CH 20: Corporations and Partnerships

A legislative change, however, has raised major obstacles to shifting income to children. The kiddie tax applies to all children under age 19 and to those who are full-time students under age 24.

As a result, shifting investment income (or capital gains) to a child provides no benefit to the extent the income is taxed at the parents' tax rate.

Qualified joint venture

At the election of the taxpayers, certain joint ventures between spouses can avoid partnership classification. Known as a qualified joint venture, the spouses generally report their share of the business activities from the venture as sole proprietors (using two Schedule C forms). This would be reported on Schedule E if the venture relates to a rental property. § 761(f).

A shareholder's basis in the stock of an S corporation, like that of a regular corporation, is the original investment plus additional capital contributions less return of capital distributions.

At this point, however, the symmetry disappears. Generally, basis is increased by the income items passed through (including those separately stated) and decreased by the loss items passed through (including those separately stated).

Check-the-box Regulations

By using the check-the-box rules prudently, an entity can select the most attractive tax results offered by the Code, without being bound by legal forms. By default, an unincorporated entity with more than one owner is taxed as a partnership; an unincorporated entity with one owner is a disregarded entity, taxed as a sole proprietorship or corporate division. No action is necessary by the taxpayer if the legal form or default status is desired. Form 8832 is used to "check a box" and change the tax status. Not available if the entity is incorporated under state law.

The business deductions of corporations parallel those available to individuals. Corporate deductions are allowed for all ordinary and necessary expenses paid or incurred in carrying on a trade or business.

Corporations may also deduct interest, certain taxes, losses, bad debts, depreciation, cost recovery, charitable contributions subject to corporate limitation rules, net operating losses, research and experimental expenditures, and other less common deductions.

For the partnership form, one major obstacle arises. Family partnership rules preclude the assignment of income to a family member unless capital is a material income-producing factor.

If not, the family member must contribute substantial or vital services. Ordinarily, capital is not a material income-producing factor if the income of the business consists principally of compensation for personal services performed by members or employees of the partnership. Conversely, capital is a material income-producing factor if the operation of the business entails a substantial investment in physical assets (e.g., inventory, plant, machinery, or equipment).

Regardless of the form of organization used for the business, income shifting will not take place unless the transfer is complete.

If the donor continues to exercise control over the interest transferred and does not recognize and protect the ownership rights of the donee, the IRS may argue that the transfer is ineffective for tax purposes. In that case, the income from the transferred interest continues to be taxed to the donor.

Unfortunately, the income from property (a business) cannot be shifted to another without also transferring an interest in the property. If, for example, a father wants to assign income from his sole proprietorship to his children, he must form a partnership or incorporate the business.

In either case, the transfer of the interest may be subject to the Federal gift tax. But any potential gift tax can be eliminated or controlled through judicious use of the annual exclusion, the election to split gifts (for married donors), and the unified tax credit (refer to the discussion of the Federal gift tax in Chapter 1).

Unless an election is made under Subchapter S, operating as a corporation yields a potential double tax result. Corporate-source income will be taxed twice—once as earned by the corporation and again when distributed to the shareholders. The payment of a dividend does not result in a deduction to the corporation, and the receipt of a dividend generally results in income to a shareholder.

In the case of closely held corporations, therefore, a strong incentive exists to avoid the payment of dividends. Instead, a premium is put on distributing profits in some manner that is deductible by the corporation. This can be accomplished by categorizing the distributions as salaries, interest, or rent—all of which are deductible by the corporation.

If not properly structured, however, these devices can generate a multitude of problems. Excessive debt, for example, can lead to its reclassification as equity (under the thin capitalization approach) with a resulting disallowance of any interest deduction.

Large salaries could fail the reasonableness test, and rent payments must meet an arm's length standard to avoid treatment as a constructive dividend.

Earnings and profits (E & P)

Measures the economic capacity of a corporation to make a distribution to shareholders that is not a return of capital. Such a distribution results in dividend income to the shareholders to the extent of the corporation's current and accumulated earnings and profits.

Schedule M-1

On the Form 1120, a reconciliation of book net income with Federal taxable income. Accounts for temporary and permanent differences in the two computations, such as depreciation differences, exempt income, and nondeductible items. On Forms 1120S and 1065, the Schedule M-1 reconciles book income with the owners' aggregate ordinary taxable income.

Without special provisions in the Code, a transfer of property to a corporation in exchange for its stock would be a sale or exchange of property and would constitute a taxable transaction to the transferring shareholder.

Section 351 provides for the non-recognition of gain or loss upon such transfers of property if the transferors are in control of the corporation immediately after the transfer. Gain or loss is merely postponed in a manner similar to a like-kind exchange.

S corporation

Sections 1361-1379 of the Internal Revenue Code. An elective provision permitting certain small business corporations (§ 1361) and their shareholders (§ 1362) to elect to be treated for income tax purposes in accordance with the operating rules of §§ 1363-1379. However, some S corporations usually avoid the corporate income tax, and corporate losses can be claimed by the shareholders.

