chapter 13

Considering the Qualified Business Income (Q B I) Deduction

-Another technique to minimize the tax liability of the business entity is to operate as a sole proprietorship, partnership (including an L L C taxed as a partnership), or S corporation -A deduction is available for individuals (and estates and trusts) that own these forms of business -The purpose of the qualified business income deduction is to, in effect, lower the tax rate applicable to the owner, to compensate for how the tax reform lowered the rate for C corporation from a maximum of 35% to a flat 21% -The Q B I deduction generally reduces the individual business owner's taxable income by an amount equal to 20% of the Q B I

Ideally, a fringe benefit produces the following tax consequences:

-Deductible by the entity (employer) that provides the fringe benefit. -Excludable from the gross income of the taxpayer (employee) who receives the fringe benefit.

Conduit concept

A perspective taken toward a venture that regards the venture as an aggregation of its owners joined together in an agency relationship rather than as a separate entity. For tax purposes, this results in the income of the venture being taxable directly to its owners. For example, items of income and expense, capital gains and losses, tax credits, etc., realized by a partnership pass through the partnership (a conduit) and are subject to taxation at the partner level. Also, in an S corporation, certain items pass through and are reported on the returns of the shareholders. partnership LLC

entity concept

A perspective taken toward a venture that regards the venture as an entity separate and distinct from its owners. For tax purposes, this results in the venture being directly responsible for the tax on the income it generates. The entity perspective taken toward C corporations results in the double taxation of income distributed to the corporation's owners. C corp

Many factors affect the choice of business entity

Both tax and nontax Understanding the comparative tax consequences related to the different types of entities is important for effective tax planning

Not subject to A M T

C Corp

Alternative Minimum Tax (AMT)

Created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions.

T or F: Greater-than-2% shareholders of an S corporation are treated the same as employees for fringe benefit purposes.

False

Filing Requirements - Partnership & L L C (if P/S elected)

Files Form 10 65

Filing Requirements - C Corporation

Files Form 11 20

Filing Requirements - S Corporation

Files Form 11 20S

Filing Requirements - Sole Proprietorship

Files Schedule C, Form 1040

Nontax Factors—Limited Liability (C Corporation)

Generally have limited liability

Nontax Factors—Limited Liability (S Corp)

Generally have limited liability

Nontax Factors—Capital Formation (C Corporation)

Greatest ease and potential for raising capital

Nontax Factors—Capital Formation (S Corp)

Greatest ease and potential for raising capital, but limited number of investors

Limited Liability Company (L L C)

Hybrid business form that combines the corporate characteristic of limited liability for owners with tax characteristics of a partnership

The basis for an ownership interest that applies to an S corporation

Increased by an investment by the owner. Decreased by a distribution to the owner. Increased by entity profits. Decreased by entity losses.

The basis for an ownership interest that applies to a partnership

Increased by an investment by the owner. Decreased by a distribution to the owner. Increased by entity profits. Decreased by entity losses. Increased as the entity's liabilities increase. Decreased as the entity's liabilities decrease.

The basis for an ownership interest that applies to a C corporation

Increased by an investment by the owner. For C corporation, only if in excess of E & P.

Nontax Factors—Capital Formation (Sole Proprietorship)

Limited ability to raise capital

Wage income

M. An additional Medicare tax of .9 percent is imposed on wage and self-employment income in excess of $200,000 ($250,000 for joint returns, $125,000 for married filing separate returns).

Dividend received from a C corporation.

N. NII is broad and includes traditional forms of investment income (interest and dividends, for example), as well as rents and income from passive activities. The NIIT applies to net investment income (NII). For individuals, high income is defined as more than $200,000 ($250,000 if married filing jointly). For this purpose, income is defined as modified AGI (MAGI).

Return of capital from a C corporation.

NE. A return of capital is a tax-free event.

Taxable distribution from a retirement plan.

NE. Note: This increase in MAGI will increase NIIT if (MAGI less the threshold amount) is less than NII, until (MAGI less the threshold amount) equals NII.

Applies to an S corporation

Not subject to double taxation Has limited liability Profits and losses affect the basis for an ownership interest Limit on types and number of shareholders Individual owners potentially can claim the 20% qualified business income deduction

Applies to a partnership

Not subject to double taxation Has unlimited liability Profits and losses affect the basis for an ownership interest Entity liabilities affect the basis for an ownership interest Individual owners potentially can claim the 20% qualified business income deduction

Applies to a sole proprietorship

Not subject to double taxation Has unlimited liability Profits and losses affect the basis for an ownership interest Entity liabilities affect the basis for an ownership interest Individual owners potentially can claim the 20% qualified business income deduction

Indirectly subject to A M T

Partnership and L L C •A M T adjustments & preferences flow through and partners subject to A M T S Corporation •A M T adjustments & preferences flow through and S/H's subject to A M T

Guaranteed payment from a partnership for services.

SE, M. See (e) above. Guaranteed payments are taxable as earned income.

General partner's distributive share of income from a partnership.

SE, M. The purpose of the self-employment tax is to provide Social Security and Medicare benefits for self-employed individuals. This requires the self-employed taxpayer to pay both the employee and employer shares of the Social Security and Medicare tax.

Sole proprietorship income

SE, M. The purpose of the self-employment tax is to provide Social Security and Medicare benefits for self-employed individuals. This requires the self-employed taxpayer to pay both the employee and employer shares of the Social Security and Medicare tax.

