Principles of Taxation

1
Principles of Taxation

• Chapter 11
• The Choice of Business Entity

2
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.

3
Passthrough Entities

• Partnerships (includes LLCs) and S Corps are not
  taxed as entities. Investors pay tax on their
  share of entity income.
• Is there a single or double level of taxation?
• Are cash distributions are generally taxable?

4
Benefits of Passthrough Losses

• When are passthrough losses generally deductible?
• At what rates?
• Corporation loss must be carried (back) forward
  and used to offset income in a taxable year where
  profits are reported. Thus, when, and at what
  rates, is a benefit obtained?

5
Example

• Investor A has 200,000 of taxable income in
  1996, 1997 and 1998 before his investment in
  Entity X. Entity X has an end of year loss in
  1996 and 1997 of (50,000) per year and has
  profits in 1998 of 200,000. What is the net
  present value at 10 of the tax refunds or
  payments due on Entity X losses and profits if X
  is a
• a) pass-through entity?
• b) corporation?

6
Passthrough Example

• 1996 deduction (50,000) x 36 (
  ) refund
• 1997 deduction (50,000) x 36 (
  ) refund
• 1998 income 200,000 x 36 _________ tax
• NPV tax cost at 10 if END of year payments
  ________________

7
Corporation Example

• 1998 net income 100,000, corporate tax
  _____________
• NPV ___________. Why is this better even
  though the tax refund was delayed?
• BUT, if corporation pays a dividend, then
  individual also taxed on 77,750 x 36
  ___________.
• NPV of total tax __________
• Is this better or worse than passthrough?

8
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

9
Family Income Shifting

• What is the goal?
• Remember, income shifting is the RESULT of
  shifting property ownership - cant assign
  income.
• If children or other relatives are made partners
  or co-shareholders, they own part of the
  business.
• The transfer of ownership may have GIFT TAX
  consequences if relatives dont pay FMV.

10
Limits on Family Income Shifting

• Family members cannot be partners in a personal
  service business unless they can do what?
• Family members providing services must first
  receive ______________________before net income
  is allocated.
• How is income allocated if the entity is
• a family partnership?
• an S corporation?

11
Other Considerations

• Gift tax (See Q3).
• Legal and accounting costs of creating and
  operating business.
• Dilution of parents wealth - transfers must be
  complete and legally binding, irrevocable.

12
Partnership versus S Corporation

• What are some administrative requirements of S
  Corps?
• Partnership agreements have more flexibility, but
  require more careful legal drafting.
• Refresher (chapter 9) - which owners receive tax
  basis for liabilities of the entity?
• S Corporation shares are transferable.
  Partnership interests are not - requires new
  partnership agreement.

13
Type of Flow-Through Entity

• Liability (See Q6)
• In which case(s) is the owner liable for
  losses/debts of the entity
• General partner
• Limited partner
• Partner in an LLP
• Partner in an LLC
• Shareholder in an S Corp
• Shareholder in a C Corp

14
Closely-Held Corporations

• Biggest challenge is how can the investors avoid
  double taxation of corporate earnings.
• If shareholders are also creditors, is interest
  expense deductible to corporation?
• If shareholders are also employees, is wage
  expense deductible to corporation?
• If shareholders are also landlords, is rent
  expense deductible to corporation?

15
Closely-Held Corporations

• IRS challenge turns unreasonable payments into
  constructive dividends.
• How does the IRS decide what is unreasonable?
  (AP6)
• interest
• wages
• rent

16
Accumulating Corporate Profits as a Tax Shelter

• The goal of the taxpayer
• Keep earnings in corporation.
• Small corporations are taxed at low rates.
• Delay paying dividends.
• Possibly convert ordinary dividend to capital
  gain by selling stock.

17
IRS Weapons Against Using Corporation as Tax
Shelter

• Accumulated earnings tax
• Penalty is to assess tax on accumulated taxable
  income at what rate?
• How is this like a deemed dividend?
• What are common traits that IRS looks for?

18
IRS Weapons Against Using Corporation as Tax
Shelter

• Personal Holding Company tax
• Similar penalty assesses tax on undistributed
  earnings at _______
• Applies to corporations whose income is
  principally what?
• Application of Accum. Earn Tax and PHC tax rules
  prevent abuse, so practical assessment of these
  taxes is rare.

19
Controlled Group Tax Rates

• Aggregate the taxable income of all members of a
  controlled group (gt _______ common ownership).
• Compute tax.
• Allocate tax according to proportion of taxable
  income.
• These rules prevent disbursing corporate income
  into numerous units all taxed at 15.