Business Organizations • Taxpayer = owners = flow-through entities • sole proprietorship • partnerships • LLCs • S Corporations • Taxpayer = corporation • C Corporation is taxed first, then shareholders may be taxed on distributions (double taxation).
Corporation Legal Characteristics • Limited liability of shareholders • Owners of closely-held corporations often are required to sign personal liability on bank debt. • Unlimited life • Free transferability • Closely-held corporations:buy-sell agreement may prevent transferability. • Centralized management
Affiliated Groups and Consolidations • Parent + all >= 80% domestic subsidiaries. • Affiliated groups may elect to file a consolidated tax return - applies to all members of affiliated group. • Advantage: losses and profits of affiliated members offset. Like financial accounting, intercompany transactions are eliminated. • If the same individual(s) own 80% or more of more than one corporation, these corporations are a ‘controlled group’ (see Ch 11 end). They may not file a consolidated return, but the tax bracket benefits are limited.
Computing Corporate Taxable Income • Page 1 of the Form 1120 resembles a financial income statement or a Schedule C in a personal tax return (Ch 9). • Use chapters 5, 6, 7 and 8 for general rules on business income. • Deduct only 50% of meals and entertainment expenses. • Deduct charitable contributions up to 10% of taxable income BEFORE charity and before dividends-received deduction.
Dividends-received Deduction • Ownership Deduction • < 20% of stock 70% DRD • 20%<= own < 80% 80% DRD • 80%<= own 100% DRD • Reason for DRD? Mitigate “triple” taxation. • Additional details: DRD can’t create loss - tricky computations not in this text.
Book Versus Taxable Income - Schedule M-1 • This schedule reconciles book income to taxable income. • net book income - line 1 • federal tax expense for books - line 2 • lines 3 - 6 explain increases in taxable income relative to books. • lines 7 - 9 explain decreases in taxable income relative to books. • line 10 = taxable income before NOLD and DRD = line 28 form 1120 • Try problem AP7.
Book Versus Taxable Income • Book-tax differences are scrutinized by IRS. • The Schedule M-1 contains permanent and temporary items. • The tax footnote in the financial statement contains numerous estimates of amounts that are finalized by the time the return is filed. Thus, Schedule M-1 items will not exactly = amounts in F/S footnotes.
Computing Regular Tax • The surtax rates of 39% and 38% eliminate bracket benefits for ‘rich’ corporations. • Corporations with taxable income > $18.33 million just pay a flat rate of 35% on all income. • Personal service corporations are taxed at a flat 35% rate.
Tax Credits • Credits directly reduce computed tax. Deductions only reduce the income subject to tax. Thus, $1 of credit provides $1 of benefit. $1 of deduction only provides $1 x the tax rate. • Tax credits are generally limited to some % of tax before credits. Often a provision permits carry back or carry forward of excess credits. • Biggest credits: R&D credit, foreign tax credit (see Chapter 12).
Payment and Filing Requirements • Tax return due 15th day of 3rd month, may extend to 15th day of 9th month. • Estimated payments are due on the 15th day of 4th, 6th, 9th, and 12th months. • Must pay 100% of tax due (small corporations (TI < $1 mill) may use safe-harbor rule of paying 100% of prior year tax). • Underpayment penalty is computed like interest expense but is nondeductible.
Distributions to Investors • Interest payments are deductible. • Payments on stock are non-deductible. • Payments on stock are taxable dividends to the shareholder if the corporation has either current or cumulative earnings and profits. • E&P similar to tax basis retained earnings • Payments in excess of earnings and profits are first a return of capital and then a gain to the shareholder.
Distributions to Investors • Nondeductibility of dividends makes paying dividends hard to explain. • One result is the high leverage of many corporations, because interest expense is deductible. • Investors may prefer that the corporation keep the funds and reinvest them; sell stock for a capital gain in future. • Will administration eliminate double taxation?
Partnerships • The partnership agreement states the rights and obligations of partners, and the % of profits and losses allocable to each partner. Such agreements permit flexibility. • General partnership: all partners have unlimited liability; joint and severable • Limited partnership: one or more limited partners are only liable for their contributed capital. Legally, all limited partnerships have at least one general partner. • Limited liability partnership (LLP) used for professional services. General partners are not liable for malpractice of other partners.
