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Module 5

Module 5. Choice of Entity and Tax Regimes. Module Topics. Overview of business entities Comparison of different business entities Kinds of business entities in the U.S. Choice of business entity Tax regimes. Overview of Business Entities. Key Learning Objective

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Module 5

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  1. Module 5 Choice of Entity and Tax Regimes

  2. Module Topics • Overview of business entities • Comparison of different business entities • Kinds of business entities in the U.S. • Choice of business entity • Tax regimes

  3. Overview of Business Entities Key Learning Objective • Classify the various types of business entities • Check the box regulations

  4. What is a Business Entity? • It “carries on” a trade or business • Has one or more associates • Has assets • Engages in some business activity • Classification of entities: • Taxable • Conduit • Tax-exempt

  5. Research Query: “Carrying On A Business”? • A professional corporation (PC) transferred some medical equipment to a newly formed S Corp • its shareholders were the children of the shareholders of the PC • The S Corp used the equipment to provide certain of the services needed by patients of the PC • A percentage of the PC’s fees went to the S Corp • Did this allow income to be shifted to the children?

  6. Solution--Research Query: “Carrying On A Business”? --NOT! • Horn, Louis III, (1982) TC Memo 1982-741 • The Tax Court found that there was • No business purpose for the S Corp AND • The S Corp's activities didn't amount to carrying on a business. • Therefore the S corp entity was ignored • Also cited as • PH TCM ¶82741, 45 CCH TCM 413.

  7. Taxable Entity • Liable for tax on its taxable income • Individual (sole proprietor) • C corporation • Some estates and trusts

  8. Conduit Entity • Nontaxable reporting entity • Partnership • S corporation • Income, deductions, etc., “flow through” to the tax returns of its owners

  9. Tax-Exempt Entity • Nontaxable reporting entity • Not-for-profit organizations • Organized to carry on a tax-exempt purpose • Can be taxed on unrelated business income

  10. Compliance Query: Club or Business? • The “guys” love to smoke cigars and are frustrated by smoking restrictions. • They want to form a social club that will be financed by membership dues and user fees. • Mary wants to make sure that the club will be a tax exempt entity. • HINT: Check out §501(c).

  11. Solution--Compliance Query: Not For Profit • Clubs organized for pleasure, recreation, and other not for profit purposes are exempt if the following two conditions are met: • (1) Substantially all of the activities of the club are for these purposes. • (2) No part of the net earnings inures to the benefit of any private shareholder or individual. • §501(c)(7).

  12. Check the Box Rules: Classification of Entity by Election in Most Cases • Separate entity status is first determination • Certain joint undertakings may or may not be a separate entity • Question of federal, not local law • Basically divide all entities into eligible and ineligible classes

  13. Entities Ineligible for Election-”Per Se” Corporation • Domestic statutory corporations • Association (elected or by default) • Statutory joint-stock company or joint-stock association • Insurance company taxable under subchapter L

  14. Ineligible Entities (con’t) • State-chartered banking business if insured under FDIC or similar federal statute • Business entity wholly owned by a State or political subdivision • Corporation under another provision of the Internal Revenue Code • Listed foreign “Per Se” corporate entities

  15. Available Elections • Eligible entities with 2 or more members • Association -- i. e. Corporation • Partnership • Eligible entities with a single member • Association-- i. e. Corporation • Disregarded as a separate entity • Frequently referred to as a single member LLC

  16. Foreign Entity Default Rules Operate where no election made • If limited liability for all members -Association • If unlimited liability by any member • Partnership, if two or more members • Disregarded entity, if single owner • Branch--if corporate owner • Sch C--if individual • Unlimited liability dependent on local law

  17. Comparison of Different Business Entities Key Learning Objectives • Define the various business entities • Compare corporate form to other forms

  18. Sole Proprietor • Individual engaged in a trade or business • Spouse or child can be an employee • Owner is not an employee (no salary deduction) • Advantages of sole proprietorship • Easy to form • Owner controls decisions • Disadvantage of sole proprietorship • Unlimited personal liability • unless formed under LLC rules

  19. How is a Sole Proprietor Taxed? • Income tax • Business income and expenses reported on Schedule C • Net income or loss from Schedule C included in owner’s gross income on Form 1040 • Self-employment tax • Net income from sole proprietorship is subject to Social Security and Medicare tax

  20. C Corporation • Taxable entity that is • Incorporated under the laws of a state • Unincorporated association (e.g., LLC) • if election to be treated as corporation under the “check the box” regulations discussed earlier.

  21. Corporate Tax Rate StructureA Bumpy Road • < individual rates if T.I. < $75,000 • T.I. between $100,000 & $335,000 • Corporate MTR = 39% • Individual MTR < 39.6% until taxable income exceeds $263,750 • T.I. > $18,333,333 • MTR = 35% • Average tax rate = 35%

  22. Special Tax Rates May Apply If • Personal service corporations • Foreign corporations • Controlled groups • Corporations taxed under • §594 (alternative tax for mutual savings bank conducting life insurance business). • Subchapter L (life insurance companies). • Subchapter M (regulated investment and real estate investment trusts).

  23. Special Tax Rates May Apply If • Personal service corporations • Foreign corporations • Controlled groups • Corporations taxed under • §594 (alternative tax for mutual savings bank conducting life insurance business). • Subchapter L (life insurance companies). • Subchapter M (regulated investment and real estate investment trusts).