A corporation may choose to amortize organizational expenses over a period of 15 years starting in the taxable year in which the corporation begins business. A special exception, similar to the expensing of startup expenditures discussed in Chapter 6, which can also apply to a corporation, allows the corporation to immediately expense the first $5,000 of these costs in addition to the first year's amortization amount.31

The exception, however, is phased out on a dollar-for-dollar basis when these expenses exceed $50,000.

A corporation must make payments of estimated tax unless its tax liability can reasonably be expected to be less than $500. The payments must equal the lesser of 100 percent of the corporation's final tax or 100 percent of the last year's tax. These payments may be made in four installments due on or before the fifteenth day of the fourth, sixth, ninth, and twelfth months of the corporate taxable year.

The full amount of the unpaid tax is due on the date of the return. Failure to make the required estimated tax prepayments will result in assessment of a nondeductible penalty on the corporation. The penalty can be avoided, however, if any of various exceptions apply

Sole proprietorships are not separate taxable entities.

The owner of the business reports all business transactions on his or her individual income tax return.

Qualified Joint Ventures: For Federal tax purposes, an unincorporated business operated by spouses is considered a partnership. As a result, a business co-run by spouses is generally required to comply with filing and recordkeeping requirements for partnerships and partners. Married co-owners wanting to avoid the burden of partnership documentation can form a qualified joint venture. The election to do so is made by simply reporting each spouse's share of income, losses, gains, and deductions on a Schedule C (along with other related forms) regarding each spouse's interest in the joint venture.

To qualify for joint venture treatment, the only members of the joint venture can be spouses filing a joint return, both spouses must materially participate, and both spouses must elect not to be treated as a partnership. The business must be operated by the spouses as co-owners and not through a separate entity under state law.

One objective of tax planning is to keep the income from a business within the family unit but to disperse the income in such a manner as to minimize the overall tax burden.

To the extent feasible, therefore, income should be shifted from higher-bracket to lower-bracket family members.

Can an organization not qualifying as a corporation under state law still be treated as such for Federal income tax purposes?

Yes. The tax law defines a corporation as including "associations, joint stock companies, and insurance companies."7 As the Code contains no definition of an "association," the issue was the subject of frequent litigation prior to the issuance of the Check-the-box Regulations.

Many corporate and all noncorporate taxpayers are subject to the alternative minimum tax (AMT). For AMT purposes, many adjustments and tax preference items are the same for both,

but other adjustments and tax preferences apply only to corporations or only to individuals. The AMT is discussed in Chapter 12.

Other tax considerations having a bearing on the choice of the corporate form to operate a business are summarized below:

•Corporate-source income loses its identity as it passes through the corporation to the shareholders. Thus, items possessing preferential tax treatment (e.g., interest on municipal bonds) are not taxed as such to the shareholders. •As noted earlier, it may be difficult for shareholders to recover some or all of their investment in the corporation without a dividend income result. Recall that most corporate distributions are treated as dividends to the extent of the corporation's E & P. Structuring the capital of the corporation to include debt is a partial solution to this problem. Thus, the shareholder-creditor could recoup part of his or her investment through the tax-free payment of principal. Too much debt, however, may lead to the debt being reclassified as equity. •Corporate losses cannot be passed through to the shareholders. •The domestic production activities deduction generated by the corporation is not available to its shareholders. •The liquidation of a corporation may generate tax consequences to both the corporation and its shareholders. Even when the corporation being liquidated does not sell its assets but distributes them in kind (i.e., "as is") to the shareholders, gain (or loss) is not avoided. The corporation must treat the distribution as a sale and recognize gain or loss measured by the fair market value of the assets involved. •The corporate form provides the shareholders with the opportunity to be treated as employees for tax purposes if they render services to the corporation. This status makes a number of attractive tax-sheltered fringe benefits available (e.g., group term life insurance). These benefits are not available to partners and sole proprietors.

Sole proprietorships and partnerships, on the other hand, expose owners to personal liability in situations where the business cannot cover its liabilities.

A sole proprietorship is not an entity separate from its owner. Thus, the individual owner is fully liable for business liabilities. Partners in a partnership are fully liable for partnership liabilities that cannot be satisfied by the partnership. Even for a limited partnership, at least one partner must be responsible for partnership liabilities (the general partner). The limited partners are typically liable only to the extent of their capital investment in the partnership.

Constructive dividend

A taxable benefit derived by a shareholder from his or her corporation that is not actually initiated by the board of directors as a dividend. Examples include unreasonable compensation, excessive rent payments, bargain purchases of corporate property, and shareholder use of corporate property. Constructive dividends generally are found in closely held corporations.

Finally, for the thriving entrepreneur, the corporate form is the most likely form when the business is preparing to enter into its initial public offering (IPO). Corporations operate under a centralized management beholden to the board of directors and not directly to the shareholders.

The IPO can help raise the necessary capital to expand the business; however, the limited management rights of owners under the corporate form makes that entity choice the optimal one for preventing wayward shareholders from interfering with the day-to-day operations of the business as shareholder involvement is generally limited to voting for board members and other corporate resolutions. In addition, corporate form often lends itself to free transferability of ownership, allowing shareholders to set their stake in the business with lower transaction costs (e.g., on a stock exchange).

