Choice of Business Entity

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