Chapter-12-

Entities-Overview Howard Godfrey, Ph.D., CPA

Professor of Accounting ©Howard Godfrey-2015

Chapter 12. Entities Entity legal classification: [2] Corporation, LLC (disregard?) Partnership, Proprietorship NON-TAX characteristics: [3] Rights, Responsibilities

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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 - 2 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 unless serving as an executive. Board controls corp. 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 - 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

ENTITY TAX Classification: [5] Regular corp. vs. Flow-through entities Types: C corporation, [6] Partnership, Proprietorship

Entity level income tax. [8: 52,53] Double taxation (when dividends are paid) Shareholders that are [10: 56] corporations get a dividend received deduction

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Tax Factors

Double Taxation

Employee vs Owner

Fringe Benefits

Social Security Taxes

Planning

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–Separate 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 top bracket individualsWhat is combined effective tax rate?

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

Corp. after-tax incomeShareholder tax rate 20%

Total income taxTotal Tax as % of Taxable Income

Corporation distributes after-tax Income

Corp. has taxable income of $1,500,000.All after-tax income is paid out as dividendsShareholders are top tax rate 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 20%

198,000Total income tax 708,000

47.20%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 $1,000Long Term capital gain 4,000

Partnership Ordinary IncomeAl's share of ordinary incomeAl's income taxed at 15% rate?

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 37,000Partnership net income included:

Dividend income $1,000 (1,000)Long Term capital gain 4,000 (4,000)

Partnership Ordinary Income $32,000Al's share of ordinary income $16,000Al's income taxed at 15% rate? $2,775

Earnings retained to [11] avoid double taxation: Accum. Earnings Tax Personal Hold. Co. Tax (PHC)

Ms. Rich has taxable income from a salary $800,000

Her stocks are owned by her corporation.

"Rich Corporation" dividend income $100,000

Dividends received deduction $70,000

Rich Corporation taxable income $30,000

Corporate tax rate 15%

Rich Corporation Tax Liability $4,500

Effective tax rate on the dividend income 4.5%

What is the remedy for this tax loophole?

Reduce corp. income tax: [12: 58,59] make deductible payments to owners Lower indiv. income tax: [13] Lower tax rates for dividends and capital gains

Please study the tax information for Mr. Rich and his corporation on the next two slides and answer the questions on the slide following those two slides.

Rich Corporation (owner: Mr. Rich)Revenue 200,000Expense other than owner salary (70,000)Salary to owner (40,000)Corporate taxable income 90,000

0 50,000 15% 50,000 7,50050,000 75,000 25% 25,000 7,50075,000 100,000 34% 15,000 13,750

Corporate tax 90,000 28,750

Rich (Single, under age 50) Salary 40,000

Exemption & itemized deductions (20,000)

Taxable income 20,000

Single, 2015 Base Rate Tax

Top full layer 9,225 923

Amount above layer 10,775 15% 1,616

Income and Tax 20,000 2,539

Use information for Rich & Rich Corporation aboveThere is no state income tax. Ignore FICA.

What is the total income tax burden (individual & corp.)?

What is change in burden if Rich takes a $10,000 dividend?

What is the change in burden if Rich takes a $10,000 bonus?

What is the tax burden if Rich elects S staus?

Assume the business is a proprietorship.

How much self-employment tax is paid?

How much income tax is paid?

Entity Losses [14] Net Operating Loss (for C Corporation) Flow-through of loss to owners (for S Corporation & Ptshp)

#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

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

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

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

Ans: B (Suppose Wood 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 $118,500 for 2015

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) Max. for Soc. Security $118,500Social Security base 118,500Rate-Social Security 6.20%Social Security Tax 7,347Medicare base 120,000Rate-Medicare Tax 1.45%Medicare Tax 1,740FICA (Soc. Security & Medicare) (9,087) Take-home pay 90,913$ Employer pays to IRS $9,087 + $9,087.

Mary-2015

Self-Employment Taxes. Pg. 18.• 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 $118,500 in 2015– 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 self-employment 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%

BaseS.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%Base for SE tax 23,088

S.E. Tax Rate 15.30%S.E. Tax 3,532

Deduct 50% of S.E. tax 1,766$ No S.E. Tax is paid in a 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 $100,000, 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. TaxSalary 100,000Limit on full rate 15.30%Excess 2.90%

Totals

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

Self-employment tax for George - 2Net profit on Schedule CFactor for S.E. tax baseBase for S.E. Tax

$43,00092.35%39,711$

Limit for S.E. Tax $118,500Salary 100,000Limit on full rate $18,500 15.30% $2,831Excess 21,211 2.90% 615.10

Totals $39,711 $3,446

What amount may he deduct? [50%] $1,723Note: George has paid 7.65% on $100,000 salary above.

Self-employment tax for George - 3Net profit on Schedule CFactor for S.E. tax baseBase for S.E. Tax

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