The receipt of stock for the performance of services always results in ordinary income to the transferring shareholder. An example might be an attorney who does not charge a fee for incorporating a business but instead receives the value equivalent in stock of the newly formed corporation.

The basis of stock received for the performance of services is equal to the fair market value of the services.

The C corporation form of doing business carries with it the imposition of the corporate income tax.

The corporation is recognized as a separate taxpaying entity apart from its shareholders. Income is taxed to the corporation as earned and taxed again to the shareholders when distributed as dividends.

Unlike corporations, partnerships are not considered separate taxable entities. Each member of a partnership is subject to income tax on the partner's distributive share of the partnership's income, even if an actual distribution is not made.

The tax return (Form 1065) required of a partnership serves only to provide information necessary in determining the character and amount of each partner's distributive share of the partnership's income and expense. Because a partnership acts as a conduit, items that pass through to the partners do not lose their identity. For example, tax-exempt income earned by a partnership is picked up by the partners as tax-exempt income. In this regard, partnerships function in much the same fashion as S corporations, which also serve as conduits.

In measuring and reporting partnership income, certain transactions must be segregated and reported separately on the partnership return. Items such as charitable contributions, the domestic production activities deduction, capital gains and losses, qualified dividend income, and foreign taxes are excluded from partnership taxable income and are allocated separately to the partners.

These items must be segregated and allocated separately because they affect the computation of various exclusions, deductions, and credits at the individual partner level.

The general rule is that no gain or loss is recognized by a partnership or any of its partners on the contribution of property in exchange for a capital interest in the partnership.

This rule also applies to all subsequent contributions of property.

Qualified dividends received by individual shareholders are subject to preferential tax rates. For those shareholders in the top tax bracket, the maximum rate of 20 percent applies (to income otherwise taxed at the 39.6 percent rate); for the next four tax brackets (25, 28, 33, and 35 percent), the rate is 15 percent; for those in the bottom two brackets (10 and 15 percent), the rate is 0 percent.

Corporate taxpayers do not benefit from such preferential rates, but as discussed later, corporate shareholders enjoy the alternative of the dividends received deduction.

In the past, a Form 1120 had to be filed on or before the fifteenth day of the third month following the close of the corporation's tax year. A 2015 tax law changed the due date to the fourth month following the close of the corporation's tax year.

Corporations can receive an automatic extension of six months for filing the corporate return by filing Form 7004 by the due date of the return.37 However, the IRS may terminate an extension by mailing a 10-day notice to the taxpayer corporation.

Many of the tax credits available to individuals, such as the foreign tax credit, can be claimed by corporations. Not available to corporations are certain credits that are personal in nature.

Examples of credits not available to corporations include the credit for child and dependent care expenses, the credit for the elderly or disabled, and the earned income credit.

Both corporate and noncorporate taxpayers are required to aggregate gains and losses from the taxable sale or exchange of capital assets.

For long-term capital gains (including gains from collectibles and unrecaptured § 1250 gain), individuals enjoy an advantage. The maximum applicable tax rate is 28 percent for collectibles, 25 percent for unrecaptured § 1250 gain, and 20 percent for other capital gains. In the case of corporations, all capital gains are taxed using the rates for ordinary income.

When carried back or forward, both short-term capital losses and long-term capital losses are treated as short-term capital losses by corporate taxpayers.

For noncorporate taxpayers, carryovers of capital losses retain their identity as short or long term.

Net Operating Losses: Corporations are not subject to the complex adjustments required for individuals because a corporation's loss more clearly approximates a true economic loss. Artificial deductions (e.g., personal and dependency exemptions) that merely generate paper losses are not permitted for corporations.

In computing the NOL of a corporation, the dividends received deduction (discussed below) can be claimed in determining the amount of the loss. Generally, NOLs may be carried back 2 years and forward 20 years (or taxpayers may elect to forgo the carryback period) to offset taxable income for those years.

As noted in Chapter 10, the deduction for charitable contributions of ordinary income property is limited to the lesser of the fair market value or the adjusted basis of the property. A special rule provides an exception that permits a corporation to contribute inventory (ordinary income property) to certain charitable organizations and receive a deduction equal to the adjusted basis plus one-half of the difference between the fair market value and the adjusted basis of the property.

In no event, however, may the deduction exceed twice the adjusted basis of the property. To qualify for this exception, the inventory must be used by the charity in its exempt purpose for the care of children, the ill, or the needy.

In some instances, the IRS has attempted to disregard (or collapse) a corporation to make the income taxable directly to the shareholders.

In other cases, the IRS has asserted that the corporation is a separate taxable entity so as to assess tax at the corporate level and to tax corporate distributions to shareholders as dividend income (double taxation).

As noted in Chapter 7, § 199 was designed to replace various export tax benefits that our world trading partners deemed discriminatory. Known as the domestic production activities deduction (DPAD), the provision is equally applicable to C corporations.

