Comparative Forms of Business Entities: Choosing Wisely

1. Chapter 18 Comparative Forms of Doing Business

2. The Big Picture (slide 1 of 2) Bill and George are going to start a new business in which they both will participate on an active basis. They will use savings to finance the business. They have narrowed the choice of business forms to A C corporation, An S corporation, or An LLC. Limited liability is important in their choice of business form, but minimizing taxes is also important. They expect losses for the first 2 years of operations, but after that they expect to earn $200,000 in before-tax profit. Any after-tax profit will be distributed to Bill and George.

3. The Big Picture (slide 2 of 2) George also is considering investing $10,000 in a limited partnership. He provides you with information on projected partnership profits and losses. See Example 2. As a way of leveraging the risks and rewards associated with his investments, Bill earlier had acquired a 30% interest in a boutique retail coffee franchise outlet. Bill now is considering selling this investment, which has experienced rapid appreciation. He needs to know the adjusted basis of his ownership interest. See Example 13. Read the chapter and formulate your response.

4. Choice of Form of Business Entity Many factors affect the choice of business entity Both tax and nontax Understanding the comparative tax consequences related to the different types of entities is important for effective tax planning

5. Principal Forms of Doing Business • Sole Proprietorship • Partnership • C corporation • S corporation • Limited liability company (LLC)

6. Limited Liability Company (LLC) • Hybrid business form that combines the corporate characteristic of limited liability for owners with tax characteristics of a partnership

7. The Big Picture – Example 2Nontax Factors(slide 1 of 2) Return to the facts of The Big Picture on p. 18-1. George is considering investing $10,000 in a limited partnership. He projects that he will be able to deduct the $10,000 capital contribution within the next 2 years (as his share of losses). Since George’s marginal tax rate is 28%, the deductions will produce a positive cash-flow effect of $2,800 ($10,000 X 28%).

8. The Big Picture – Example 2Nontax Factors(slide 2 of 2) However, there is a substantial risk that he will not recover any of his original investment. If this occurs, his negative cash flow from the investment in the limited partnership is $7,200 ($10,000 - $2,800). George must decide if the investment makes economic sense.

9. Filing Requirements • S Corporation • Files Form 1120S • C Corporation • Files Form 1120 Sole Proprietorship • Files Schedule C, Form 1040 Partnership & LLC • Files Form 1065

10. Nontax Factors—Capital Formation • Sole Proprietorship • Limited ability to raise capital • Partnership • Can raise funds through pooling of owner resources • Ltd. p’ship can raise capital from investors • C Corporation • Greatest ease and potential for raising capital • S Corporation • Greatest ease and potential for raising capital, but limited number of investors

11. Nontax Factors—Limited Liability • Sole Proprietorship • Unlimited liability • Partnership • General partners are jointly and severally liable • Ltd. partners’ liability is limited to investment • C Corporation • Generally have limited liability • S Corporation • Generally have limited liability

12. Other Nontax Factors • Estimated life of business • Number of owners and their roles in management of the business • Freedom of choice in transferring ownership interests • Organizational formality and related costs

13. Single vs. Double Taxation Sole Proprietorship • Single taxation Partnership and LLC • Single taxation • S Corporation • Generally, single taxation • May be subject to built-in gains tax and passive investment income tax • C Corporation • Double taxation

14. Alternative Minimum Tax • Sole Proprietorship • Directly subject to AMT • Partnership and LLC • Indirectly subject to AMT • AMT adjustments & preferences flow through and partners subject to AMT • C Corporation • Directly subject to AMT • May have advantage here since corp AMT rate is only 20% • S Corporation • Indirectly subject to AMT • AMT adjustments & preferences flow through and S/H’s subject to AMT

15. Controlling the Entity Tax • Various techniques can be used to control the tax liability, whether imposed on the entity or owners, such as: • Distribution policy • Recognizing the interaction between the regular tax liability and the AMT liability • Utilization of special allocations • Minimizing double taxation

16. Minimizing Double Taxation of C Corporations (slide 1 of 5) • Several techniques are available for reducing the double taxation of C corps including: • Making distributions to shareholders that are deductible by corp • Retaining earnings at corp level • Making distributions treated as a return of capital • Making the S corp election

17. Minimizing Double Taxation of C Corporations (slide 2 of 5) • Deductible distributions include: • Salary payments to shareholder-employees • Rental payments to shareholder-lessors • Interest payments to shareholder-creditors • IRS scrutinizes these types of transactions • Must be reasonable

18. Minimizing Double Taxation of C Corporations (slide 3 of 5) • Retain earnings at corporate level • Double tax is avoided unless corp makes distributions (actual or deemed) to shareholders • Must watch out for accumulated earnings tax problems • The 0%/15%/20% rates for qualified dividends reduces the potential negative impact of double taxation