  24. Benefits of C Corp • Continuity of life • Centralized management • Ease of Transfer • Limited liability • Generous fringe benefits

  25. Disadvantages of C Corp • Double taxation of dividends • Accumulated earnings tax • Corporation taxed on distributions of appreciated property • Tax costs to liquidation

  26. Getting the Money Out • Don’t • Salaries and fringe benefits • Dividends • Interest payments • Liquidation

  27. Partnership • An organization composed of two or more entities that: • Carries on a trade or business, financial operation, or venture • Shares profits and losses among its owners • Is not a corporation, trust, or estate • Co-ownership of property is not a partnership, unless significant services are provided

  28. Types of Partnerships • General Partnership • All partners personally liable • Limited Partnership • General partner(s) personally liable • Limited liability for limited partner(s)

  29. Types of PartnershipsLLC’s • Formed as a Limited Liability Company • Election to be treated as a flowthrough • Limited liability for all partners • Limited Liability Partnership (LLP) • Same as LLC, but partner liable for own faults • For remainder of discussion partnership and LLC are inter-changable terms

  30. Partners(Or Members of LLC) • Can be individuals, corporations, trusts, estates, or partnerships • Are not employees of the partnership • Include in gross income • Their share of the partnership’s income, deductions, losses and credits • Guaranteed payments (but not cash draws) • Timing of inclusion depends on partnership tax year

  31. Research Query: When is a Partnership Not a Partnership? • Harry and Larry are tenants in common of farm property. • They lease the land to a farmer for a cash rental • Have Larry and Harry formed a partnership for U.S. tax purposes?

  32. Solution--Research Query: Mere Co-ownership is Not a Partnership • Reg § 1.761-1(a) Mere co-ownership of property which is maintained, kept in repair, and rented or leased does not constitute a partnership. For example, tenants in common of farm property do not create a partnership among themselves merely by leasing it to a farmer for a cash rental or a share of the crops.

  33. S Corporation • Incorporated entity or LLC electing to be treated as a corporation • Nontaxable conduit entity like a partnership • More restrictive than partnership • Limited liability for owners • Valid S election required

  34. S CorporationEligible Corporation • S election allowed if: • Domestic, nonaffiliated corporation • Only one class of stock • No more than 75 shareholders. • Only individuals, estates, and some trusts • Not partnerships, nonresident aliens, certain trusts

  35. Partnership or S Corporation?Some factors the same. • Limited liability of owners • if properly formed should be the same • Allocation of income, deductions, and losses • more options available to partnership • Deductibility of losses • more opportunity for partners to generate basis

  36. Partnership or S Corporation?More factors to consider. • Recognition of gain on property contribution • partnerships have less likelihood of recognition • Transferability of ownership • stock better understood? • Costs to form • Lawyer may charge less to form an S • State law • rules for both may vary from state to state

  37. Kinds of Business Entities in the United States Key Learning Objective • Describe the different types of entities doing business in the U.S.

  38. Entities Doing Business in U.S. • By type Sole proprietorships 73% (15.0 million) C corporations 10% ( 2.0 million) S corporations 9% ( 1.7 million) Partnerships 8% ( 1.5 million) • By size of net income C corporations 64% Sole proprietorships 27% S corporations and partnerships 9%

  39. Choice of Business Entity Key Learning Objective • Understand the key factors in choosing the form of doing business, including important tax and non-tax factors

  40. Choice of Follow-through Entity? S or LLC ? • Allocation of income, deductions, losses • Deductibility of losses • Contribution of property • Liquidation/distribution of property

  41. S-Corp One class of stock Allocate in proportion to stock ownership LLC Generally free to allocate in any way If allocation has substantial economic effect Allocation of Income, Deductions, Losses

  42. S-Corp Basis consists of Direct investment Loans to corp LLC Basis consists of Direct investment Share of many debts of the partnership Deductibility of LossesLimited to Basis

  43. S-Corp Gain recognized to extend FMV of property > basis in S Loss recognized only if liquidation LLC Gain recognized only if cash distributed > basis in partnership Losses only recognized if liquidation and only cash equivalents received Distributions of Property

  44. Compliance Query:Partnership or S Corp? • John and Mary want to start a business that they will own equally. John will provide most of the capital and Mary will provide most of the work. • The business will have losses in the first two years, then it should be profitable. • If they want to allocate the tax losses to John, is a partnership or an S a better arrangement?

  45. Solution--Compliance Query: Partnership or S Corp?Partnership • The partnership format appears best for John and Mary. • Both partnerships and S-corps allow losses to be passed through to the equity owners and deducted on their tax returns. • However, only partnerships allow losses to be allocated on a non-pro rata basis.

  46. In-Class Project • Form a 3-5 person group. • Select a client from the list of “new businesses in town”. • Discuss the pros and cons of each type of entity for your “new” business client. • Decide which entity is preferable and explain why.

  47. Tax Regimes Key Learning Objectives • Understand the tax formula • Illustrate basic tax calculations

  48. General Income Tax Structure • Tax = base x rate • Tax base = taxable income • Corporations: gross income - expenses • Individuals: gross income - deductions - exemptions • Tax rates • Progressive vs. proportional • Marginal vs. average

  49. Corporate Tax Structure • Marginal rate: 15% to 39% • Flat 35% for personal service corporations • Highest average rate: 35% • Other possible taxes: • Alternative minimum tax • Accumulated earnings tax • Personal holding company tax

  50. Individual Tax Structure • Marginal rate: 15% to 39.6% • Average rate is always lower than marginal rate • Rate structure varies by filing status • Marriage “penalty” or marriage “bonus” may apply • Computation of taxable income can be complex for some taxpayers

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