In the case of C corporations, however, the limitation is based on taxable income, rather than AGI (both computed without considering the deduction). Thus, the DPAD is 9 percent of the lesser of qualified production activities income (QPAI) or taxable income. As with individual taxpayers, the DPAD cannot exceed 50 percent of the W-2 wages involved (those subject to withholding plus certain elective deferrals). Domestic gross receipts from manufacturing activities are a major source of QPAI. These gross receipts are adjusted by cost of goods sold and other assignable expenses to arrive at QPAI.

A distribution of property to a shareholder is measured by the fair market value of the property on the date of distribution. The fair market value is also the shareholder's basis in the property.

A corporation that distributes appreciated property to its shareholders as a dividend must recognize the amount of the appreciation as gain. However, if the property distributed has a basis in excess of its fair market value, the distributing corporation cannot recognize any loss.

Small business corporation

A corporation that satisfies the definition of § 1361(b), § 1244(c), or both. Satisfaction of § 1361(b) permits an S election, and satisfaction of § 1244 enables the shareholders of the corporation to claim an ordinary loss on the worthlessness of stock.

Personal service corporation (PSC)

A corporation whose principal activity is the performance of personal services (e.g., health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and where such services are substantially performed by the employee-owners. The 35 percent statutory income tax rate applies to PSCs.

Dividends received deduction

A deduction allowed a shareholder that is a corporation for dividends received from a domestic corporation. The deduction usually is 70 percent of the dividends received, but it could be 80 or 100 percent depending upon the ownership percentage held by the recipient corporation. §§ 243-246.

Another significant difference is that unlike general partners in a partnership, LLC members (LLC owners) are not personally responsible for the debts of the LLC. Another significant difference is that an LLC can be formed with only one member.

A so-called single-member LLC is treated as a disregarded entity for tax purposes. As a result, the operations of a single-member LLC are treated like a sole proprietorship for tax purposes.

Like individuals, corporations are not permitted an unlimited charitable contribution deduction. In any one year, a corporate taxpayer is limited to 10 percent of taxable income. For this purpose, taxable income is computed without regard to the charitable contribution deduction, any net operating loss carryback or capital loss carryback, or the dividends received deduction (discussed later in this chapter).

Any contributions in excess of the 10 percent limitation are carried forward to the five succeeding tax years. Any carryover must be added to subsequent contributions and is subject to the 10 percent limitation. In applying the limitation, the most recent contributions must be deducted first.

Upon the sale or other taxable disposition of depreciable personalty, the recapture rules of § 1245 make no distinction between corporate and noncorporate taxpayers. In the case of the recapture of depreciation on real property (§ 1250), however, corporate taxpayers experience more severe tax consequences.

As illustrated later, corporations must recognize as additional ordinary income 20 percent of the excess of the amount that would be recaptured under § 1245 over the amount recaptured under § 1250.

Like regular dividends, constructive dividends must be covered by E & P to carry dividend income consequences to the shareholders.

As noted previously, however, constructive dividends need not be available to all shareholders on a pro rata basis.

The receipt of money or property in exchange for capital stock produces neither recognized gain nor loss to the recipient corporation.47 Gross income of a corporation does not include shareholders' contributions of money or property to the capital of the corporation.

Contributions by nonshareholders are also excluded from the gross income of a corporation.49 The basis of the property transferred by nonshareholders to the corporation is zero.

If a corporate distribution is not covered by E & P (either current or past), it is treated as a return of capital (refer to the discussion of the recovery of capital doctrine in Chapter 4).

Because this treatment allows the shareholder to apply the amount of the distribution against the basis of the stock investment, the distribution represents a nontaxable return of capital. Any amount received in excess of the stock basis is classified as a capital gain (if the stock is a capital asset in the hands of the shareholder).

Corporations must comply with the specific requirements for corporate status under state law. For example, it is necessary to draft articles of incorporation and file them with the state regulatory agency (usually the Secretary of State), be granted a charter, and issue stock to shareholders.

Compliance with state law, although important, is not the only requirement that must be met to qualify for corporate tax status. For example, a corporation qualifying under state law may be disregarded as a taxable entity if it is a mere sham lacking in economic substance.4 The key consideration is the degree of business activity conducted at the corporate level.

All allowable corporate deductions are treated as business expenses. The determination of adjusted gross income, so essential for individuals, has no relevance to corporations.

Corporations need not be concerned with classifying deductions into deduction for and deduction from categories.

The gross income of a corporation is determined in much the same manner as for individuals. Both individuals and corporations are entitled to exclusions from gross income, such as interest on municipal bonds.

Gains and losses from property transactions are also treated similarly. For example, whether a gain or loss is capital or ordinary depends on the nature and use of the asset rather than the type of taxpayer.

Changes in the liabilities (including trade accounts payable and bank loans) of a partnership also affect the basis of a partnership interest. A partner's basis is increased by his or her assumption of partnership liabilities and by his or her pro rata share of liabilities incurred by the partnership.

Likewise, the partner's basis is decreased by the amount of any personal liabilities assumed by the partnership and by the pro rata share of any decreases in the liabilities of the partnership.

After the separately stated items have been removed, the balance represents the taxable income of the S corporation. In arriving at taxable income, the dividends received deduction, the DPAD, and the NOL deduction are not allowed. An S corporation does come under the regular corporate rules, however, for purposes of amortization of organizational expenditures.

