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Chapter 13Choice of Entity- General

Fall, 2009 Howard Godfrey, Ph.D., CPA

UNC CharlotteCopyright © 2009, Dr. Howard Godfrey

Edited November 18, 2009. T9-Chp-13-1-Entity-Choice-General-2009

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Introduction Fringe BenefitsNontax Factors Social Security TaxesSole Proprietorship Planning CommentaryPartnership FormationCorporation Transfers to an EntityS Corporation Sole proprietorshipLimited Liability Company PartnershipLimited Liability Partnership CorporationPlanning Commentary Basis Considerations General Tax Factors Sole proprietorshipIncidence of Inc.Taxation PartnershipSole proprietorship CorporationPartnership Organizational CostsCorporation Accounting PeriodsPersonal Service Corp. Accounting MethodsDouble Taxation Planning CommentaryEmployee versus Owner Summary

13. Entity-Factors/Formation

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Nontax FactorsSole ProprietorshipPartnership CorporationS CorporationLtd. Liability CompanyLtd. Liability Partnership

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General Tax Factors

Incidence of Income Tax

Sole proprietorship

Partnership

Corporation

Personal Service Corp.

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Non-Tax Factors- choice of a form for a business entity•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?•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?

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Sole Proprietorship: A business owned by one individual.

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

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Partnership -two or more persons engage collectively in a profit making activity.The owners:Are fully liable (except for limited partners) Cannot easily transfer ownership interest Have full management controlThe entity:Ceases to exist if >50% ownership changes Has a moderate cost of formation Has a good ability to raise capital

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Corporation: an artificial entity created under the auspices of state law.

The owners: Have limited liability Can easily transfer ownership interest Have no right to direct management No limit on number of shareholders

The entity: Continues to exist when ownership changes Has a relatively high cost of formation Has an excellent ability to raise capital

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S Corporation: a regular corporation with special tax attributes.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

S Corporation Election• 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

S Corporation Election Termination• 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

Limited Liability Company: corporate characteristics with the conduit tax treatment of partnerships.The owners: Have limited liability Cannot easily transfer ownership interest Have full management control No limit on number of ownersThe entity: Ceases to exist when ownership changes Has a moderate cost of formation Has a good ability to raise capital

Limited Liability Partnership is a general partnership with limited liability for owners.

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

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Tax Factors-Continued

Double TaxationEmployee vs OwnerFringe BenefitsSocial Security TaxesPlanning

General Income Tax Factors• Three tax factors also influence choice of

entityIncidence 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?

#1: 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

#1: Who Pays the Tax?• S Corporation: conduit to

shareholders–Form 1120S, Schedule K-1–Separable items like partnership

• C Corporation: Corporation pays–Form 1120–Owners pay income tax on div.

Corporation has taxable income of $1,500,000.

All after-tax income is paid out as dividendsShareholders are individualsWhat is combined effective tax rate?

Corp. taxable income $1,500,000Corp. income tax rate 34%

Corp. after-tax incomeShareholder tax rate 15%

Total income taxTotal Tax as % of Taxable Income

Corp distributes after-tax Income

Corp. has taxable income of $1,500,000.All after-tax income is paid out as dividendsShareholders are individualsWhat is combined effective tax rate?

Corp. taxable income $1,500,000Corp. Income tax rate 34%

$510,000Corp. after-tax income $990,000Shareholder tax rate 15%

148,500Total income tax 658,500

43.90%Total Tax as % of Taxable Income

Corp distributes after-tax Income

#1: 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– How will Jan’s computer repair company tax

differ if it is a PSC? (2 slides forward)

#2: Is Double Taxation a Problem?• No

–Sole Proprietorships–Partnerships–S Corporations

• Yes–C Corporations

Jan owns 100% of two Computer Web Jan's

corps which reported Repair Consulting 1040

these results for 2010. [C Corp] [S Corp] Income

Revenue $100,000 $200,000

Salary to Jan (owner) (30,000) (80,000)

Rent expenses (20,000) (70,000)

Other expenses (10,000) (10,000)

Net income before tax 40,000

Net income before tax 40,000

Corp. income tax owed

Dividends paid to Jan 10,000

Dividends paid to Jan 10,000

Jan's Gross Income?

