ACCT 522 Ch 15
Business entities classification for tax purposes
-Check the box regulations -Taxpaying entities -Flow-through entities
Legal Classification and Nontax Characteristics of Entities
-Entities are created by State law which generally classifies entities as either corporations, limited liability companies, general partnerships, limited partnerships, or sole proprietorships. -Corporations and limited liability companies shield all of their owners against the entity's liabilities. -Corporations are less flexible than other entities but are generally better suited for going public.
Double Taxation
-Most profitable C corporations are taxed at a 35 percent rate. -Individual C corporation shareholders are generally taxed at a 15 percent rate on dividends when received (20 percent for high income taxpayers). Further, certain taxpayers may be charged a 3.8 percent net investment income tax on dividends and capital gains. -C corporation shareholders that are C corporations are generally eligible to receive a 70 percent or greater dividends received deduction. -C corporation shareholders who are individuals generally pay capital gains taxes when shares are sold at a gain. -The double tax is mitigated when income is shifted from C corporations to shareholders and when dividends are deferred or not paid.
Limited Liability Company
-a type of flow-through entity for federal income tax purposes. By state law, the owners of the LLC have limited liability with respect to the entity's debts or liabilities. Limited liability companies are taxed as partnerships for federal income tax purposes. -Files articles of organization -Solely responsible
4 Business Entities
1. C 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)
Tax Classification of Legal Entities
1.) Corporations are C corporations unless they make a valid S election. 2.) Unincorporated entities are taxed as partnerships if they have more than one owner. 3.) Unincorporated entities are taxed as sole proprietorships if held by a single individual or as disregarded entities if held by a single entity. 4.) Unincorporated entities may elect to be treated as C corporations. They then could make an S election if eligible.
Unincorporated entities
Also under the check-the-box regulations, unincorporated entities are, by default, treated as flow-through entities. However, owners of an unincorporated entity can still elect to have their business taxed as a C corporation instead of as the default flow-through entity. In fact, the owner(s) of an unincorporated entity could elect to have the business taxed as a C corporation and then make a second election to have the "C corporation" taxed as an S corporation (provided that it meets the S corporation eligibility requirements). Finally, unincorporated flow-through entities (all flow-through entities except S corporations) are treated (for tax purposes) as either partnerships, sole proprietorships, or disregarded entities. Unincorporated entities (including LLCs) with more than one owner are treated as partnerships
Converting to Other Entity Types
C corporations can take steps to mitigate the double tax. For example, deductible compensation, rent, and interest payments, to the extent they are reasonable, provide a mechanism for shifting income to their shareholders. Depending on the total amount of these deductible shareholder payments relative to a corporation's income before the payments, they effectively convert or partially convert C corporations into flow-through entities in the sense that these payments are taxed at the owner level and not at the corporate level. If this is true, why not avoid the constraints associated with deductible shareholder payments and accomplish the same result more directly by converting an existing corporation into a flow-through entity?
Corporate shareholders (after-tax)
Corporate shareholders receiving dividends are not entitled to the reduced dividend tax rate available to individual shareholders. That is, dividends received by a C corporation are subject to the corporation's ordinary tax 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 before-tax earnings prompted Congress to allow corporations to claim the dividends received deduction (DRD). The underlying concept is that 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 dividend-receiving corporation distributes the dividend to its shareholders. The dividends received deduction percentage is 70, 80, or 100 percent of the dividend received 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.
Business Trust
File articles of organization
Sole proprietorship (liabilities)
Finally, if a business is conducted as a sole proprietorship, the individual owner is responsible for the liabilities of the business. It is important to note, however, that individual business owners may also organize their businesses as single-member LLCs. In exchange for observing the formalities of organizing as an LLC, they receive the liability protection afforded LLC members.
Besides making deductible payments to their shareholders, existing corporations really only have 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 (flow-through entity), if they are eligible to do so. This option is not available for many corporations due to the tax rule restrictions prohibiting certain corporations from operating as S corporations. The only other option is for the shareholders to liquidate the corporation and form the business as a partnership or LLC. This may not be a viable option, however, because the taxes imposed on liquidating corporations with appreciated assets can be very punitive. As described in Exhibit 15-3, 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 from the liquidating corporation and their tax basis in their stock. Effectively, the total double-tax cost of liquidating a corporation can swamp the expected tax savings from operating as a flow-through entity.
Partnership (liabilities)
For entities formed as partnerships, all general partners are ultimately responsible for the liabilities of the partnership.
Initial public offering
For example, when businesses decide to "go public" with an initial public offering (IPO) on one of the public securities exchanges, they usually solicit a vast pool of potential investors to become corporate shareholders. As shareholders, state corporation laws prohibit them from directly amending corporate governance rules and from directly participating in management—they only have the right to vote for corporate directors or officers. In comparison, LLC members generally have the right to amend the LLC operating agreement, provide input, and manage LLCs. Obviously, managing a publicly traded business would be next to impossible if thousands of owners had the legal right to change operating rules and to directly participate in managing the enterprise.