Once taxable income has been determined, it passes through to each shareholder as of the last day of the S corporation's tax year.

Corporations with less than $250,000 of gross receipts and less than $250,000 in assets do not have to complete Schedule L (balance sheet) and Schedules M-1 and M-2 (see the next section) of Form 1120.

Similar omissions are allowed for Form 1120S. These rules are intended to ease the compliance burden on small business.

If the holders of a majority of the shares consent to a voluntary revocation of S status, the election to revoke must be made on or before the fifteenth day of the third month of the tax year to be effective for that year.

Suppose the shareholders in Example 39 file the election to revoke on January 4, 2017, but do not want the revocation to take place until 2018. If the election so specifies, Stork Corporation will cease to have S status as of January 1, 2018. In the case where S status is lost because of a disqualifying act (involuntarily), the loss of the election takes effect as of the date on which the event occurs. Barring certain exceptions, the loss of the election places the corporation in a five year holding period before S status can be reelected.

Partnerships are not subject to the income tax.

Under the conduit concept, the various tax attributes of the partnership's operations flow through to the partners to be reported on their income tax returns.

Corporations selling depreciable real estate may have ordinary income in addition to that required by § 1250. Under § 291, the additional ordinary income element is 20 percent of the excess of the § 1245 recapture potential over the § 1250 recapture. As a result, the § 1231 gain is correspondingly decreased by the additional recapture.

Under § 1250, the excess of accelerated depreciation over straight-line depreciation is recaptured as ordinary income as to real property. Because all real property purchased since 1986 is depreciated using only the straight-line method, after 2005, the § 1250 amount is zero because the depreciation period (19 years in 1986) has expired and such buildings are fully depreciated.

C corporation

A separate taxable entity subject to the rules of Subchapter C of the Code. This business form may create a double taxation effect relative to its shareholders. The entity is subject to the regular corporate tax and a number of penalty taxes at the Federal level.

The dividends received deduction may be limited to a percentage of the taxable income of a corporation computed without regard to the NOL deduction, the dividends received deduction, the DPAD, or any capital loss carryback. The percentage of taxable income limitation corresponds to the deduction percentage. Thus, if a corporate shareholder owns less than 20 percent of the stock in the distributing corporation, the dividends received deduction is limited to 70 percent of taxable income (as previously defined). However, this limitation does not apply if the DRD creates an NOL for the current taxable year.29 In addition, the DRD applies to dividends received from domestic corporations.30 In working with these myriad rules, the following steps need to be taken:

1.Multiply the dividends received by the deduction percentage. 2.Multiply the taxable income (as previously defined) by the deduction percentage. 3.The deduction is limited to the lesser of step 1 or step 2, unless subtracting the amount derived from step 1 from taxable income (as previously defined) generates a negative number. If so, the amount derived in step 1 should be used.

Pass-through entity

A form of business structure for which the income and other tax items are attributed directly to the owners and generally no separate tax is levied upon the entity itself. Examples include sole proprietorships, partnerships, and S corporations. Also referred to as a flow-through entity.

Limited liability company (LLC)

A legal entity in which all owners are protected from the entity's debts but which may lack other characteristics of a corporation (i.e., centralized management, unlimited life, free transferability of interests). LLCs are treated as partnerships (or disregarded entities if they have only one owner) for tax purposes.

The contributing partner's basis in the partnership interest received is the sum of money contributed plus the adjusted basis of any other property transferred to the partnership.

A partner's basis in the partnership interest is determined without regard to any amount reflected on the partnership's books as capital, equity, or a similar account.

A partnership is considered a separate taxable entity for purposes of making various elections and selecting its taxable year, method of depreciation, and accounting method.

A partnership is also treated as a separate legal entity under civil law with the right to own property in its own name and to transact business free from the personal debts of its partners.

Corporations are subject to an alternative minimum tax (AMT) that has the same objective and is structured in the same manner as that applicable to individuals. The AMT defines a more expansive tax base than for the regular tax. Like individuals, corporations are required to apply a minimum tax rate to the expanded base and pay the difference between the tentative AMT liability and the regular tax.

Although many of the adjustments and tax preference items necessary to arrive at alternative minimum taxable income (AMTI) are the same for individuals and corporations, the rate and exemptions are different. As noted in Chapter 12, certain small business corporations are effectively exempt from the corporate AMT.

Schedule M-3

An expanded reconciliation of book net income with Federal taxable income (see Schedule M-1). Required of C and S corporations and partnerships/LLCs with total assets of $10 million or more.

Distributions by an S corporation reduce the basis of a shareholder's stock investment. However, if the amount of the distribution exceeds basis, the excess normally receives capital gain treatment.

As previously noted, operating losses of an S corporation pass through to the shareholders and reduce the basis in their stock investment. Because the basis of the stock cannot fall below zero, an excess loss is then applied against the basis of any loans the shareholder may have made to the corporation. In the event the basis limitation precludes an operating loss from being absorbed, the loss can be carried forward and deducted when and if it is covered by basis.

Limited liability companies (LLCs) are generally treated as a partnership for tax purposes (although refer to text Section 20-1 in the chapter for Check-the-box options). An LLC differs from a partnership in a few significant ways.

