Post on 13-Jan-2015
description
How to Choose the Best Business Entity
by
Alan D. Campbell
Ph.D., CPA, CMA, CFP®
alancampbell@elmore.rr.com
Author of the forthcoming book
Tax Savings Prescriptions
2
Objectives• Explain how to
choose the best business entity:– Sole proprietorship– Partnership– Limited liability
company– S Corporation– C Corporation
3
Sole Proprietorship
4
Characteristics
• Easy to form and operate
• The owner has unlimited liability
• The owner has limited ability to raise capital
5
Formation• The owner may
operate under a fictitious name (a d/b/a)
• The owner may have to file a fictitious name registration with the county or parish
6
Formation
• The individual owner owns the assets
• No owner recognizes any gain or loss on the transfer of personal use assets to the business
7
Income Tax Treatment
• Only one level of income tax
• Income and expenses retain their character
• The net income is taxed at the owner’s marginal tax rate
8
Income Tax Treatment
• The owner reports income and expenses on Form 1040, Schedule C
• Losses (except passive losses) are deductible against the owner’s other income
9
More Than One Business• Income and expenses
from each different business are reported on separate Schedules C
• A net loss from one active business may offset net income from other businesses
10
Self-Employment Tax • Reported on Form
1040, Schedule SE
• The net income is multiplied by 92.35%
• The resulting amount is multiplied by the SE tax rate of 15.3%
• Half of the SE tax is deductible for AGI
11
Passive Losses• A passive loss may be
deducted only against passive income for both income tax and self-employment tax purposes
• Unused passive losses are carried forward
12
Employing One’s Children
• Can reduce income taxes and the self-employment tax
• Wages paid to one’s children under age 18 are exempt from employment taxes
13
Employing One’s Spouse
• Salaries are subject to income taxes and employment taxes
• Can be useful in saving self-employment tax on health insurance premiums and income tax and SE tax on medical expense reimbursement plans
14
Employing One’s Spouse
• Can make business travel costs for the accompanying spouse deductible
• Can provide the spouse with earnings that can be tax sheltered with pension plans such as a SIMPLE plan
15
Section 179 Deduction
• The Section 179 deduction reduces income tax and the self-employment tax
• Wages count as business income for purpose of the income limitation
16
Net Operating Losses
• May generally be carried back two years and forward for up to 20 years for income tax purposes
• Are not deductible for self-employment tax purposes
17
Transferring the Business
The owner cannot transfer a part of the equity in the business without first changing it to another type of entity
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Sale of the Business
• A sale of a sole proprietorship is treated as a sale of its assets
• Part of any gain will be ordinary income
19
Transferring the Business to Reduce Estate Taxes• Bequeath the
business to the surviving spouse
• Sell the business outright and make annual gifts from the proceeds
20
Transferring the Business to Reduce Estate Taxes• Sell the business
for a private annuity
• Sell the business for a self-canceling installment note
21
Partnership
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Characteristics
• General partners have unlimited liability
• Partnerships have a greater ability to raise capital than do sole proprietorships
23
Characteristics• Partnerships have
relatively simple administration and filing requirements compared to corporations
• Partnerships are often much more complex for tax purposes than are other entities
24
Formation• Transfers of property to a
partnership in exchange for an interest in the partnership are generally tax deferred
• The receipt of a partnership interest for services is taxable as determined under Section 83
25
Tax Year
• The partnership must use the same tax year as used by partners that own more than 50% of the interest in the partnership
• If not possible, use the tax year of all the principal partners
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Tax Year
• If not possible, use the tax year with the least amount of income deferral
• The IRS may approve a different tax year if a business purpose exists
27
Tax Year
The partnership may elect a different tax year if the partnership makes the required payment and the deferral period is three months or less
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Income Tax Treatment
• Partnerships have a great deal of flexibility in allocating income between or among the partners
• Single level of taxation• Partners, not the
partnership, pay taxes
29
Income Tax Treatment
Income is taxed to the partners even if the partnership makes no distributions of cash or other assets
30
Employment Tax Treatment
For general partners, the distributive share of ordinary income and any guaranteed payments are subject to the self-employment tax
31
Reporting Partnership Income
• The partnership must file Form 1065
• Income is reported to each partner on Schedule K-1
• Ordinary income or (loss)
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Reporting Partnership Income
• Separately reported items include portfolio income, capital gain/loss, and the Section 179 deduction
• Net earnings from self-employment