Jan owns 100% of two Computer Web Jan's

corps which reported Repair Consulting 1040

these results for 2010. [C Corp] [S Corp] Income

Revenue $100,000 $200,000

Salary to Jan (owner) (30,000) (80,000) $110,000

Rent expenses (20,000) (70,000)

Other expenses (10,000) (10,000)

Net income before tax 40,000 $0

Net income before tax 40,000 $40,000

Corp. income tax owed 6,000 0

Dividends paid to Jan 10,000 $10,000

Dividends paid to Jan 10,000 $0

Jan's Gross Income? $160,000

AB Partnership is owned equally by Aland Beth. AB had these results this year.

Total partnership revenue $100,000

Total partnership expenses (63,000)

Partnership net income 37,000

Partnership net income included:Dividend income $1,000

Long Term capital gain 4,000

Partnership Ordinary Income

Al's share of ordinary income

Al's income taxed at 15% rate?

See Appendix C-14 and C-16

AB Partnership is owned equally by Aland Beth. AB had these results this year.

Total partnership revenue $100,000

Total partnership expenses (63,000)

Partnership net income 37,000

Partnership net income included:Dividend income $1,000 (1,000)

Long Term capital gain 4,000 (4,000)

Partnership Ordinary Income $32,000

Al's share of ordinary income $16,000

Al's income taxed at 15% rate? $2,500

See Appendix C-14 and C-16

#3: 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

Fringe BenefitsLegislative 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

• Sole proprietors are not employees–No deduction allowed for salary or

benefits

Fringe Benefit Limitations• 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

Willie is the director of golf for Rooney Corp. Willie owns a 20% interest in Rooney. He receives a salary of $60,000 and fringe benefits costing $6,000. Rooney's taxable income before considering the payments to and on behalf of Willie is $250,000. Rooney distributes a $50,000 dividend to its shareholders. How much income does Willie have from Rooney?

a. $ 60,000 b. $ 70,000

c. $ 76,000 d. $ 96,800 e. $102,800

Ans: B (Suppose Rooney is an S Corp or Ptshp.)

Social Security TaxesThe social security tax is 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% = 12.4% OASDI + 2.9% Medicare

– Maximum amount subject to OASDI is $106,800 for 2009

Social Security Taxes• 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

Mary’s salary is $120,000 per year. She has federal income tax of $20,000 withheld. There is no state income tax. What is her take-home pay for the year? See following slide.

Salary $120,000Federal income tax withheld: (20,000) Maximum for Soc. Sec. $106,800Social Security base 106,800Rate-Social Security 6.20%Social Security Tax 6,622Medicare base 120,000Rate-Medicare Tax 1.45%Medicare Tax 1,740FICA (Soc. Security & Medicare) (8,362) Take-home pay 91,638$ Employer pays to IRS $8,362 + $8,362.

Mary-2009

Self-Employment Taxes. Pg. __.• Self-employed individuals must pay both the

employer’s and the employee’s share of FICA taxes for a combined rate of 15.3%– 12.4 % (6.2% x 2) for Social Security on income

up to $106,800 in 2009– 2.9% (1.45% x 2) for Medicare – no income

limit• Deduction for employer portion simulated

by multiplying net income from self-employment by 92.35% (100% - 7.65%) before calculating SE tax

Self-Employment Taxes• Tax computed on Schedule SE• Self-employed individuals are also

allowed a deduction for AGI for the employer’s half of self-employment taxes– Calculated by multiplying net income from

self-employment by 92.35% (100% - 7.65%) before calculating SE tax

• There is no deduction for the employee’s half of the taxes

Self-Employment TaxCarrie owns a business that she operates as a sole proprietorship. The business had a net profit of $25,000. This is Carrie’s only earned income.a. How much self-employment taxes will she pay?b. How much can she deduct on her tax return?c. If the business had a net loss of $10,000 (instead of a $25,000 profit), how much in self-employment taxes must Carrie pay?

Self-Employment Tax for Carrie [2]Compute self-employment taxNet profit on Schedule C $25,000Factor for S.E. tax base 92.35%

S.E. Tax RateS.E. Tax Deduct 50% of S.E. tax

Self-Employment Tax for Carrie [2]Compute self-employment taxNet profit on Schedule C $25,000Factor for S.E. tax base 92.35%

23,088S.E. Tax Rate 15.30%S.E. Tax 3,532Deduct 50% of S.E. tax 1,766$ No S.E. Tax for Loss Year.

Self-Employment Tax – George -1George has net income from self-employment of $43,000 (from his week-end tax practice).He has a salary of $72,000, earned as a VP of a local corporation.What is his self-employment tax?What amount may he deduct?

