module 5 choice of entity and tax regimes. module topics n overview of business entities n...
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Module 5
Choice of Entity and Tax Choice of Entity and Tax RegimesRegimes
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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
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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
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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
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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?
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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.
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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
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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
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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
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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).
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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).
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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%
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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).
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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).
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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
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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
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Getting the Money Out
Don’t Don’t Salaries and fringe Salaries and fringe
benefitsbenefits DividendsDividends Interest paymentsInterest payments LiquidationLiquidation
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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
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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)
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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
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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
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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?
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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.
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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
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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
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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
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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
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Kinds of Business Entities in the United States
Key Learning ObjectiveKey Learning Objective
Describe the different types of entities Describe the different types of entities doing business in the U.S.doing business in the U.S.
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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%
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Choice of Business Entity
Key Learning ObjectiveKey Learning Objective
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
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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
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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
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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
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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
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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?
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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.
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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.
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Tax Regimes
Key Learning ObjectivesKey Learning Objectives
Understand the tax formulaUnderstand the tax formula Illustrate basic tax calculationsIllustrate basic tax calculations
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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
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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
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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
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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)