Tax Basis in Partnership Interest • Cash plus adjusted basis contributed. • + Share of partnership debt for which partner could be responsible.
Partnership Reporting • The partnership files an information return, Form 1065. • Included with the Form 1065 are Forms K-1, which show EACH partner’s share of income and deductions. • EACH partner reports his or her share on partnership income on Schedule E, as part of his or her Form 1040. “Non-ordinary” items are SEPARATELY STATED and retain their character on the partner’s return. Q9 • Because the partnership does not pay tax, the partnership is referred to as a FLOW-THROUGH ENTITY.
Guaranteed Payments • A guaranteed payment is a special allocation of ordinary income to the partner receiving it - similar in nature to a salary. • The receiving partner reports as ordinary income BOTH: • 1) his guaranteed payment • 2) his share of partnership income after the guaranteed payment. • Other partners report their shares of partnership income after the guaranteed payment.
Self-Employment Income From Partnership • SE tax must be paid by the partner on • Guaranteed payments + • Distributive share of ordinary business income from partnership • Limited partners do NOT pay SE tax on share of ordinary income.
Adjusting Partnership Basis • These things increases basis: • Contributions (initial and ongoing): cash + adjusted basis contributed • Positive income (taxable and tax-exempt) • Share of partnership liabilities for which partner is liable. (Also allow nonrecourse real estate loans for limited partners). • These things decrease basis: • Distributions • Losses and deductions (and shares of nondeductible expenses).
Partnership Losses Limited to Basis • Partners CANNOT deduct losses in excess of basis. See AP13, 14 • Excess losses are carried forward indefinitely until additional basis is restored. • by additional contributions or additional positive income. • This rule applies to EACH partnership separately. • AP 11, 12 • Are there questions about examples in the text? This can be complicated.
Limited Liability Company • Treated as a corporation for liability purposes, but as a partnership for federal tax purposes. • Relatively new organizational form - less legal precedence. • Every state (and DC) permits LLCs. • Still unclear whether LLC income is subject to SE tax.
S Corporations • Legally a corporation under state law. • An S Corporation is a flow-through entity for tax purposes. • Income and loss items are allocated among shareholders based on their % ownership of stock (this allocation is not flexible like partnership agreements). • Flow-through items retain their character on the individual tax return (e.g. ordinary income, capital losses, charitable contributions, etc).
S Corporation Eligibility • Only individuals, estates and some trusts may be shareholders. • The number of shareholders (not including spouses) is limited to 100. • The corporation may only have one class of outstanding common stock. • Shareholders must unanimously elect S Corp status.
Shareholder Basis • Initial basis = cash + adjusted basis of contributed property. • Loan FROM a shareholder to S Corp increases basis for THAT shareholder. Any other debt of the S Corp does NOT increase shareholder basis. (E.g., a bank loan guaranteed by shareholder does not increase basis for any shareholder, even the one that guaranteed the loan). • Like partnerships, basis is increased by contributions and income items. Basis is decreased by distributions and loss items.
S Corporation Operation • Shareholders can be paid a salary. • Salary is subject to payroll taxes and reduces ordinary income of the S Corporation. • S Corp can use corporate employee benefit plans for shareholder/employees. • Share of ordinary income is NOT subject to Self-Employment tax. • Allocable share of loss items can only be deducted up to BASIS, like with partnerships. Losses in excess of basis are carried over until the shareholder has basis again.
Limitations on the Deduction of Allocated Losses • 3 Provisions limit the deductibility of partnership/LLC and S corporation losses • Overall Basis rules – partners/LLC member and S corporation shareholders may deduct losses only to the extent of their respective basis • Sec. 465 - partners may not deduct losses in excess of his/her at risk amount • Sec. 469 - prohibits individuals and closely held corporations from deducting PALs in excess of PAI
Section 704(d) • A partners deduction cannot exceed his/her total investment including share of debt. - • If allocated share of partnership losses exceeds his/her basis in the partnership interest - • excess does not reduce basis, but is carried forward indefinitely and may be deducted when the partner has basis. • For purposes of this limitation - any distributions made to the partner during the year are accounted for before the application of the basis limitation • The allocation of loss is the last adjustment to basis to be applied.
