4-1

Taxation of Alternative Forms of Business

Proprietorship Not a separate legal entity Income reported by and taxed to

proprietor

Partnership Separate legal entity, but not a taxable

entity Partnership files information return Income reported by and taxed to

partners when earned by the partnership

4-2

Taxation of Alternative Forms of Business continued

Corporation Separate legal entity C corporation

Taxable entity – income reported by and taxed to the corporation

Dividend distributions are not deductible by the corporation, and are taxable income to the recipient shareholders

Increases in value of shares taxed as capital gains when stock is sold

4-3

Taxation of Alternative Forms of Business continued

S corporation Not a taxable entity – files an information

return Income reported by and taxed to

shareholders when earned by the corporation

Limited to 75 non-corporate shareholders

Limited Liability Company (LLC) Generally elect to be taxed as

partnerships

4-4

Calculating After-Tax Business Accumulations

Some more notation tp = partner-level tax rate on ordinary income tc = corporate income tax rate Rp = before-tax return on partnership investment rp = after-tax rate of return on partnership earnings

= Rp(1 – tp) Rc = before-tax return on corporate investment rc = after-corporate-level-tax (but before

shareholder-level tax) rate of return on corporate earnings = Rc(1 – tc)

ts = effective annualized tax rate on shares

4-5

After-Tax Partnership Accumulation

Assume that partnership distributes cash each year to the partners sufficient to pay tax, then reinvests remaining after-tax earnings for n periods, then liquidatesAfter-tax accumulation =

$I[1 + Rp(1-tp)]n

(same as IV1 from Chapter 3)

4-6

After-Tax Corporate Accumulation

Assume that corporation makes no dividend distributions; it reinvests all after-corporate-tax earnings for n periods, then liquidatesAfter-tax accumulation =

$I[1 + Rc(1 – tc)]n (1-tcg) + tcg$I

(similar to IV2 from Chapter 3)

4-7

Choice of Partnership or Corporate Form

Assuming Rp = Rc, difference in after-tax accumulations depends on tp, tc, tcg, and n If tp = tc and tcg = 0, after-tax

accumulations are identical If tp = tc and tcg > 0, the partnership form

dominates the corporate form for all n If tp > tc and tcg = 0, the corporate form

dominates the partnership form for all n If tp > tc and tcg > 0, either form may be

preferred

4-8

Choice of Form continued

Why might Rp Rc? Liability issues Administrative and reporting cost

differences Access to capital Owner control over management

4-9

Comparing Partnership and Corporate Forms when Rp Rc

One approach: find a rate of return to corporate form at which investor is indifferent rc

* = {[(1+rp)n – tcg]/(1 – tcg)}1/n – 1 For any given set of tax rate variables

and time horizon, can solve for rc* using

the above formula. Then solve for the required before-tax rate of return, Rc

*, using: Rc

* (1 – tc) = rc*

For any Rc > Rc*, corporate form

preferred; otherwise, partnership form preferred

4-10

Example

Let Rp = 10%, tp = 40%, tc = 35%, tcg = 20%, and n = 5. Then rp = 10%(1 - 40%) = 6%rc

* = {[1.065 - .20]/(1-.20)}1/5 –1 = 0.073 or 7.3%Rc

* = 7.3%/(1 - .35) yields Rc* = 11.2%

Interpretation: The corporation must produce a before-tax rate of return 1.2% higher than the partnership, to overcome its tax disadvantage

4-11

Example continued

Suppose n = 25. rc

* = {[1.0625 - .20]/(1-.20)}1/25 –1 = 0.067 or 6.7%

Rc* = 10.3%

Interpretation: Over a longer time horizon, the tax deferral of the lower capital gains tax on the corporate liquidation becomes more valuable, and the required corporate before-tax rate of return is only .3% higher than the partnership return

4-12

Example continued

Finally, suppose n = 50 rc

* = {[1.0650 - .20]/(1-.20)}1/50 –1 = 0.064 or 6.4%

Rc* = 9.8%

Interpretation: Over a very long time horizon, the corporation is preferred to the partnership even with a lower before-tax return. Why? The annual corporate tax rate is lower than the annual partnership tax rate, and the capital gains tax is deferred 50 years.

4-13

Effective Annualized Tax Rate on Shares

Example showed that increased deferral of capital gains taxation reduces the required corporate returnOne way to calculate the impact of such deferral is the effective annual tax rate – the rate of annual taxation on increased corporate value at which the shareholder would end up with the same after-tax accumulationts = 1 – rp/rc

*

4-14

Example continued

When n = 5, rc* = 7.3%, and

ts = 1 - .06/.073 = 17.8%

When n = 25, rc* = 6.7%, and

ts = 1 - .06/.067 = 10.4%

When n = 50, rc* = 6.4%, and

ts = 1 - .06/.064 = 6.3%

Interpretation?

4-15

Comparisons of Corporate and Partnership Forms over Time

Review Table 4.4 in textHow were these numbers calculated?I would use: rc

* = {[(1+rp)n – tcg]/(1 – tcg)}1/n – 1 Rc

* = rc*/ (1 – tc)

4-16

Required Corporate Return with Dividends

Recall our initial assumption that the corporation pays no dividendsWould we expect the payment of dividends to increase or decrease the required corporate rate of return, relative to the partnership? Why?We can incorporate dividends into the equation for rc

*, but we won’t do so

4-17

Other Complications

Corporate and individual tax rates are not constant Vary across taxpayers, given

progressive rate structures Vary across time

Rates of return are not constant over time Corporate net operating losses and

carryback/carryover rules affect timing of taxation

4-18

Other Complications continued

Different types of investors have different tax characteristics and thus different rates Fully taxable individual investors Tax-exempt investors (pension funds,

non-profit organizations) Corporations Foreign investors Broker-dealers

4-19

Other Organizational Forms and Their Tax Characteristics

Foreign subsidiariesClosely held corporationsNot-for-profit corporationsTax-imputation corporationsREITsREMICs