LLC (liabilities)
Similarly, LLCs and not their members are responsible for the liabilities of the business.
As costly as it can be to convert corporations to flow-through entities, it is equally as easy and inexpensive to convert entities taxed as partnerships or sole proprietorships into corporations. Typically, converting entities taxed as partnerships or sole proprietorships into corporations 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 then convert to C corporations when they finally decide to go public.
Note, however, that other types of shareholders will face different tax consequences when they sell their shares.
If a corporation with corporate shareholders retains after-tax earnings, corporate shareholders are taxed on capital gains at ordinary rates (there is no preferential tax rate on capital gains for corporations) when they eventually sell the stock. Consequently, a corporate shareholder's income from capital appreciation may be subject to more than two levels of taxation because income from capital appreciation doesn't qualify for the dividends received deduction. Also, institutional shareholders don't pay tax when they sell their stock and recognize capital gains. However, retirees generally pay tax on the gains at ordinary rates when they receive distributions from their retirement accounts. Finally, tax-exempt shareholders do not pay tax on capital gains from selling stock and foreign investors are generally not subject to U.S. tax on their capital gains from selling corporate stock.
Personal Guarantee
If corporation doesn't have history, personally must sign and be liable
Limited partners (liabilities)
In contrast, limited partners are not responsible for the partnership's liabilities.
LLCs (Rights and Responsibilities)
In contrast, while state laws provide default provisions specifying rights and responsibilities of LLCs and their members, members have the flexibility to alter their arrangement by spelling out, through an operating agreement, the management practices of the entity and the rights and responsibilities of the members consistent with their wishes. Thus, LLCs allow more flexible business arrangements than do corporations.
Individual shareholders (after-tax)
Individual shareholders receiving distributions from C corporations pay the second tax on the dividends they receive generally at a 15 percent tax rate. However, to the extent the dividends would be taxed at 39.6 percent if they were ordinary income, they are taxed at 20 percent and to the extent they would be taxed at 15 percent or less as ordinary income, they are taxed at 0 percent. 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
Second, shareholders also pay a second level of tax when corporations retain their after-tax earnings.
Keep in mind that shareholders should experience an increase in the value of their shares to reflect any undistributed earnings (increase in assets). Individual shareholders generally pay the second tax at capital gains rates on this undistributed income when they realize the appreciation in their stock (from the retained earnings) by selling their shares. These long-term capital gains are generally taxed at 15 percent, However, to the extent the (long-term) capital gains would be taxed at 39.6 percent if they were ordinary income, they are taxed at 20 percent and to the extent they would be taxed at 15 percent or less as ordinary income, they are taxed at 0 percent. Also, taxpayers with (modified) AGI in excess of a threshold amount pay an additional 3.8 percent net investment income tax on net capital gains. 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 portion of the second tax until they sell their shares, taxes on capital gains must be discounted to reflect their present value.
Sole Proprietorship
a business entity that is not legally separate from the individual owner of the business. The income of a sole proprietorship is taxed and paid directly by the owner. -Not required to formally organize their business with the state. -Individual owners are responsible
Institutional shareholders (after-tax)
Pension and retirement funds are some of the largest institutional shareholders of corporations. However, these entities do not pay shareholder-level tax on the dividends they receive. Ultimately, retirees pay the second tax on this income when they receive retirement distributions from these funds. While retirees pay the second tax at ordinary rates, not the reduced dividend rates, they are able to defer the tax until they receive fund distributions.
When feasible, S elections or corporate liquidations, like deductible payments to shareholders, are used to convert existing corporations into flow-through entities. Why then, didn't shareholders of existing corporations initially form the entities as flow-through entities?
Perhaps at the time of formation the corporate form was optimal from purely a tax perspective because corporate marginal tax rates were significantly lower than shareholder marginal tax rates at that time. Or, maybe, the corporations were willing to be treated as C corporations in order to go public but then became closely held when all their outstanding shares were purchased by a small number of shareholders.