At Risk Limitations • While partners get tax basis in all debts, they are generally at risk for their investment in the partnership + their portion of recourse debt or qualified non-recourse debt. • S corporation shareholders are not at-risk for S corporation debt unless it is directly from the shareholder to the corporation • Qualified non-recourse debt - nonrecourse debt secured by real estate, which are obtained from a bank, S&L, or other commercial lender. Excludes seller financed loans, and non-real estate non recourse loans • This means tax basis for partners/LLC members may differ from at-risk basis because of the classification of debt as recourse v. non-recourse.
At Risk Limitations Continued • Regular tax basis rules and Sec. 465 limitations are applied sequentially • Only losses allowed by Sec. 704(d) can be limited by Sec. 465. • Where basis and at risk are the same, losses will be disallowed under the general tax basis rules. • Where basis and at risk differ, losses can be disallowed under both sections • Sec. 465(e) discusses at risk recapture, when at risk basis is negative (excess distributions or debt reduction), amount taken into income is typically ordinary income rather than capital
Sec 469 - Passive Activity Loss Limitations . • If a partner cannot take a loss because of the above limitations, the passive activity loss rules cannot be applied until the above limitations are lifted. • General rule - passive activity losses are disallowed to the extent the passive activity losses exceed passive activity income. • Net disallowed PALs are carried forward to tax years when PAI is available. • Passive Activities are aggregated to determine the limitation.
Sec. 469 (continued) • Passive Activity • TP does not materially participate in the activity • Partner is a limited partner • Partnership is engaged in a rental activity (2 exceptions, real estate professionals and general partners who actively participate but make less than $150,000) • Passive losses disallowed must be allocated to all passive activities on a pro-rata basis. You cannot choose which passive activities you want to take the losses from, etc. • Suspended passive losses can be taken in the year the passive activity is disposed by the taxpayer.
Choice of Entity • This is a tax planning chapter - HOW to use rules • Pass-through losses • After-tax cash flows to individual investor. • Family income shifting • Partnership versus S Corp characteristics • Closely-held corporations • Constructive dividends limit corporate tax avoidance. • accumulated earnings tax, personal holding company tax, tax rates on members of a controlled group.
Passthrough Entities • Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income. • Single level of taxation. • Cash distributions are generally NOT taxable.
Benefits of Passthrough Losses • Passthrough loss is generally deductible in the year the loss is generated at the individual’s marginal tax rate. • Corporation loss must be carried (back) forward and used to offset income in a taxable year where profits are reported. NOL deduction provides a benefit at the corporation’s tax rate in the year the NOL offsets profits.
Passthrough Entities Only Have a Single Level of Tax • The preceding example illustrates the benefits of a pass-through entity: • a) use losses immediately • b) single level of taxation
Partnership versus S Corporation • S Corps require an IRS election, incorporation documents, possible corporate state tax payments. • Partnership agreements have more flexibility, but require more careful legal drafting. • Partners (but not S Corp shareholders) receive tax basis for liabilities of the partnership. • S Corporation shares are transferable. Partnership interests are not - requires new partnership agreement. • Employee benefit planning favors S Corp.
Types of Flow-Through Entity • Liability • Full - General partnership • Limited liability partnership - general partners are not personally liable for malpractice-related claims of another general partner. • Limited partnership - at least one general partner, but other partners have no liability. • Limited liability partnership - partners not responsible for other parter’s malpractice. • Limited liability company (treated like partnership for tax, corporation legally). • S Corporation creates limited liability.
Closely-held Corporations • Biggest challenge is how can the investors avoid double taxation of corporate earnings. • If shareholders are also creditors, interest expense is deductible to corporation. • If shareholders are also employees, wage expense is deductible to corporation. • If shareholders are also landlords, rent expense is deductible to corporation.
Closely-held Corporations • IRS challenge turns “unreasonable” payments into constructive dividends. • How does the IRS decide what is unreasonable? (AP6) • interest • wages • rent
Accumulating Corporate Profits as a Tax Shelter • Keep earnings in corporation. • Small corporations are taxed at low rates. • Delay paying dividends. • Possibly convert ordinary dividend to capital gain by selling stock.
Controlled Group Tax Rates • Aggregate the taxable income of all members of a controlled group (>= 80% common ownership). • Compute tax. • Allocate tax according to proportion of taxable income. • These rules prevent disbursing corporate income into numerous legal entities all taxed at 15%.