$43,000

Limit for S.E. Tax

Salary 72,000

Limit on full rate 15.30%

Excess 2.90%

Totals

What amount may he deduct? [50% of S.E. Tax.]

Compute self-employ. tax for George - 2

Net profit on Schedule C

Factor for S.E. tax base

Base for S.E. Tax

$43,000

92.35%

39,711$

Limit for S.E. Tax $106,800

Salary 72,000

Limit on full rate $34,800 15.30% $5,324

Excess 4,911 2.90% 142.40

Totals $39,711 $5,467

What amount may he deduct? [50%] $2,733Note: George has paid 7.65% on $72,000 salary above.

Compute self-employment tax for George - 3

Net profit on Schedule C

Factor for S.E. tax base

Base for S.E. Tax

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Formation of Entity

Transfers to Entity

Proprietorship

Partnership

Corporation

Formation• At the formation of a business entity, a number

of tax issues arise– 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?

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

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

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

Tinker incorporates his proprietorship by transferring his land to the Big Tinker Corp. in exchange for all its stock, which has a basis of $800,000 and a value of $1,200,000. The land is subject to a $40,000 liability that the corporation assumes. Tinker receives Big Tinker stock worth $1,160,000. What is Tinker’s gain on receipt of the stock? What is his basis in the stock received from the corporation?

Value received:Stock received by S/H 1,160,000Other assets receivedDecrease in S/H debt 40,000

Total value received 1,200,000

Basis Given:Cash given by S/HOther assets given 800,000

Total basis given by S/H 800,000

Gain realized $400,000

Gain Recognized $0

Formula for Gain or loss

S/H Basis in Stock Amount

Basis of Old Asset $800,000

Add: Boot Paid

Less: Boot Received (40,000)

Add: Gain Recognized

Basis - Stock Rec'd $760,000

S/H Basis in Stock - 2 Amount

FMV of Asset Received 1,160,000

Less: Gain not Recognized ($400,000)

Add: Loss not Recognized

Basis - Stock Received $760,000

Loss is recognized in some transactions.

Basis of property to S/H

Add: S/H Gain Recognized

Corp's Basis in New Asset

See Page ___

Corp's basis in asset invested

The following slide illustrates the unique impact of debt for partners in a partnership as explained in the text on page ____.Please ignore recourse and non-recourse debt material.

Existing Partnership debt. $0 Ptr-1's Percent ownership 40% Ptr-1's land:

Had a FMV of: Had a basis of: 7,000$ Was subject to debt of: 9,000$

T/P invests land in partnership - 1

Partnership assumed Ptr-1's debt.

Ptr-1 invested land into partnership.Ptr-1 received general ptshp interest.

Ptr-1 is admitted to Local PartnershipT/P is called Ptr-1 in this example.

1 Ptr-1's asset had a value of

2 Ptr-1's asset had a basis of 7,000$

3 Ptshp capital % received by Ptr-1 40%

4 Ptshp capital % - other partners 60%

5 Partnership debt before investment

6 Partnership debt assumed by Bob

7 Ptr-1's debt assumed by PTSHP

8 Ptr-1's debt assumed by other Ptnrs

Ptr-1 contributes land to partnership - 2

1 Ptr-1's asset had a value of

2 Ptr-1's asset had a basis of 7,000$

3 Ptshp capital % received by Ptr-1 40%

4 Ptshp capital % - other partners 60%

5 Partnership debt before investment -

6 Partnership debt assumed by Bob -

7 Ptr-1's debt assumed by PTSHP 9,000

8 Ptr-1's debt assumed by other Ptnrs 5,400

Ptr-1 contributes land to partnership - 2A

Ptr-1's basis before contribution

Add:Partnership debt assumed by Ptr-1

Less: Ptr-1's Debt assumed by other Ptnrs

Ptr-1's Basis-Cannot be negative

Ptr-1's Basis in partnership

Ptr-1 contributes land to partnership - 3

Ptr-1's basis before contribution 7,000

Add:Partnership debt assumed by Ptr-1

Less: Ptr-1's Debt assumed by other Ptnrs (5,400)

Ptr-1's Basis-Cannot be negative $1,600

Ptr-1's Basis in partnership

Ptr-1 contributes land to partnership - 3A

(CPAM95#27-Mod) Strom acquired a 25 percent interest in Ace Partnership by contributing land with a basis of $20,000 and FMV of $50,000. The land was subject to a $24,000 debt, which was assumed by Ace. No other debt existed at the time of the contribution. What was Strom's basis in Ace?a. $0 b. $2,000 c. $26,000 d. $32.000

