Choice of Business Entity – Tax Factors

1. Choice of Business Entity – Tax Factors • double-taxation of regular (C) corporate earnings • single level of tax on earnings of pass-through entities, assessed on entity owners • not all pass-through entities are created equally • Partnerships, LLPs and LLCs • S Corporations • tax treatment of start-up losses • Losses incurred by pass-through entities are deductible against owners’ income from other sources • limitations: PAL and at-risk limitations (chapter 15) • losses incurred in corporate form may be carried back/forward • tax reporting requirements

2. Choice of Business Entity – Non-Tax Factors • legal liability • ease and costs of formation • cash flow needs of owners • Interaction of tax and non-tax factors • taxation of income and payment of tax liability • taxable versus non-taxable cash flows to owners

3. Changes in Ownership and Organizational Form • Changes in ownership • expanding the business to include additional owners/investors is more complicated in partnership form than in corporate form • Changes in organizational form • termination of a corporation results in double taxation • taxable versus nontaxable restructurings • costs of restructuring

4. Important Differences between Partnerships and S Corporations • S corporations provide limited liability to all shareholders, while partnerships must have at least one general partner • LLPs provide general partners protection from liability for malpractice of other general partners • Partnerships can make special allocations of taxable items among partners; all S corporation allocations must be based on stock ownership share

5. Partnership and S Corporation Differences continued • Partners cannot be employees of their partnerships, while S corporation shareholders can be employees of their corporations • Partnership guaranteed payments and general partners’ share of partnership ordinary income are subject to SE tax, while S corporation shareholders’ share of corporation income is not

6. Partnership and S Corporation Differences continued • Partnerships can involve greater numbers and types of owners than S corporations • Contributions (distributions) of property to (from) S corporations are more likely to result in taxable gain than contributions (distributions) to (from) partnerships

7. LLCs • Provide the limited liability not available to general partners, without the participation restrictions of limited partners • Membership unrestricted versus S corporation shareholder restrictions • Special allocations possible • Contributions and distributions of property subject to partnership treatment versus S corporation treatment

8. Closely-Held Corporations as Tax Shelters • Avoid double taxation by distributing cash flow in tax-deductible or nontaxable ways • salary payments, interest and principal on debt • Potential benefactors: high-income taxpayers willing to reinvest after-tax cash flow from business activities • goal: obtain tax benefit from lower corporate tax rates on initial increments of business taxable income • defer second level of tax into the future by avoiding dividend distributions

9. Issues for Closely-Held Corporations • Constructive Dividends - Indirect distributions of earnings treated as dividends for income tax purposes • examples: excessive compensation, loans which are never repaid • intent: prevent owners of closely-held corporations from avoiding double taxation by taking cash out of the business disguised as deductible or nontaxable payments

10. Issues for Closely-Held Corporations continued • Accumulated Earnings Tax - penalty tax on accumulations of earnings beyond ‘reasonable needs’ of the business • tax rate of 38.6% • intended to discourage retention of funds not reinvested in business activities • Personal Holding Company Tax - penalty tax on undistributed income of a PHC • tax rate of 38.6% • PHCs not subject to Accum. Earnings Tax

11. Income Shifting • As previously discussed, the progressive nature of our tax rate system creates incentive to shift income to (usually related) taxpayers subject to lower marginal tax rates • Strategies for income shifting in closely-held businesses: • gift partnership interests or shares of stock to children or other family members • employ children/family members in the business activity

12. Limits on Income Shifting • Assignment of income doctrine - income is taxed to the provider of services or owner of capital generating the income • if a partnership business is based on services provided by partners, a gift of a partnership interest to non-service providers will be ineffective • Kiddie tax - unearned income of children under 14 taxed at parents’ marginal tax rate

13. Limits on Income Shifting continued • Controlled groups - corporate progressive rate schedule applied only once to entire group • parent-subsidiary controlled group - applies even if consolidated return not filed • brother-sister controlled group exists if 5 or fewer individuals control 2 or more corporations • Sec. 482 - gives IRS authority to re-allocate income of businesses under common control as necessary to prevent tax evasion