Chapter 4 Entity Overview
Who pays the first level of tax on a C corporation's income? What is the tax rate applicable to the first level of tax? Did recent tax law changes increase or decrease the corporate tax rate?
A C corporation files a tax return and pays taxes on its taxable income. For tax years beginning after 2017, corporations pay tax at a flat 21 percent on their income. For tax years beginning before 2018, a corporation's marginal tax rate depended on the amount of the corporation's taxable income. Marginal rates ranged from a low of 15 percent to a maximum of 39 percent. The most profitable corporations were taxed at a flat 35 percent rate. Consequently, the new tax law significantly reduced the corporate tax rate.
What are the differences, if any, between the legal and tax classifications of business entities?
A business entity may be legally classified as a corporation, limited liability company (LLC), a general partnership (GP), a limited partnership (LP), or a sole proprietorship under state law. However, for tax purposes a business entity can be classified as either a separate taxpaying entity or as a flow-through entity. Separate taxpaying entities pay tax on their own income. In contrast, flow-through entities generally don't pay taxes because income from these entities flows through to their business owners who are responsible for paying tax on the income. C corporations are separate taxpaying entities and, if elected, some flow-through entities may be treated as separate taxpaying entities. Flow-through entities are usually taxed as either partnerships, sole proprietorships, or disregarded entities.
How do corporations protect shareholders from liability? If you formed a small corporation, would you be able to avoid repaying a bank loan from your community bank if the corporation went bankrupt? Explain.
A corporation is solely responsible for its liabilities. One exception to this is for payroll tax liabilities. Shareholders of closely-held corporations may be held responsible for these liabilities. If a corporation were to go bankrupt, the bank may have priority in the corporation's assets but it could not force the shareholders to satisfy the outstanding bank loan. The shareholders may lose their investment in the corporation but their personal assets would be safe from the bank.
Who pays the second level of tax on a C corporation's income? What is the tax rate applicable to the second level of tax and when is it levied?
A corporation's shareholders are responsible for the second level of tax on corporate income. The applicable rate for the second level of tax depends on whether corporations retain their after-tax earnings and on the type of shareholder(s). The shareholders pay tax either when they receive dividends at the dividend tax rate or when they sell their stock at the capital gains tax rate (either long-term or short-term, depending on how long they held the stock). The maximum tax rate on long-term capital gains and qualified dividends is 20 percent. Individual shareholders may also be required to pay the 3.8% net investment income tax on capital gains and dividends, depending on their income level. Corporate shareholders may be eligible for a dividends received deduction on dividends received from stock ownership. This deduction reduces the dividend tax rate for corporate shareholders. Institutional and tax-exempt shareholders also have special rules on the taxation of dividends and capital gains.
What types of business entities does the U.S. tax system recognize?
Although there are more types of legal entities, there are really only four categories of business entities recognized by the U.S. tax system: C corporations (treated as separate taxpaying entities), S corporations, partnerships, and sole proprietorships (treated as flow-through entities).
What is an operating agreement for an LLC? Are operating agreements required for limited liability companies? If not, why might it be important to have one?
An operating agreement is a written document among the owners of an LLC specifying the owners' legal rights and responsibilities for dealing with each other. Generally, operating agreements are not required by law for limited liability companies; however, it might be important to have one to spell out the management practices of the new entity as well as the rights and responsibilities of the owners.
What is the qualified business income deduction and how does it affect the tax rate on flow-through entity income?
Beginning in 2018, owners of partnerships, S corporations, and sole proprietorships are allowed to deduct 20 percent of the qualified business income allocated to them from the entities. The deduction applies only to qualified business income generated in the United States. In general, qualified business income is income from nonservice business (not investment) activities other than architecture and engineering. There are limitations to the deduction imposed at the owner level. Taxpayers who qualify claim the deduction as a from AGI deduction that is not an itemized deduction. Thus taxpayers can claim the deduction even when they claim the standard deduction. Because this is a 20 percent deduction, it effectively reduces the tax rate on flow-through entity income by 20 percent. Said another way, the tax rate is 80 percent of what it would be without the deduction. Consequently, a taxpayer with a marginal rate of 37 percent on the flow through income would pay tax at 29.6 percent on the income after factoring in the deduction [37 percent × (1 - 0.2)].
Why are C corporations still popular despite the double tax on their income?
C corporations have an advantage in liability protection compared to sole proprietorships and partnerships. In addition, C corporations have an advantage if owners ever want to take a business public. As a result, C corporations remain desirable legal entities despite their tax disadvantages.
Explain how legal entities differ in terms of the liability protection they afford their owners.