Reducing the shareholder-level 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 gains is generally 15 or 20 percent depending on the taxpayer's income level. Further, high-income taxpayers may be charged an additional 3.8 percent net investment income tax on dividends and capital gains. However, because individual shareholders defer paying the second tax on capital gains until they sell their stock, the present value of the second tax is a function of the (1) percentage of after-tax earnings the corporation retains rather than currently distributing as dividends and (2) the length of time shareholders hold the stock before selling. By retaining after-tax earnings, corporations defer the second level of tax until the shareholder sells the stock. The longer a shareholder holds stock in a corporation that retains earnings, the lower the present value of the shareholder-level tax on the corporation's earnings. Individuals who make lifetime gifts of appreciated stock to their children utilize this basic strategy. The concept is that by deferring the second level of tax until children sell the shares many years into the future, the double tax becomes very small on a present value basis.27 Alternatively, the donor could have sold the shares, paid the resulting capital gains tax, and given the remainder to her children, but this would have immediately triggered the shareholder tax leaving her children with less after-tax wealth on a present value basis. It is important to note that the length of time a shareholder holds stock before selling and the percentage of earnings retained are not always under the shareholder's or corporation's control. For example, a shareholder may need cash for reasons unrelated to the business and therefore may need to sell the stock before recognizing the deferral benefits of holding the stock. Also, as we discussed above, the accumulated earnings tax and personal holding company tax may force corporations to distribute rather than retain earnings. In spite of the fact that the double tax can be reduced by careful planning at both the corporate and shareholder level, some element of the double tax will likely remain, leaving corporations disadvantaged relative to flow-through entities under our current system of individual and corporate tax rates. -Retain earnings -Hold stock before selling
Partnership (Rights and Responsibilities)
Similar to LLC statutes, state partnership laws provide default provisions specifying the partners' legal rights and responsibilities for dealing with each other absent an agreement to the contrary. Because partners have the flexibility to depart from the default provisions, they frequently craft partnership agreements that are consistent with their preferences.
Corporations (Rights and responsibilities)
State corporation laws specify the rights and responsibilities of corporations and their shareholders. For example, to retain limited liability protection for shareholders, corporations must create, regularly update, and comply with their bylaws (internal rules governing how the corporation is run). They must have a board of directors. They must have regular board meetings and regular (at least annual) shareholder meetings, and they must keep minutes of these meetings. They must also issue shares of stock to owners (shareholders) and maintain a stock ledger reflecting stock ownership. They must comply with annual filing requirements specified by the state of incorporation, pay required filing fees, and pay required corporate taxes, if any. Consequently, shareholders have no flexibility to alter their legal treatment with respect to one another, with respect to the corporation, and with respect to outsiders.
Tax-exempt and foreign shareholders (after-tax)
Tax-exempt organizations such as churches and universities are exempt from tax on their investment income, including dividend income from investments in corporate stock. Similarly, foreign investors may be eligible for reduced rates on dividend income depending on the tax treaty, if any, their country of residence has signed with the United States.
Can corporations avoid the second level of tax entirely by not paying dividends?
The answer is no for two reasons. First, corporations that retain earnings may be required to pay a penalty tax in addition to income tax on their earnings. Second, shareholders also pay a second level of tax when corporations retain their after-tax earnings.
Corporation (liabilities)
Under state law, a corporation is solely responsible for its liabilities.
Responsibility for Liabilities
Under state law, a corporation is solely responsible for its liabilities. Similarly, LLCs and not their members are responsible for the liabilities of the business. For entities formed as partnerships, all general partners are ultimately responsible for the liabilities of the partnership. In contrast, limited partners are not responsible for the partnership's liabilities. However, limited partners are not allowed to actively participate in the activities of the business. Finally, if a business is conducted as a sole proprietorship, the individual owner is responsible for the liabilities of the business. It is important to note, however, that individual business owners may also organize their businesses as single-member LLCs. In exchange for observing the formalities of organizing as an LLC, they receive the liability protection afforded LLC members.
Partnerships
Unincorporated entities (including LLCs) with more than one owner are treated as partnerships.15 Partnerships report their operating results to the IRS on Form 1065.
Reducing the corporate-level tax.
When a C corporation's marginal tax rate exceeds its individual shareholders' marginal tax rates, the overall tax rate on corporate income will exceed the flow-through tax rate even if shareholders can defer the second 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 corporations and to shareholders with payments that are deductible (dividends are not deductible payments) by the corporation and (generally) taxable to shareholders. Making tax-deductible payments to shareholders accomplishes two objectives. First, it shifts income away from (relatively) high tax rate corporations to (relatively) low tax rate shareholders. Second, 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 only to the extent they are reasonable). -Paying fringe benefits to shareholders (generally taxable to shareholders unless benefits are specifically excluded from taxation). -Leasing property from shareholders. -Paying interest on loans from shareholders.
First, corporations that retain earnings may be required to pay a penalty tax in addition to income tax on their earnings.
With certain exceptions, 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 generating primarily investment income) are subject to a 20 percent personal holding company tax on their undistributed income. These penalty taxes remove the tax incentive for corporations to retain earnings.
