© 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.
PartnershipBasis Determination
13-37
C CorporationBasis Determination
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
© 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.
13-38
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
© 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.
C CorporationBasis Determination
13-39
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
© 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.
S CorporationBasis Determination
13-40
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
© 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.
S CorporationBasis Determination
13-41© 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 are costs incurred prior to and during formation treated?
13-42
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.
13-43
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
© 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.
Organization and Start-up Costs
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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What accounting period and method should be used?
13-45
Accounting Periods
The annual accounting period concept requires all entities to report operations on an annual basis
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classroom use.
13-46
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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classroom use.
Accounting Periods
13-47
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
© 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
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