Generally, a partnership can be formed without any formal paperwork, whereas an LLC is required to file articles of organization with the state.

Most C corporations enjoy greater flexibility in the selection of a tax year than do other business entity types. For example, C corporations usually can have different tax years from those of their shareholders. Also, a newly formed corporation generally has a free choice of any permissible accounting period without having to obtain the consent of the IRS.

However, personal service corporations and S corporations are subject to severe restrictions on the use of a fiscal year.

Qualified dividend income is taxed like net long-term capital gain.52 Consequently, the tax rate on such income cannot exceed 20 percent (0 percent for individual shareholders in the 15 percent or lower tax bracket).

If a corporate distribution is not covered by E & P (either current or past), it is treated as a return of capital (refer to the discussion of the recovery of capital doctrine in Chapter 4). Because this treatment allows the shareholder to apply the amount of the distribution against the basis of the stock investment, the distribution represents a nontaxable return of capital. Any amount received in excess of the stock basis is classified as a capital gain (if the stock is a capital asset in the hands of the shareholder).

As previously noted, separately stated loss items (e.g., capital losses and § 1231 losses) flow through to the shareholders on an as is basis. Their treatment by a shareholder depends on the shareholder's individual income tax position.

If the S corporation's taxable income determination results in an operating loss, it also passes through to the shareholders. As is the case with separately stated items, the amount of the loss each shareholder receives depends upon the stock ownership during the year.

Because the income and losses of an S corporation are passed through to the owners, distributions to shareholders from an S corporation are generally excluded from gross income to the extent of the shareholder's stock basis.

If the distribution is greater than the shareholder's basis, then the amount in excess of basis is treated as a capital gain. However, should the S corporation have been converted from an earlier C corporation that had earnings and profits at the time of the conversion, a different set of complex rules apply, making it more likely that the shareholders will not escape dividend taxation by converting to an S corporation.

A corporation must file a return whether or not it has taxable income.35 A corporation that was not in existence throughout an entire annual accounting period is required to file a return for the fraction of the year during which it was in existence.

In addition, the corporation must file a return even though it has ceased to do business if it has valuable claims for which it will bring suit. It is relieved of filing returns once it ceases business and dissolves.

The basis of property contributed to a partnership by a partner is the adjusted basis of the property to the contributing partner at the time of the contribution.

In addition, the holding period of the property for the partnership includes the period during which the property was held by the contributing partner. This is logical because the partnership's basis in the property is the same basis the property had in the hands of the partner.

In cases involving nontaxable exchanges and certain transactions allowing the deferral of gain recognition, many of the rules are the same. Thus, both individuals and corporations can utilize the like-kind exchange provisions of § 1031 and the deferral allowed by § 1033 for involuntary conversions.

In contrast, the § 121 exclusion for gain from the sale of a principal residence is a relief measure available only to individual taxpayers.

Corporate distributions of cash or property to shareholders are treated as dividend income to the extent the corporation has accumulated and/or current earnings and profits (E & P).

In determining the source of the distribution, a dividend is deemed to have been made initially from current E & P.

Organizational expenditures

Items incurred early in the life of a corporation or partnership that are eligible for a $5,000 limited expensing (subject to phaseout) and an amortization of the balance over 180 months. Organizational expenditures exclude those incurred to obtain capital (underwriting fees) or assets (subject to cost recovery). Typically, eligible expenditures include legal and accounting fees and state incorporation payments. Such items must be incurred by the end of the entity's first tax year. §§ 248 and 709(b).

The members of a family who own stock are treated as a single shareholder.

Members of a family include all lineal descendants (e.g., children, grandchildren) of a shareholder and spouse (or ex-spouse) and the spouses (or ex-spouses) of such lineal descendants.

Guaranteed payments

Payments made by a partnership to a partner for services rendered or for the use of capital to the extent the payments are determined without regard to the income of the partnership. The payments are treated as though they were made to a nonpartner and thus are deducted by the entity.

The amount of the dividends received deduction depends upon the percentage of ownership the recipient corporate shareholder holds in the corporation making the dividend distribution.28 For dividends received or accrued, the deduction percentage is summarized as follows:

Percentage of Ownership byCorporate ShareholderDeduction Percentage Less than 20% 70% 20% or more (but less than 80%) 80% 80% or more 100%

A further factor that favors the corporate form (either a regular or S corporation) as a device for income splitting is the ease with which it can be carried out.

Presuming the entity already exists, the transfer of stock merely requires an entry in the corporation's stock ledger account. In contrast, a gift of a partnership interest probably requires an amendment to the partnership agreement.

A partner's deduction of the distributive share of partnership losses (including capital losses) could be limited. The limitation is the adjusted basis of the partnership interest at the end of the partnership year in which the losses were incurred.

The limitation for partnership loss deductions is similar to that applicable to losses of S corporations. Like S corporation losses, partnership losses may be carried forward by the partner and utilized against future increases in the basis of the partnership interest. Such increases might result from additional capital contributions to the partnership, from additional partnership liabilities, or from future partnership income. Unlike S corporations, however, loans to the entity cannot be utilized by a partner to absorb the pass-through of losses.

