module 5 choice of entity and tax regimes. module topics n overview of business entities n...

Module 5

Choice of Entity and Tax Choice of Entity and Tax RegimesRegimes

Module Topics

Overview of business entitiesOverview of business entities Comparison of different business Comparison of different business

entitiesentities Kinds of business entities in the U.S.Kinds of business entities in the U.S. Choice of business entityChoice of business entity Tax regimesTax regimes

Overview of Business Entities

Key Learning ObjectiveKey Learning Objective

Classify the various types of business Classify the various types of business entitiesentities

Check the box regulationsCheck the box regulations

What is a Business Entity?

It “carries on” a trade or businessIt “carries on” a trade or business Has one or more associatesHas one or more associates Has assetsHas assets Engages in some business activityEngages in some business activity

Classification of entities:Classification of entities: TaxableTaxable ConduitConduit Tax-exemptTax-exempt

Research Query: “Carrying On A Business”?

A professional corporation (PC) transferred some A professional corporation (PC) transferred some medical equipment to a newly formed S Corp medical equipment to a newly formed S Corp its shareholders were the children of the shareholders of its shareholders were the children of the shareholders of

the PCthe PC

The S Corp used the equipment to provide certain The S Corp used the equipment to provide certain of the services needed by patients of the PCof the services needed by patients of the PC A percentage of the PC’s fees went to the S CorpA percentage of the PC’s fees went to the S Corp

Did this allow income to be shifted to the Did this allow income to be shifted to the children?children?

Solution--Research Query: “Carrying On A Business”? --

NOT! Horn, Louis III, (1982) TC Memo 1982-741Horn, Louis III, (1982) TC Memo 1982-741 The Tax Court found that there wasThe Tax Court found that there was

No business purpose for the S Corp ANDNo business purpose for the S Corp AND The S Corp's activities didn't amount to The S Corp's activities didn't amount to

carrying on a business.carrying on a business. Therefore the S corp entity was ignoredTherefore the S corp entity was ignored Also cited asAlso cited as

PH TCM ¶82741, 45 CCH TCM 413.PH TCM ¶82741, 45 CCH TCM 413.

Taxable Entity

Liable for tax on its taxable incomeLiable for tax on its taxable income Individual (sole proprietor)Individual (sole proprietor) C corporationC corporation Some estates and trustsSome estates and trusts

Conduit Entity

Nontaxable reporting entityNontaxable reporting entity PartnershipPartnership S corporationS corporation

Income, deductions, etc., “flow through” to Income, deductions, etc., “flow through” to the tax returns of its ownersthe tax returns of its owners

Tax-Exempt Entity

Nontaxable reporting entityNontaxable reporting entity Not-for-profit organizationsNot-for-profit organizations Organized to carry on a tax-exempt purposeOrganized to carry on a tax-exempt purpose

Can be taxed on unrelated business incomeCan be taxed on unrelated business income

Compliance Query: Club or Business?

The “guys” love to smoke cigars and are The “guys” love to smoke cigars and are frustrated by smoking restrictions.frustrated by smoking restrictions.

They want to form a social club that will be They want to form a social club that will be financed by membership dues and user fees.financed by membership dues and user fees.

Mary wants to make sure that the club will Mary wants to make sure that the club will be a tax exempt entity.be a tax exempt entity.

HINT: Check out §501(c).HINT: Check out §501(c).

Solution--Compliance Query: Not For Profit

Clubs organized for pleasure, recreation, and Clubs organized for pleasure, recreation, and other not for profit purposes are exempt if the other not for profit purposes are exempt if the following two conditions are met: following two conditions are met:

(1) Substantially all of the activities of the (1) Substantially all of the activities of the club are for these purposes. club are for these purposes.

(2) No part of the net earnings inures to the(2) No part of the net earnings inures to the benefit of any private shareholder or benefit of any private shareholder or individual. individual. §501(c)(7). §501(c)(7).

Check the Box Rules: Classification of Entity by Election in Most Cases

Separate entity status is first determinationSeparate entity status is first determination Certain joint undertakings may or may not be a Certain joint undertakings may or may not be a

separate entityseparate entity Question of federal, not local lawQuestion of federal, not local law Basically divide all entities into eligible and Basically divide all entities into eligible and

ineligible classesineligible classes

Entities Ineligible for Election-”Per Se” Corporation

Domestic statutory corporationsDomestic statutory corporations Association (elected or by default)Association (elected or by default) Statutory joint-stock company or joint-stock Statutory joint-stock company or joint-stock

associationassociation Insurance company taxable under Insurance company taxable under

subchapter Lsubchapter L

Ineligible Entities (con’t)

State-chartered banking business if insured State-chartered banking business if insured under FDIC or similar federal statuteunder FDIC or similar federal statute