19. Minimizing Double Taxation of C Corporations (slide 4 of 5) • Make return of capital distributions • For ongoing businesses, redemption provisions may help reduce gross income at the shareholder level • Corporate liquidation provisions can be used if business will cease to operate in corporate form

20. Minimizing Double Taxation of C Corporations (slide 5 of 5) • Electing S corp status • Generally eliminates double taxation but other factors must be considered such as: • Will all shareholders consent to election? • Can qualification requirements be met currently and on an ongoing basis? • Are conditions favorable to an S corp election and how long will those conditions be favorable • Distribution policy may cause problems paying tax at shareholder level

21. Entity Formation (slide 1 of 2) • Generally, owners make contributions of cash and property to entity in exchange for an ownership interest • Generally, tax-free to both the entity and the owner • In corporate setting, requirements of §351 must be met • Owners and entities take a carryover basis in their ownership interest and in assets contributed, respectively

22. Entity Formation(slide 2 of 2) • If FMV of property contributed > adjusted basis, may want to make special allocation • Required in partnerships • Not available for C corps or S corps

23. Basis Considerations Sole Proprietorship • N/A • Partnership and LLC • Profits & losses affect partner’s basis • Partner’s basis is increased by share of p’ship liabilities • C Corporation • Shareholder’s basis is not affected by corporate profits & losses • S Corporation • Shareholder’s basis is increased by profits, decreased by losses, not affected by corporate liabilities

24. The Big Picture – Example 13 Effect On Basis Of Ownership Interest (slide 1 of 2) Return to the facts of The Big Picture on p. 18-1. Bill contributed cash of $100,000 to an entity for a 30% ownership interest in the franchise. The entity borrows $50,000 and repays $20,000 of this amount by the end of the taxable year. The profits for the year are $90,000.

25. The Big Picture – Example 13 Effect On Basis Of Ownership Interest (slide 2 of 2) If the entity is a partnership or limited liability entity, Bill’s basis at the end of the period is $136,000. $100,000 investment + $9,000 share of net liability increase + $27,000 share of profits. If Bill is a C corporation shareholder instead, his stock basis is $100,000. $100,000 original investment. If the corporation is an S corporation, Bill’s stock basis is $127,000. $100,000 + $27,000.

26. Distributions • Distributions can be made to partners, LLC owners, or S corp. shareholders tax-free • The same distribution would produce dividend income treatment for C corp. shareholders • If appreciated property is distributed to S corp. shareholders, realized gain is recognized at the corporate level (same treatment as a C corp.) • This corporate-level gain is passed-through to the S corp. shareholders

27. Passive Activity Losses (slide 1 of 2) • Loss limits apply to owners of partnerships, LLCs, and S corps • Passive losses are separately stated items that flow through to owners • Passive loss rules apply at the owner level

28. Passive Activity Losses (slide 2 of 2) • For corporations, only apply if a closely held corp or a personal service corp • Closely held corp—more than 50% of value of stock at any time during last half of year is owned by 5 or less individuals • Passive losses can offset active income but not portfolio income • Personal service corp—principal activity is performance of personal services by owner-employees who own more than 10% in value of corp’s stock • General passive loss rules apply

29. At-Risk Rules • At-risk rules apply to: • Partnerships • LLCs • S corps • Closely held C corps • May be more troublesome for partnerships and LLCs since liabilities are included in partner’s basis in partnership interest

30. Special Allocations • Partnership and LLCs have many opportunities to use special allocations • Not generally available in C corps and S corps • May be able to achieve the same results using payments to owners for services, rents and interest

31. Disposition of a Business or an Ownership Interest • Disposing of a business may be viewed as either: • A sale of an ownership interest, or • A sale of assets • Tax consequences are, in general, more favorable for a sale of an ownership interest

32. Sale of Assets by Entity —Seller’s Issues (slide 1 of 3) • Sole Proprietorship • Treated as a sale of separate assets • Gain or loss is calculated for each asset • Character of income or loss depends on nature of asset

33. Sale of Assets by Entity —Seller’s Issues (slide 2 of 3) • Partnership, LLC, or S Corp—Same as proprietorship • Gain/loss flows through to shareholders or partners • They report & pay tax on gain or loss • Distribution of cash proceeds does not cause double tax since basis is adjusted by gain/loss

34. Sale of Assets by Entity —Seller’s Issues (slide 3 of 3) • C Corp—double taxation occurs • Gain is determined for each asset and tax paid by corporation • Net cash is distributed • Taxed as dividend, return of capital or capital gain to shareholder

35. Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 1 of 3) • Partnership • Distribution rules determine partner’s basis in assets received from partnership • Partner has gain if cash received > basis • Partner has loss if cash, inventory and unrealized receivables are only assets rec’d and are < basis • Character of gain on asset sale depends on nature of assets received by partner • No double tax • Limited Liability Company – Same as above.

36. Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 2 of 3) • S Corp • S Corp has gain if appreciated assets distributed to shareholders • No corporate level tax unless “built-in gain” • Shareholder has gain (tax) on receipt of assets > basis (after basis increase for gain) • Shareholder’s basis in assets = FMV, so no gain on later sale of assets

37. Liquidating Distribution of Assets to Owner Followed by Owner’s Sale to Third Party (slide 3 of 3) • C Corp • Double tax • Gain on distribution and tax at entity level • Net (after tax) assets distributed at FMV & result in gain to shareholder

38. Purchase of Business Assets—Buyer’s Issues (slide 1 of 2) • The purchaser of individual assets is not generally affected by the type of entity through which the seller operates: • The buyer (whether individual, partnership, LLC, C corp or S corp) allocates the total amount paid to the individual assets acquired • Part of the cost may be allocated to intangible assets such as goodwill

39. Purchase of Business Assets—Buyer’s Issues (slide 2 of 2) • Asset cost is recovered through depreciation, amortization, sale of inventory, collection of accounts receivable, etc... • The buyer can contribute the assets to a partnership or C corp under §721 or §351 • If the C corp is qualified, an S corp election can be made

40. Sale of Business Interest—Seller’s Issues (slide 1 of 3) • Sole Proprietorship • No distinction between sale of interest or assets • Partnership • Sale of partnership interest results in ordinary income to partner for share of partnership’s ordinary income assets; capital gain for remainder

41. Sale of Business Interest—Seller’s Issues (slide 2 of 3) • S Corp • Sale treated as sale of stock • Results in capital gain or loss to shareholder • In general, no corporate-level consequences • However, if purchaser is not qualified shareholder, S election is automatically terminated

42. Sale of Business Interest—Seller’s Issues (slide 3 of 3) • C Corp • Sale treated as sale of stock • Results in capital gain or loss to shareholder • No corporate level consequences

43. Purchase of Business Interest—Buyer’s Issues (slide 1 of 3) • If the purchaser acquires an interest in one of these types of entities, he or she is treated as follows: • Sole Proprietorship • Purchaser is deemed to buy assets • Purchase price is allocated to assets • Assets are depreciated, amortized, etc...

44. Purchase of Business Interest—Buyer’s Issues (slide 2 of 3) • Partnership • Purchaser buys partnership interest • Purchaser may ask partnership to make §754 election to step up inside basis in assets

45. Purchase of Business Interest—Buyer’s Issues (slide 3 of 3) • S Corp or C Corp • Purchaser buys stock • There is no effect on underlying assets owned by the entity

46. Refocus On The Big Picture (slide 1 of 6) Conducting their business as a C corp, an S corp, or an LLC would meet Bill and George’s objectives of providing limited liability. From a tax perspective, both the S corp and the LLC would allow the early-year losses to be passed through to the owners. This cannot be achieved with a C corp. The losses are trapped until future years when the company is profitable. Once the entity turns profitable, the tax consequences are as follows.

47. Refocus On The Big Picture (slide 2 of 6) As a C corp, the entity would pay income tax of $61,250 on taxable earnings of $200,000. If the after-tax earnings of $138,750 are distributed equally to Bill and George, they would Each receive a taxable dividend of $69,375, Each pay an additional income tax of $10,406 ($69,375 x 15%). The combined entity/owner tax liability is $82,062, resulting in after-tax cash flows of $117,938

48. Refocus On The Big Picture (slide 3 of 6) If the entity is operated as an S corp or an LLC, no tax is paid at the entity level. The entire $200,000 is taxed as ordinary income at the owner level. Each owner pays $28,000 ($100,000 X 28%) income tax. The combined entity/owner tax liability is $56,000, resulting in after-tax cash flows of $144,000.

49. Refocus On The Big Picture (slide 4 of 6) Both the S corp and the LLC meet Bill and George’s objectives of having limited liability and minimizing tax liability. The LLC form offers an additional advantage An LLC need not satisfy the numerous requirements to elect and maintain S corporation status. However, based on the facts in this situation, it is unlikely that satisfying the requirements would create any difficulty for Bill and George.

50. Refocus On The Big Picture (slide 5 of 6) The results of George’s investing in a limited partnership appear in Example 2. While beneficial tax results are expected to occur, George needs to be aware of the economic risk of losing his $10,000 investment. For Bill, the recognized gain on the sale of his investment in the retail coffee franchise outlet is dependent on the entity form. If Bill uses a pass-through entity, the recognized gain differs from that if the entity were a C corporation: Entity profits increase the owner’s interest basis in a pass-through entity, Entity profits have no effect on a shareholder’s basis in C corporation stock.