Tax Chapter 15
To retain limited liability protection for shareholders
1. Create, update, and comply with bylaws 2. Have a BOD and hold regular Board meetings 3. Annual shareholder meeting 4. Issue shares of stock to owners 5. Comply with annual filing requirements specified by the state of incorporation 6. Pay any required corporate taxes
2 objectives accomplished by making tax-deductible payments to shareholders
1. It shifts income away from (relatively) high tax rate corporations to (relatively) lower tax rate shareholders. 2. The deduction shields income from the corporate level tax. Strategies that shift income from corporations to shareholders include: • Paying salaries to shareholders (salaries are deductible to the extent they are reasonable) • Paying fringe benefits to shareholders (common fringe benefits include medical insurance, group-term insurance, dependent care assistance, tuition benefits). • Leasing property from shareholders • Paying interest on loans from shareholders.
4 main categories of business entity recognized by tax system
1. Taxable corporation (separate taxpaying entity, income reported on Form 1120) 2. S corporation (flow-through entity, income reported on Form 1120S) 3. Partnership (flow-through entity, income reported on Form 1065) 4. Sole Proprietorship (flow-through entity, income reported on Form 1040, schedule C)
C Corporations tax form
1120
S Corporation tax form (flow through entity)
1120S
Partnerships liability
All general partners are ultimately responsible for the liabilities of the partnership
Basis Computation Flow through
An owner's tax basis in a flow through entity interest is increased for contributions to the entity and income allocated from the entity to the owners. The tax basis of the interest is decreased by distributions to owners and losses allocated from the entity to the owner.
Double taxation
C Corporations pay the first level of tax on their taxable income. The most profitable corporations are taxed at a flat 35 percent rate. Corporate shareholders are subject to double taxation because they pay a second level of tax on corporate income. Distributions to shareholders of C corporations are taxes as dividends to the extent they come from the "earnings and profits" (similar to economic income) of corporations. The applicable rate for the second level of tax depends on whether corporations retain after-tax earnings and on the type of shareholders.
S corp tax year
Calendar year
Taxable corps accounting period
Can choose a tax year that ends on the last day pf any month of the year - year end of owners is not relevant
Flow-through entities
Do not pay taxes because income flows through to business owners who are responsible for paying tax on their income
Corporate shareholders
Corporate shareholders receiving dividends are not entitled to the reduced dividend tax rate (15 percent) available to individual shareholders. Rather, the dividends are subject to the corporate shareholder's ordinary rates. Further, dividends received by a corporation are potentially subject to another (third) level of tax when the corporation receiving the dividend distributes its earnings as dividends to its shareholders. This potential for more than two levels of tax on the same earnings prompted Congress to allow corporations to claim the dividends received deduction (DRD). A corporation receiving a dividend is allowed to deduct a certain percentage of the dividend from its taxable income to offset the potential for additional layers of taxation on the dividend when the corporation distributes the dividend to its shareholders. The dividends received deduction percentage is 70, 80 or 100 percent depending on the extent of the recipient corporation's ownership in the dividend paying corporation. Thus, the DRD partially mitigates the tax burden associated with more than two levels of tax on corporate income.
Corporation liabilities
Corporation is solely liable
Legal classifications of a business entity
Corporation, limited liability company, general partnership, limited partnership, sole proprietorship under state law
Distributions Partnerships
Entities taxed as partnerships do not recognize gain or loss when they distribute property (appreciated or depreciated) to owners. distributions to owners of entities taxed as partnerships are treated as a nontaxable return of capital to the extent of the owner's basis. Amounts in excess of basis are generally treated as capital gain to the owners.
Converting to other entity types
Existing corporations have only two options for converting into flow-through entities. First, shareholders of C Corporations could make an S election to treat the corporation as an S corporation (a flow through entity). The only other option is for shareholders to liquidate the corporation and form the business as a partnership or LLC.
Articles of organization
Filed to form LLC with the state
Articles of incorporation
Filed to legally form corporation with the state
General partnerships
Formed by written agreement among the partners (partnership agreement) or formed informally without a written agreement when 2 or more owners join together in an activity to generate profits
FICA and Self Employment Tax for partnerships
If owner is a general partner - income allocation is subject to self employment tax Limited partner - not subject to self employment tax
FICA and Self Employment Tax for S Corp
If you receive a salary from an S Corp as well as income from being an owner the income allocation is not subject to FICA or self employment tax
Individual shareholders
Individual shareholders receiving distributions from corporations pay the second tax on the dividends they receive, usually at a 15 percent tax rate. Also, taxpayers with modified AGI in excess of a threshold amount pay an additional 3.8 percent net investment income tax on dividends. The threshold amount is $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers.
Taxable Corporations
Least restrictive ownership requirements - can have between 1 and infinity shareholders
Limited liability companies (LLC)
Legal entities separate from owners (members)
Limited partners liability
Limited partners are not responsible for liabilities but they also cannot participate in the activities of a business
Partnership accounting method
May use cash method unless they have a taxable corp as a member or partner
S corp accounting method
May use cash or accrual
S Corps ownership
Most restrictive - no more than 100 shareholders and cannot have shareholders that are corporations, partnerships, nonresident aliens, or certain types of trusts
Entities taxed as partnerships (LLC, GP, LLPs)
Must have at least 2 partners Partnerships - no restriction on owner type Limited partnerships - must have at least one general partner
Can corporations avoid the second level of tax entirely by not paying dividends?