Corporations and LLCs offer owners limited liability. General partners and sole proprietors may be held personally responsible for the debts of the general partnership and sole proprietorship. However, limited partners are not responsible for the partnership's liabilities.
What are the most common legal entities used for operating a business? How are these entities treated similarly and differently for state law purposes?
Corporations, limited liability companies (LLCs), general or limited partnerships, or sole proprietorship. These entities differ in terms of the formalities that must be observed to create them, the legal rights and responsibilities conferred on them and their owners, and the tax rules that determine how they and their owners will be taxed.
For flow-through entities with individual owners, how many times is flow-through entity income taxed, who pays the tax, and what is the tax rate?
Flow-through entity income is taxed once to the individual owner at the individual's tax rate. The top individual marginal tax rate is 37 percent. Individuals may also be subject to the 3.8 percent net investment income tax on income from an entity in which they are a passive investor. For sole proprietorships and entity's taxed as partnerships, owners participating in the entity's business activities may be subject to self-employment tax and the additional Medicare tax on the income from the flow-through entity. The income could be taxed entirely at 15.3 percent, entirely at 2.9 percent, or part at 15.3 percent and part at 2.9 percent. The additional Medicare tax rate is 0.9 percent. Further, when the owner qualifies for the qualified business income (QBI) deduction, the taxpayer is allowed to deduct 20 percent of the qualified business income allocated to them from the entity. This reduces the tax rate to 29.6 percent [37 percent × (1 - 0.2)] on flow-through income before the net investment income tax, self-employment tax, and additional Medicare Tax.
According to the tax rules, how are profits and losses allocated to owners of entities taxed as partnerships (partners or LLC members)? How are they allocated to S corporation shareholders? Which entity permits greater flexibility in allocating profits and losses?
For entities taxed as partnerships (partnerships or LLCs with more than one member), the entity profits and losses are allocated according to the LLC operating/partnership agreement. The agreement may provide for special allocations that are different from owners' actual ownership percentages. In contrast, S corporation profits must be allocated to shareholders pro rata according to their ownership percentages. Thus, entities taxed as partnerships provide for greater flexibility in allocating profits and losses.
When a C corporation reports a loss for the year, can shareholders use the loss to offset their personal income? Why or why not?
No. Because C corporations are treated as separate entities for tax purposes, their losses do not flow through to shareholders.
How do business owners create legal entities? Is the process the same for all entities? If not, what are the differences?
The process of creating legal entities differs by entity type. Business owners legally form corporations by filing articles of incorporation in the state of incorporation while business owners create limited liability companies by filing articles of organization in the state of organization. General partnerships may be formed either with or without written partnership agreements, and they typically can be formed without filing documents with the state. However, limited partnerships are usually organized by written agreement and must typically file a certificate of limited partnership to be recognized by the state.
Can unincorporated legal entities ever be treated as corporations for tax purposes? Can corporations ever be treated as flow-through entities for tax purposes? Explain.
Treasury regulations permit owners of unincorporated legal entities to elect to have the entities treated as C corporations. On the other hand, shareholders of certain eligible corporations may elect to have the entities receive flow-through tax treatment as S corporations.
In general, how are unincorporated entities classified for tax purposes?
Unincorporated entities are taxed as either partnerships, sole proprietorships, or disregarded entities (an entity that is considered to be the same entity as the owner). Unincorporated entities (including LLCs) with more than one owner are taxed as partnerships. Unincorporated entities (including LLCs) with only one individual owner such as sole proprietorships and single-member LLCs are taxed as sole proprietorships.
Is it possible for shareholders to defer or avoid the second level of tax on corporate income? Briefly explain.
Yes. The second level of tax is deferred to the extent corporations don't pay dividends and shareholders defer selling their shares. However, if a corporation retains earnings for the purpose of avoiding the second level or tax rather than to invest in the business, it may be subject to the accumulated earnings tax. This is a penalty tax that eliminates the tax incentive for retaining earnings strictly to avoid the double tax. The second level of tax can be avoided entirely to the extent corporations retain after-tax income and shareholders hold the stock until death. At death, in the hands of the heirs, the stock would take a basis equal to its fair market value and the gain built into the stock would disappear.
Is a current-year net operating loss of a C corporation available to offset income from the corporation in other years? Explain.
Yes. While NOLs provide no tax benefit to a corporation in the year the corporation experiences the NOL, they may be used to reduce corporate taxes in other years. For tax years ending before 2018, C corporations may carry back the loss two years and then forward 20 years to offset up to 100 percent of the income of the C corporations in those years. For tax years ending after 2017, C corporations can carry net operating losses forward indefinitely (no limit) but they may not carry them back. Further, the net operating deduction can only offset 80 percent of taxable income before the deduction in a given year.