Business entity wholly owned by a State or Business entity wholly owned by a State or political subdivisionpolitical subdivision

Corporation under another provision of the Corporation under another provision of the Internal Revenue CodeInternal Revenue Code

Listed foreign “Per Se” corporate entitiesListed foreign “Per Se” corporate entities

Available Elections

Eligible entities with 2 or more members Eligible entities with 2 or more members Association -- i. e. Corporation Association -- i. e. Corporation PartnershipPartnership

Eligible entities with a single member Eligible entities with a single member Association-- i. e. Corporation Association-- i. e. Corporation Disregarded as a separate entityDisregarded as a separate entity

Frequently referred to as a single member LLCFrequently referred to as a single member LLC

Foreign Entity Default Rules Operate where no election made

If limited liability for all members If limited liability for all members -Association-Association

If unlimited liability by any memberIf unlimited liability by any member Partnership, if two or more membersPartnership, if two or more members Disregarded entity, if single ownerDisregarded entity, if single owner

Branch--if corporate ownerBranch--if corporate owner Sch C--if individualSch C--if individual

Unlimited liability dependent on local lawUnlimited liability dependent on local law

Comparison of Different Business Entities

Key Learning ObjectivesKey Learning Objectives

Define the various business entitiesDefine the various business entities Compare corporate form to other formsCompare corporate form to other forms

Sole Proprietor

Individual engaged in a trade or businessIndividual engaged in a trade or business Spouse or child can be an employeeSpouse or child can be an employee Owner is Owner is notnot an employee (no salary deduction) an employee (no salary deduction)

Advantages of sole proprietorshipAdvantages of sole proprietorship Easy to formEasy to form Owner controls decisionsOwner controls decisions

Disadvantage of sole proprietorshipDisadvantage of sole proprietorship Unlimited personal liability Unlimited personal liability

unless formed under LLC rulesunless formed under LLC rules

How is a Sole Proprietor Taxed?

Income taxIncome tax Business income and expenses reported on Business income and expenses reported on

Schedule CSchedule C Net income or loss from Schedule C included Net income or loss from Schedule C included

in owner’s gross income on Form 1040in owner’s gross income on Form 1040 Self-employment taxSelf-employment tax

Net income from sole proprietorship is subject Net income from sole proprietorship is subject to Social Security and Medicare taxto Social Security and Medicare tax

C Corporation

Taxable entity that isTaxable entity that is Incorporated under the laws of a stateIncorporated under the laws of a state Unincorporated association (e.g., LLC) Unincorporated association (e.g., LLC)

if election to be treated as corporation under if election to be treated as corporation under the “check the box” regulations discussed the “check the box” regulations discussed earlier.earlier.

Corporate Tax Rate StructureA Bumpy Road << individual rates if T.I. < $75,000 individual rates if T.I. < $75,000 T.I. between $100,000 & $335,000T.I. between $100,000 & $335,000

Corporate MTR = 39%Corporate MTR = 39% Individual MTR < 39.6% until taxable income Individual MTR < 39.6% until taxable income

exceeds $263,750exceeds $263,750 T.I. > $18,333,333 T.I. > $18,333,333

MTR = 35%MTR = 35% Average tax rate = 35%Average tax rate = 35%

Special Tax Rates May Apply If

Personal service corporationsPersonal service corporations Foreign corporationsForeign corporations Controlled groupsControlled groups Corporations taxed under Corporations taxed under

§594 (alternative tax for mutual savings bank §594 (alternative tax for mutual savings bank conducting life insurance business).conducting life insurance business).

Subchapter L (life insurance companies).Subchapter L (life insurance companies). Subchapter M (regulated investment and real Subchapter M (regulated investment and real

estate investment trusts).estate investment trusts).

Benefits of C Corp

Continuity of lifeContinuity of life Centralized managementCentralized management Ease of TransferEase of Transfer Limited liabilityLimited liability Generous fringe benefitsGenerous fringe benefits

Disadvantages of C Corp

Double taxation of dividendsDouble taxation of dividends Accumulated earnings taxAccumulated earnings tax Corporation taxed on distributions of Corporation taxed on distributions of

appreciated propertyappreciated property Tax costs to liquidationTax costs to liquidation

Getting the Money Out

Don’t Don’t Salaries and fringe Salaries and fringe

benefitsbenefits DividendsDividends Interest paymentsInterest payments LiquidationLiquidation

Partnership

An organization composed of two or more An organization composed of two or more entities that:entities that: Carries on a trade or business, financial operation, Carries on a trade or business, financial operation,

or ventureor venture Shares profits and losses among its ownersShares profits and losses among its owners Is not a corporation, trust, or estateIs not a corporation, trust, or estate

Co-ownership of property is not a partnership, Co-ownership of property is not a partnership, unless significant services are providedunless significant services are provided