C corporation
a corporate taxpaying entity with income subject to taxation. Such a corporation is termed a "C" corporation because the corporation and its shareholders are subject to the provisions of subchapter C of the Internal Revenue Code. These corporations and their shareholders are subject to tax provisions in Subchapter C (and not Subchapter S) of the Internal Revenue Code. C corporations report their taxable income to the IRS on Form 1120. C corporations (or entities taxed as C corporations) pay the first level of tax on their taxable income. The marginal rate for the first level of tax depends on where the corporation's taxable income falls in the corporate tax rate schedule (provided in Appendix D).19 The current lowest marginal tax rate for corporations is 15 percent and the top marginal rate is 39 percent. The most profitable corporations are taxed at a flat 35 percent rate.
S corporation
a corporation under state law that has elected to be taxed under the rules provided in subchapter S of the Internal Revenue Code. Under subchapter S, an S corporation is taxed as a flow-through entity.
Certificate of limited partnership
a document limited partnerships must file with the state to be formerly recognized by the state. The document is similar to articles of incorporation or articles or organization.
Articles of incorporation
a document, filed by a corporation's founders with the state describing the purpose, place of business, and other details of the corporation.
Articles of orgnizations
a document, filed by a limited liability company's founders with the state, describing the purpose, place of business, and other details of the company.
Single member LLC
a limited liability company with only one member. Single member LLCs with individual owners are taxed as sole proprietorships and as disregarded entities Income from businesses taxed as sole proprietorships is reported on Schedule C of Form 1040. Similarly, unincorporated entities with only one corporate owner, typically a single-member LLC, are disregarded for tax purposes. Thus, income and losses from this single, corporate-member LLC is reported as if it had originated from a division of the corporation and is reported directly on the single-member corporation's return.
Limited Partnership
a partnership with at least one general partner (management of business) with unlimited liability for the entity's debts and at least one limited partner (cannot manage, no authority) with liability limited to the limited partner's investment in the partnership. -written agreement and file certificate of limited partnership -GP is responsible LP is not
General Partnership
a partnership with partners who all have unlimited liability with respect to the liabilities of the entity. -partnership agreement
Accumulated earnings tax
a tax assessed on corporations that retain earnings without a business reason to do so.
Partnership agreement
an agreement among the partners in a partnership stipulating the partners' rights and responsibilities in the partnership. or may be formed informally without a written agreement when two or more owners join together in an activity to generate profits. Although general partners are not required to file partnership agreements with the state, general partnerships are still considered to be legal entities separate from their owners under state laws
Corporation
business entity recognized as separate entity from its owners under state law. -Solely responsible
Personal holding companies
closely held corporations generating primarily investment income.
Institutional shareholders
entities, such as investment companies, mutual funds, brokerages, insurance companies, pension funds, investment banks, and endowment funds, with large amounts to invest in corporate stock entities.
Disregarded entities
incorporated entities with one owner that are treated as flow-through entities for U.S. income tax purposes.
Flow-through entities
legal entities like partnerships, limited liability companies, and S corporations that do not pay income tax. Income and losses from flow-through entities are allocated to their owners. 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.
Personal holding company tax
penalty tax on the undistributed income of a personal holding company.
Sole proprietorships
sole proprietorships are not treated as legal entities separate from their individual owners. As a result, sole proprietors are not required to formally organize their businesses with the state, and they hold title to business assets in their own names rather than in the name of their businesses.
Losses generated by C corporations are called Net operating loss (NOL)
the excess of allowable deductions over gross income. 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. Generally, C corporations with an NOL for the year can carry back the loss to offset the taxable income reported in the two preceding years and carry it forward for up to 20 years. Under this approach, losses from C corporations are not available to offset their shareholders' personal income. In contrast, losses generated by flow-through entities are generally available to offset the owners' personal income, subject to certain restrictions. For example, the owner of a flow-through entity may only deduct losses from the entity to the extent of the owner's basis in her ownership interest 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. The at-risk limitation is similar to the basis limitation but slightly more restrictive. The passive activity loss limitations typically apply to individual investors who do little, if any, work for the business activities of the flow-through entity (referred to as "passive" activities to the individual investors). In these circumstances, the taxpayer can only deduct such losses to the extent they have income from other passive activities. The ability to deduct flow-through losses against other sources of income can be a significant issue for owners of new businesses because new businesses tend to report losses early on as the businesses get established. If owners form a new business as a C corporation, the corporate-level losses provide no current tax benefits to the shareholders. The fact that C corporation losses are trapped at the corporate level effectively imposes a higher tax cost for shareholders initially doing business as a C corporation relative to a flow-through entity such as an S corporation or partnership because the flow-through entity owners, subject to the limits mentioned above, can use the losses to offset other sources of income.
Double taxation
the tax burden when an entity's income is subject to two levels of tax. Income of C corporations is subject to double taxation. The first level of tax is at the corporate level and the second level of tax on corporate income occurs at the shareholder level. Income of flow-through entities is generally not subject to double taxation. 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).