Principal Forms of Doing Business

Sole Proprietorship Partnership Limited liability company (L L C) C corporation S corporation

Applies to a C corporation

Subject to double taxation Has limited liability Distributions of earnings are taxed as dividend income to the owners Sale of the business can be subject to double taxation Greatest ability to raise capital

T or F: For group term life insurance and lodging to be treated as fringe benefits, the individual must be an employee.

True

T or F: For the owner-employees of a partnership or an S corporation who have contributions made to their retirement plans by the business entity, the amounts paid must be included in their gross income.

True

T or F: Regardless of the entity form, the amounts paid to a qualified retirement plan are deductible by the business entity.

True

Nontax Factors—Limited Liability (Sole Proprietorship)

Unlimited liability

double taxation

a corporation pays income taxes on its earnings, and when dividends are distributed to stockholders, the stockholders pay taxes a second time on the corporate dividends they receive C Corp S Corp (May be subject to built-in gains tax and passive investment income tax)

The sale of the business held by a C corporation can be structured as...

either an asset sale or a stock sale.

C corp as a stock sale

has the dual advantage to the seller of being less complex both as a legal transaction and as a tax transaction. It also has the advantage of providing a way to avoid double taxation. Finally, the gain or loss on the sale of the stock usually is a tax-favored capital gain or loss to the shareholder.

The S corporation shareholder's stock basis is

increased by the share of profits and decreased by the share of losses, but it is not affected by corporate liability increases or decreases. Thus, unlike the owner of a partnership or LLC interest, the S corporation shareholder does not potentially benefit from the leverage concept.

Various techniques can be used to control the tax liability, whether imposed on the entity or owners, such as:

oDistribution policy oRecognizing the interaction between the regular tax liability and the A M T liability oUtilization of special allocations oFringe benefits oMinimizing double taxation oConsideration of the qualified business income deduction

Retain earnings at corporate level

oDouble tax is avoided unless corporation makes distributions (actual or deemed) to shareholders -Must watch out for accumulated earnings tax problems oThe 0%/15%/20% rates for qualified dividends reduce the potential negative impact of double taxation

Make return of capital distributions

oFor ongoing businesses, redemption provisions may help reduce gross income at the shareholder level oCorporate liquidation provisions can be used if business will cease to operate in corporate form

Electing S corporation status

oGenerally eliminates double taxation but other factors must be considered such as: -Will all shareholders consent to election? -Can qualification requirements be met currently and on an ongoing basis? -Are conditions favorable to an S corporation election and how long will those conditions be favorable -Distribution policy may cause problems paying tax at shareholder level -Can the requirements of S corporation qualification that become maintenance requirements continue to be satisfied?

Deductible distributions include:

oSalary payments to shareholder-employees oLease payments to shareholder-lessors oInterest payments to shareholder-creditors •I R S scrutinizes these types of transactions (Must be reasonable)

Several techniques are available for reducing the double taxation of C corporations including:

oTransferring funds to shareholders that are deductible by corporation oRetaining earnings at corporation level oMaking distributions treated as a return of capital oMaking the S corporation election

Single Taxation

occurs when the income of a business is taxed only once sole proprietorship partnership LLC (most S Corps)

In a partnership or an LLC,

since the owner is the taxpayer, profits and losses of the entity affect the owner's basis in the entity interest. Likewise, the owner's basis is increased by the share of entity liability increases and is decreased by the share of entity liability decreases. This liability effect enables the owner to potentially benefit from the leverage concept. Accordingly, the owner's basis changes frequently.

Directly subject to A M T

sole prop

The sale of a partnership or an LLC can be structured as...

the sale of assets or as the sale of an ownership interest. If the transaction takes the form of an asset sale, it is treated the same as for a sole proprietorship (described previously). The sale of an ownership interest is treated as the sale of a capital asset, subject to ordinary income potential for unrealized receivables and substantially appreciated inventory. Thus, if capital gain treatment can produce beneficial results for the taxpayer, the sale of an ownership interest is preferable.

Regardless of the form of the transaction, the sale of a sole proprietorship is treated as

the sale of individual assets. gains and losses must be calculated separately for each asset sold. classification as capital gain or ordinary income depends on the nature and holding period of each individual asset.

C corp as an asset sale

the seller of the business can be either the corporation or the shareholders. If the seller is the corporation, the corporation sells the business (the assets), pays any debts not transferred, and makes a liquidating distribution to the shareholders. If the sellers are the shareholders, the corporation pays any debts that will not be transferred and makes a liquidating distribution to the shareholders; then the shareholders sell the business.

For the C corporation, the corporation is the taxpayer. Therefore,

the shareholder's basis for the stock is not affected by corporate profits and losses or by corporate liability increases or decreases. The treatment of an S corporation shareholder falls in between that of the owner of a partnership or LLC interest and the C corporation shareholder.

A key factor in evaluating the tax consequences of disposing of a business is whether the disposition is...

viewed as the sale of an ownership interest or as a sale of assets. Generally, the tax consequences are more favorable if the transaction is treated as a sale of the ownership interest.

state tax factors

•Also important to check state law on how entities taxed •For example, does state recognize S election? •Does state have specific tax on entities regardless of income level?

Nontax Factors—Capital Formation (Partnership)

•Can raise funds through pooling of owner resources •Limited partnership can raise capital from investors

Other Nontax Factors

•Estimated life of business •Number of owners and their roles in management of the business •Freedom of choice in transferring ownership interests •Organizational formality and related costs •Ease of increasing equity by admitting new owners

Nontax Factors—Limited Liability (Partnership)

•General partners are jointly and severally liable •Limited partners' liability is limited to investment