Types of Partnerships

General PartnershipGeneral Partnership All partners personally liableAll partners personally liable

Limited PartnershipLimited Partnership General partner(s) personally liableGeneral partner(s) personally liable Limited liability for limited partner(s)Limited liability for limited partner(s)

Types of PartnershipsLLC’s

Formed as a Limited Liability Company Formed as a Limited Liability Company Election to be treated as a flowthroughElection to be treated as a flowthrough Limited liability for all partnersLimited liability for all partners

Limited Liability Partnership (LLP)Limited Liability Partnership (LLP) Same as LLC, but partner liable for own faultsSame as LLC, but partner liable for own faults

For remainder of discussion partnership and For remainder of discussion partnership and LLC are inter-changable termsLLC are inter-changable terms

Partners(Or Members of LLC)

Can be individuals, corporations, trusts, estates, Can be individuals, corporations, trusts, estates, or partnershipsor partnerships

Are Are notnot employees of the partnership employees of the partnership Include in gross incomeInclude in gross income

Their share of the partnership’s income, deductions, Their share of the partnership’s income, deductions, losses and creditslosses and credits

Guaranteed payments (but not cash draws)Guaranteed payments (but not cash draws) Timing of inclusion depends on partnership tax yearTiming of inclusion depends on partnership tax year

Research Query: When is a Partnership Not a Partnership?

Harry and Larry are tenants in common of Harry and Larry are tenants in common of farm property.farm property.

They lease the land to a farmer for a cash They lease the land to a farmer for a cash rental rental

Have Larry and Harry formed a partnership Have Larry and Harry formed a partnership for U.S. tax purposes?for U.S. tax purposes?

Solution--Research Query: Mere Co-ownership is Not a

Partnership Reg § 1.761-1(a) Mere co-ownership of Reg § 1.761-1(a) Mere co-ownership of

property which is maintained, kept in property which is maintained, kept in repair, and rented or leased does not repair, and rented or leased does not constitute a partnership. For example, constitute a partnership. For example, tenants in common of farm property do not tenants in common of farm property do not create a partnership among themselves create a partnership among themselves merely by leasing it to a farmer for a cash merely by leasing it to a farmer for a cash rental or a share of the crops. rental or a share of the crops.

S Corporation

Incorporated entity or LLC electing to be Incorporated entity or LLC electing to be treated as a corporationtreated as a corporation

Nontaxable conduit entity like a partnershipNontaxable conduit entity like a partnership More restrictive than partnershipMore restrictive than partnership

Limited liability for ownersLimited liability for owners Valid S election requiredValid S election required

S CorporationEligible Corporation

S election allowed if:S election allowed if: Domestic, nonaffiliated corporationDomestic, nonaffiliated corporation Only one class of stockOnly one class of stock No more than 75 shareholders.No more than 75 shareholders.

Only individuals, estates, and some trustsOnly individuals, estates, and some trusts Not partnerships, nonresident aliens, certain trustsNot partnerships, nonresident aliens, certain trusts

Partnership or S Corporation?Some factors the same.

Limited liability of owners Limited liability of owners if properly formed should be the sameif properly formed should be the same

Allocation of income, deductions, and lossesAllocation of income, deductions, and losses more options available to partnershipmore options available to partnership

Deductibility of lossesDeductibility of losses more opportunity for partners to generate basis more opportunity for partners to generate basis

Partnership or S Corporation?More factors to consider.

Recognition of gain on property contributionRecognition of gain on property contribution partnerships have less likelihood of recognitionpartnerships have less likelihood of recognition

Transferability of ownershipTransferability of ownership stock better understood?stock better understood?

Costs to formCosts to form Lawyer may charge less to form an SLawyer may charge less to form an S

State lawState law rules for both may vary from state to staterules for both may vary from state to state

Kinds of Business Entities in the United States


Describe the different types of entities Describe the different types of entities doing business in the U.S.doing business in the U.S.

Entities Doing Business in U.S.

By typeBy typeSole proprietorshipsSole proprietorships 73%73% (15.0 million)(15.0 million)

C corporationsC corporations 10%10% ( 2.0 million)( 2.0 million)

S corporationsS corporations 9% 9% ( 1.7 million)( 1.7 million)

PartnershipsPartnerships 8% 8% ( 1.5 million)( 1.5 million) By size of net incomeBy size of net income

C corporationsC corporations 64%64%

Sole proprietorshipsSole proprietorships 27%27%

S corporations and partnershipsS corporations and partnerships 9% 9%

Choice of Business Entity


Understand the key factors in choosing the Understand the key factors in choosing the form of doing business, including important form of doing business, including important tax and non-tax factorstax and non-tax factors