(CPAM95#27-Mod) Strom acquired a 25 percent interest in Ace Partnership by contributing land with a basis of $20,000 and FMV of $50,000. The land was subject to a $24,000 debt, which was assumed by Ace. No other debt existed at the time of the contribution. What was Strom's basis in Ace?a. $0 b. $2,000 c. $26,000 d. $32.000

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Basis Proprietorship

Partnership

Corporation

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

Sole Proprietorship•Ownership of property never changes

•Owner’s basis remains unchanged

Partnership• Basis determines the taxability

of distributions from the entity to the partner

• Initial basis = basis in property transferred and/or FMV of services contributed

Investment or Beginning BasisChange in share of debt (+ or -)Add: Ordinary Income

Separate Income & gainsTax-free incomeContributions of Capital

Less: Ordinary LossSeparate Exp. & LossesNon-deductible ExpensesPartner Withdrawals

Ending Basis

Partner Basis - Sec. 705, 722, 742

C Corporation• 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

C Corporation• Shareholders do not adjust their

stock basis for corporate earnings.• 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.–Excess over capital recovery

S Corporation• 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

S Corporation• 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

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Organizational Costs

Accounting Periods

Accounting Methods

Planning

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

Organizational and Start-up Costs• Amortize over 180 months, or • Elect to deduct $5,000 currently

–Phased-out $1 for $1 if total costs exceed $50,000

• Costs (above write-off of up to $5,000) are amortized over 180 months.

Big Corp. -1On 1-1-10, Big Corp. was organized. On that date, Big paid $90,000 for startup costs for the corporation. What is the total amount of start-up cost deduction for 2010 (including first year write-off and amortization)?

Big Corp. was organized on 1-1-10.

Big paid Organ. costs on 1-1-10Organization costs $90,000Amortization period 15 YrsAmortization in year 1 $6,000

No first year write-off

Big Corporation - 2-

Blue Corp. -1On 1-1-10, Blue Corp. was organized. On that date, Blue paid $51,000 for startup costs for the corporation. What is the total amount of start-up cost deduction for 2010 (including first year write-off and amortization)?

Organization costs - Blue Corp. ReturnAmount spent $51,000Threshold $50,000

Excess $1,000

First-Year write-off amt $5,000Less: excess above ($1,000)

Write-off $4,000 $4,000

Amount to be amortized $47,000Amortization period - Yrs 15Amortization period - Months 180

Amortization per month 261.111Number of months 12

Total amortization for year $3,133 $3,133

Total deduction and amortization $7,133

Accounting PeriodsThe annual accounting period concept requires

all entities to report operations on an annual basis.

• Taxpayers are generally free to choose their accounting period

• 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 (> 5%)

owners if majority partners’ years do not agree

1 2 3 4 5 6 7 8 9 10 11 12 1 2 3

1 2 3 4 5 6 7 8 9 10 11 12

Owner's Tax Year 2010

Apr.

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Tax Years - Flow-Through Entities

4Calendar Year 2010

Entity Tax year

1 2 3 4 5 6 7 8 9 10 11 12 1 2 3

1 2 3 4 5 6 7 8 9 10 11 12

Owner's Tax Year 2010

Apr.

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Tax Years - Flow-Through Entities

4Calendar Year 2010

Entity Tax year

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

C Corp. recorded 2010 transactions on cash basis.

Collections for consulting serv. $8,000,000

Cash payments for expenses 6,000,000

Other informationBeginning Accounts Receivable 900,000Ending Accounts Receivable 1,000,000Write-off of uncollectible accounts 40,000Depreciation Expense 500,000Change in accounts payable 0All sales are on creditDirect Charge-Off Method is used.

What is amt of sales (accrual basis)?

What is taxable income for the year?

Note: this is a typical year.

Revenue $8,140,000

Add: Beginning Acct. Receivable 900,000

Less: Collections for consulting (8,000,000)

Less: Write-off (40,000)

Equals: Ending Acct. Receivable $1,000,000

Revenue - Accrual Basis $8,140,000

Cash payments for expenses (6,000,000)

Write-off uncollectible accounts (40,000)

Depreciation Expense (500,000)

Taxable Income $1,600,000

Large corp. must use accrual basis. Pg. 599What might change if this is an S Corp?Reg. 1.461-1(a)(1)

The End