Although a partnership is not subject to Federal income taxation, it is required to determine its taxable income and file an income tax return for information purposes.

The tax return, Form 1065, is due on the fifteenth day of the third month following the close of the taxable year of the partnership. (For tax returns covering years before 2016, the due date fell on the fifteenth day of the fourth month.)

Income shifting through the use of a partnership, therefore, may be ineffectual if a personal service business is involved. In fact, it could be hopeless if the assignees are minors.

The use of the corporate form usually involves no such impediment. Regardless of the nature of the business, a gift of stock carries with it the attributes of ownership. Thus, dividends paid on stock are taxed to the owner of the stock.

Similar to the procedure for an S corporation, the individual components needed to determine the DPAD at the partner level must be separated. These components include each partner's pro rata portion of QPAI and the W-2 wages paid by the partnership.

This information is listed on Schedule K-1 (Form 1065) and is picked up by the partner on lines 7 and 17 of his or her Form 8903 (Domestic Production Activities Deduction).

A C corporation may elect to be taxed as an S corporation if certain requirements are met.

This special treatment follows the conduit concept and is similar (although not identical) to the partnership rules. Income tax is generally avoided at the corporate level, and shareholders are taxed currently on the earnings of the S corporation.

But what if the corporate form is utilized and the S election is made? A new hurdle arises. The Code authorizes the IRS to make adjustments in situations where shareholders are not being adequately compensated for the value of their services or capital provided to an S corporation in a family setting.

Thus, an S corporation suffers from the same vulnerability that exists with family partnerships.

The S corporation is primarily a tax-reporting rather than a taxpaying entity. In this respect, the entity is taxed much like a partnership.59 Under the conduit concept, the taxable income and losses of an S corporation flow through to the shareholders who report them on their personal income tax returns.

To ascertain the annual tax consequences to each shareholder, it is necessary to carry out two steps at the S corporation level. First, all corporate transactions that will flow through to the shareholders on an as is basis under the conduit approach must be set aside. Second, what remains is aggregated as the taxable income of the S corporation and is allocated to each shareholder on a per-share and per-day of stock ownership basis.

The election is made by filing Form 2553, and all shareholders must consent. It is important to determine who needs to sign the form. For example, if a married couple owns the stock as community property, both spouses must sign the consent, even though they count as a single shareholder.

To be effective for the current year, the election must be filed anytime during the preceding taxable year or on or before the fifteenth day of the third month of the current year.

Thin capitalization

When debt owed by a corporation to the shareholders becomes too large in relation to the corporation's capital structure (i.e., stock and shareholder equity), the IRS may contend that the corporation is thinly capitalized. In effect, some or all of the debt is reclassified as equity. The immediate result is to disallow any interest deduction to the corporation on the reclassified debt. To the extent of the corporation's earnings and profits, interest payments and loan repayments on the reclassified debt are treated as dividends to the shareholders.

Significant differences between corporations and individuals exist in the treatment of capital losses for income tax purposes. Individuals, for example, can annually deduct up to $3,000 of net capital losses against ordinary income. If an individual has both net short-term and net long-term capital losses, the short-term capital losses are used first in arriving at the $3,000 ordinary loss deduction.

While corporations may not use net capital losses to offset ordinary income, they may use net capital losses to offset past or future capital gains.17 Unlike individuals, corporations are not allowed an unlimited carryover period for capital losses. Instead, they may carry back excess capital losses to the three preceding years, applying the losses initially to the earliest year. If not exhausted by the carryback, remaining unused capital losses may be carried forward for a period of five years from the year of the loss.18

Other forms of business organization are available and should be considered. Besides the sole proprietorship, the choices include:

•C corporation. •S corporation. •Limited liability company (LLC). •Partnership. •Qualified joint venture.

Corporate and individual tax rules also can vary in the following areas:

•Capital gains and losses. •Recapture of depreciation. •Charitable contributions. •Domestic production activities deduction. •Net operating losses. •Special deductions for corporations.

In terms of methods of accounting, generally, any business entity type that maintains inventory for sale to customers must use the accrual method in determining cost of goods sold.10 C corporations and partnerships with a partner that is a C corporation are generally required to use the accrual method of accounting (per the required accrual method rule).11 However, there are exceptions to this rule:

•Corporations or partnerships with average annual gross receipts in prior three-year periods that do not exceed $5 million •Certain farming businesses •A C corporation that is a qualified personal service corporation (QPSC)

There are certain exceptions to the nonrecognition of gain or loss rule, including the following:

•If a partner transfers property to the partnership and receives money or other consideration (boot) as a result, the transaction will be treated as a sale or exchange rather than as a contribution of capital. Realized gain is recognized to the extent of the fair market value of the boot received. •If a partnership interest is received in exchange for services rendered or to be rendered by the partner to the partnership, the fair market value of the transferred capital interest is regarded as compensation for services rendered. In such cases, the recipient of the capital interest must recognize the amount as ordinary income in the year actually or constructively received. •If property that is subject to a liability in excess of its basis is contributed to a partnership, the contributing partner may recognize gain.