Choice of Follow-through Entity? S or LLC ? Allocation of income, deductions, lossesAllocation of income, deductions, losses Deductibility of lossesDeductibility of losses Contribution of propertyContribution of property Liquidation/distribution of propertyLiquidation/distribution of property

Allocation of Income, Deductions, Losses

S-CorpS-Corp One class of stockOne class of stock Allocate in proportion Allocate in proportion

to stock ownershipto stock ownership

LLCLLC Generally free to Generally free to

allocate in any wayallocate in any way If allocation has If allocation has

substantial economic substantial economic effecteffect

Deductibility of LossesLimited to Basis

S-CorpS-Corp Basis consists ofBasis consists of

Direct investmentDirect investment Loans to corpLoans to corp

LLCLLC Basis consists ofBasis consists of

Direct investmentDirect investment Share of many debts of Share of many debts of

the partnershipthe partnership

Distributions of Property

S-CorpS-Corp Gain recognized to Gain recognized to

extend FMV of extend FMV of property > basis in Sproperty > basis in S

Loss recognized only Loss recognized only if liquidation if liquidation

LLCLLC Gain recognized only if Gain recognized only if

cash distributed > basis cash distributed > basis in partnershipin partnership

Losses only recognized Losses only recognized if liquidation and only if liquidation and only cash equivalents cash equivalents receivedreceived

Compliance Query:Partnership or S Corp?

John and Mary want to start a business that John and Mary want to start a business that they will own equally. John will provide they will own equally. John will provide most of the capital and Mary will provide most of the capital and Mary will provide most of the work. most of the work.

The business will have losses in the first two The business will have losses in the first two years, then it should be profitable.years, then it should be profitable.

If they want to allocate the tax losses to John, If they want to allocate the tax losses to John, is a partnership or an S a better arrangement?is a partnership or an S a better arrangement?

Solution--Compliance Query: Partnership or S Corp?

Partnership The partnership format appears best for The partnership format appears best for

John and Mary.John and Mary. Both partnerships and S-corps allow losses Both partnerships and S-corps allow losses

to be passed through to the equity owners to be passed through to the equity owners and deducted on their tax returns.and deducted on their tax returns.

However, only partnerships allow losses to However, only partnerships allow losses to be allocated on a non-pro rata basis.be allocated on a non-pro rata basis.

In-Class Project

Form a 3-5 person group. Form a 3-5 person group. Select a client from the list of “new Select a client from the list of “new

businesses in town”.businesses in town”. Discuss the pros and cons of each type of Discuss the pros and cons of each type of

entity for your “new” business client.entity for your “new” business client. Decide which entity is preferable and Decide which entity is preferable and

explain why.explain why.

Tax Regimes

Key Learning ObjectivesKey Learning Objectives

Understand the tax formulaUnderstand the tax formula Illustrate basic tax calculationsIllustrate basic tax calculations

General Income Tax Structure

Tax = base x rateTax = base x rate Tax base = taxable incomeTax base = taxable income

Corporations:Corporations:

gross income - expensesgross income - expenses Individuals:Individuals:

gross income - deductions - exemptionsgross income - deductions - exemptions Tax ratesTax rates

Progressive vs. proportionalProgressive vs. proportional Marginal vs. averageMarginal vs. average

Corporate Tax Structure

Marginal rate: 15% to 39%Marginal rate: 15% to 39% Flat 35% for personal service corporationsFlat 35% for personal service corporations

Highest average rate: 35%Highest average rate: 35% Other possible taxes:Other possible taxes:

Alternative minimum taxAlternative minimum tax Accumulated earnings taxAccumulated earnings tax Personal holding company taxPersonal holding company tax

Individual Tax Structure

Marginal rate: 15% to 39.6%Marginal rate: 15% to 39.6% Average rate is always lower than marginal Average rate is always lower than marginal

raterate Rate structure varies by filing statusRate structure varies by filing status Marriage “penalty” or marriage “bonus” may Marriage “penalty” or marriage “bonus” may

applyapply Computation of taxable income can be Computation of taxable income can be

complex for some taxpayerscomplex for some taxpayers

Self-Employment Tax

Base = self-employment income x 92.35%Base = self-employment income x 92.35% Self-employment income:Self-employment income:

Net income from sole proprietorshipNet income from sole proprietorship Distributive share of partnership ordinary income Distributive share of partnership ordinary income

(general and active LLC partners)(general and active LLC partners) Guaranteed payments from partnershipGuaranteed payments from partnership

Rate = 15.3%Rate = 15.3% 12.4 % OASDI ($76,200 ceiling in 2000)12.4 % OASDI ($76,200 ceiling in 2000) 2.9% Medicare (no ceiling)2.9% Medicare (no ceiling)

module 5 choice of entity and tax regimes. module topics n overview of business entities n...

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