No for 2 reasons 1. Corporations that retain earnings may be required to pay a penalty tax in addition to income tax on their earnings. Unless corporations have a business reason to retain earnings, they are subject to a 20 percent accumulated earnings tax on the retained earnings. Also, personal holding companies (closely held corporations) are subject to a 20 percent personal holding company tax on their undistributed income. These penalty taxes remove the tax incentives for corporations to retain earnings. 2. shareholders also pay a second level of tax when corporations retain their after-tax earnings. Shareholders should experience an increase in the value of their shares to reflect any undistributed earnings (increase in assets). Individual shareholders pay the second tax at capital gains rates on this undistributed income when they realize appreciation in their stock by selling their shares. These long-term capital gains are generally taxed at 15 percent. Taxpayers with modified AGI in excess of a threshold amount pay an additional 3.8 percent net investment income tax on dividends. The threshold amount is $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers. Because shareholders defer paying this second tax until they sell their shares, taxes on capital gains must be discounted to reflect their present value.
Sole proprietorships
Not considered separate legal entity from owner
Limited partnerships
Organized by written agreement and must file a certificate of limited partnership to be recognized by state law
Flow through entity tax year
Owner's tax year
Shareholders
Owners of a company - separate legal entity from corporation
Basis computation partnership
Owners of entities taxed as a partnership are allowed to increase the tax basis in their ownership interest by their share of the entity's liabilities. receive nontaxable distributions to the extent of the basis in their ownership interest, and they are not allowed to deduct losses allocated to them in excess of their tax basis.
LLC liability
Solely responsible
Income/ loss allocation
S - allocated based on stock ownership percentages
Shareholder tax
Shareholders generally pay the second tax immediately when they receive dividends or in the future when they sell their stock and pay capital gains tax. For individual shareholders, the tax rate applicable to both dividend income and long-term capital gain is generally 15 percent under current tax law.
Accounting method for taxable corp
Taxable corps are required to use accrual method but can use cash method if annual gross receipts do not exceed 5 million for the three previous tax years
Unincorporated entities with more than one owner tax rule
Taxed as partnerships - form 1065
Unincorporated entities with only one individual owner
Taxed as sole proprietorship - schedule C form 1040
Unincorporated entities with only one corporate owner
Typically a single member LLC - Disregarded for tax purposes - income reported as if it had originated from a division of the corporation and is reported directly on the single member corporation's return
Converting partnerships/sole proprietorships to Corps
Typically, converting entities taxed as partnerships and sole proprietorships can be accomplished in a tax-deferred transaction without any special tax elections. For this reason, many businesses that plan to eventually go public will operate for a time as entities taxable as partnerships to receive the associated tax benefits and the convert to C Corporations when they finally decide to go public.
Contributions of Property and Services
When a business owner contributes appreciated property to an entity in exchange for an ownership interest, the business owner realizes a gain in the amount of the value of the ownership interest received in excess of the basis of the property transferred. Shareholders of taxable corporations and S corporations are allowed to defer this gain as long as the shareholders contributing property to the corporation "control" the corporation after the exchange (defined as 80 percent ownership). In contrast, members of LLCs and partners in partnerships are allowed to defer the gain no matter their level of ownership in the business entity.
Reducing the Corporate Level Tax
When a corporation's marginal tax rate exceeds its individual shareholder's marginal tax rates, the overall tax rate on corporate income will exceed the flow-through rate even if shareholders can defer the second level of tax indefinitely. In these situations, it makes sense for closely held corporations and their shareholders to consider strategies to shift income from the corporation to shareholders. These strategies are all designed to move earnings out of the corporation and to shareholders with payments that are deductible (dividends are not deductible payments) by the corporation.
Partnership tax year
Year end consistent with the year end of partners
Distributions Taxable Corp and S Corp
both taxable and S corporations recognize gain when they distribute appreciated property to shareholders. However, they are not allowed to recognize loss when they distribute property with a value less than its basis (depreciated property). shareholders of taxable corporations generally recognize dividend income in the amount of the fair market value of the distributions they receive. Distributions to S corporation shareholders are treated as a nontaxable return of capital to the extent of the owner's basis.
Losses generated by flow through entities
generally available to offset the owners' personal income. Note: The owner of a flow-through entity may only deduct losses from the entity to the extent of the owner's basis in the flow-through entity. In addition, deductibility of losses from flow-through entities may be further limited by the "at-risk" and passive activity loss limitations.
Losses generated by taxable C Corps
net operating losses (NOLs). While NOLs provide no tax benefit to a corporation in the current year the corporation experiences the NOL, they may be used to reduce corporate taxes in other years. Taxable C corporations with a NOL for the current year can carry back the loss to offset the taxable income reported in the 2 preceding years and carry it forward for up to 20 years. Losses from taxable corporations are not available to offset their shareholders' personal income.
Separate taxpaying entities
pay tax on their own income
S Corp basis computation
shareholders of S corporations are not allowed to increase the basis in their S corporation stock by liabilities of the S corporation. receive nontaxable distributions to the extent of the basis in their ownership interest, and they are not allowed to deduct losses allocated to them in excess of their tax basis.
Cons of liquidating Corp
the taxes imposed on liquidating corporations with appreciated assets can be very punitive. Liquidating corporations are taxed on the appreciation in the assets they distribute to their shareholders as part of the liquidation. Further, shareholders of liquidating corporations are also taxed on the difference between the fair market value of the assets they receive form the liquidating corporation and their basis in their stock.