To qualify for S corporation status, the corporation must be a small business corporation. This includes any corporation that has the following characteristics:

•It is a domestic corporation. •There are no more than 100 shareholders. •Its shareholders are only individuals, estates, and certain trusts. •No shareholder is a nonresident alien. •It has only one class of stock outstanding.

Organizational expenditures include the following:

•Legal services incident to organization (e.g., drafting the corporate charter, bylaws, minutes of organizational meetings, and terms of original stock certificates). •Necessary accounting services. •Expenses of temporary directors and of organizational meetings of directors and shareholders. •Fees paid to the state of incorporation.

Similarly, the basis of a partner's interest is decreased, but not below zero, by distributions of partnership property (including cash) and by the sum of the current and prior years' distributive share of the following:

•Partnership losses, including capital losses. •Partnership expenditures that are not deductible in computing taxable income or loss and that are not capital expenditures.

The following are examples of constructive dividends:

•Salaries paid to shareholder-employees that are not reasonable (refer to Example 7 in Chapter 6). •Interest on debt owed by the corporation to shareholders that is reclassified as equity because the corporation is thinly capitalized (refer to the earlier discussion in this chapter). •Excessive rent paid by a corporation for the use of shareholder property. The arm's length standard is used to test whether the rent is excessive (refer to Example 27 in Chapter 1). •Advances to shareholders that are not bona fide loans. •Interest-free (or below-market) loans to shareholders. In this situation, the dividend component is the difference between the interest provided for, if any, and that calculated using the market rate. •Shareholder use of corporate property for less than an arm's length rate. •Absorption by the corporation of a shareholder's personal expenses. •Bargain purchase of corporate property by shareholders.

The nonrecognition of gain or loss is accompanied by a carryover of basis. The basis of stock received in a § 351 transfer is determined as follows:

•Start with the adjusted basis of the property transferred by the shareholder. •Add any gain recognized by the shareholder as a result of the transfer. •Subtract the fair market value of any boot received by the shareholder from the corporation.

Following are some of the items that do not lose their identity as they pass through the S corporation and are therefore picked up by each shareholder on an as is basis:

•Tax-exempt income. •Long-term and short-term capital gains and losses. •Section 1231 gains and losses. •Charitable contributions. •Domestic production activities deduction (DPAD). •Qualified dividend income. •Foreign tax credits. •Depletion. •Nonbusiness income or loss under § 212. •Intangible drilling costs. •Investment interest, income, and expenses covered under § 163(d). •Certain portfolio income. •Passive activity gains, losses, and credits under § 469. •AMT adjustments and tax preference items.

After its initial determination, the basis of a partnership interest is subject to continuous fluctuations. A partner's basis is increased by additional contributions and the sum of his or her current and prior years' distributive share of the following:

•Taxable income of the partnership, including capital gains. •Tax-exempt income of the partnership. •The excess of the deductions for depletion over the basis of the partnership's property subject to depletion.

Generally, a charitable contribution deduction is allowed only for the tax year in which the payment is made. However, an important exception is made for accrual basis corporations. The deduction may be claimed in the tax year preceding payment if the following conditions are satisfied:

•The contribution is authorized by the board of directors by the end of that tax year and •The contribution is paid on or before the fifteenth day of the fourth month of the next tax year.

The S election may be terminated voluntarily (a majority of the shareholders file to revoke the election) or involuntarily. An involuntary termination may occur in either of the following ways:

•The corporation ceases to qualify as a small business corporation (e.g., the number of shareholders exceeds 100 or a partnership becomes a shareholder). •The corporation has passive investment income (e.g., interest and dividends) in excess of 25 percent of gross receipts for a period of three consecutive years. This possibility applies only if the corporation was previously a regular corporation and has E & P from that period.

A second step in the measurement and reporting process is the computation of the partnership's ordinary income or loss. The taxable income of a partnership is computed in the same manner as the taxable income of an individual taxpayer. However, a partnership is not allowed the following deductions:

•The deduction for personal and dependency exemptions. •The deduction for taxes paid to foreign countries or possessions of the United States. •The deduction for charitable contributions. •The deduction for net operating losses. •The additional itemized deductions allowed individuals in §§ 211 through 219.

The excepted businesses (as well as S corporations because they are not subject to the required accrual method rule) are generally allowed to use either the cash or accrual (or hybrid) method of accounting. However, businesses with inventory must use the accrual method for inventory13 unless they meet a different set of exceptions:

•The small taxpayer exception for taxpayers with average annual gross receipts in the past three years of $1 million or less.14 •The qualifying small business exception for service-related businesses with average annual gross receipts in the past three years of $10 million or less unless not permitted under the required accrual method rule (C corporations or partnerships with a C corporation partner).

The following requirements must be met to qualify under § 351:

•The transferors must be in control of the corporation immediately after the exchange. Control is defined as ownership of at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock.44 •Realized gain (but not loss) is recognized to the extent that the transferors receive property other than stock. Such nonqualifying property is commonly referred to as boot. If the requirements of § 351 are satisfied and no boot is involved, nonrecognition of gain or loss is mandatory.