33
Losses• Losses flow through to
the partners to the extent of each partner’s– Amount at risk– Adjusted basis in the
partnership interest, which includes the partner’s share of the partnership’s debts
34
Losses• Passive losses are
deductible only to the extent of passive income
• Losses from a limited partnership interest are generally passive losses
35
Distributions from the Partnership
• Distributions include distributions of cash and other assets
• A net decrease in a partner’s share of the liabilities is treated as a cash distribution
36
Distributions from the Partnership
• Distributions are deemed to occur at the end of the year
• All other items that affect basis are taken into account before distributions
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Distributions from the Partnership
Distributions of property reduce the basis in the partnership interest by the adjusted basis of the property to the partnership
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Distributions from the Partnership
• Distributions of cash are a reduction in the basis of the partner’s interest in the partnership
• Distributions of cash in excess of basis result in a recognized gain
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Sale of a Partnership Interest
A sale of a partnership interest is treated as a sale of a capital asset except to the extent of “hot assets”
40
Optional Basis Adjustment• The partnership may
elect to adjust a partner’s outside basis when – A partner acquires the
interest of another partner or
– The partnership distributes property to a partner
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Sale of the Assets of the Business
• The partnership can sell the assets of the business
• The gain or loss on each asset must be calculated and characterized
42
Termination of a Partnership
A partnership terminates for legal purposes on the death, withdrawal, or bankruptcy of any partner
43
Termination of a Partnership
• A partnership terminates for tax purposes – When at least 50% of the
interest in the partnership is transferred in any 12-month period or
– When no business activity is carried on by any partner
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Transferring the Business to Reduce Estate Taxes
• Form a family limited partnership
• Make a lifetime gift of the general partnership interest or sell it
• A corporation or LLC could be formed to be the general partner
45
Transferring the Business to Reduce Estate
Taxes• Retain a limited
partnership interest
• The value of the retained interest will receive discounts for – Lack of marketability
and– Lack of control
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Four Types of Entities May Be Taxed as Partnerships
• General partnership
• Limited liability partnership (LLP)
• Limited partnership
• Limited liability company (LLC)
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General Partnership
• All partners have unlimited liability
• Each partner is taxed on the partner’s distributive share of– The partnership’s
ordinary income– The separately stated
items
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Limited Liability Partnership
• Used by professional services firms
• All partners have unlimited liability for the normal business debts of the partnership
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Limited Liability Partnership
Partners are not liable for the professional negligence of another partner unless the other partner is under their direct supervision
50
Limited Partnership
• Limited partners have limited liability
• Limited partners cannot take part in management
• Limited partners are often a source of a large amount of capital
51
Limited Partnership
• Must have at least one general partner
• The general partner is often a corporation or LLC
• Limited partners pay self-employment tax on guaranteed payments only
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Limited Liability Company (LLC)
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Characteristics
• None of the members is personally liable for the debts of the LLC
• All members have the legal right to participate in management
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Characteristics
• LLCs may have an unlimited number of members
• Any taxpayer can be a member of an LLC (corporations, non-resident aliens, trusts, partnerships)
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State Law
• Little established case law exists to interpret the various state statutes
• Uncertainty exists for LLCs that operate in more than one state as to which state’s law will prevail
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Formation• Transfer of property
to an LLC in exchange for an ownership interest is – Generally governed by
the partnership tax provisions (Subchapter K)
– Generally tax deferred
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Income Tax Treatment
• One member LLC is taxed as
– A disregarded entity (sole proprietorship)
– A corporation if the LLC so elects
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Income Tax Treatment
• LLC in the USA with two or more members is taxed as
– A partnership– A corporation if the
LLC so elects
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Employment Tax Treatment
If the LLC elects to be taxed as a corporation, the salaries of the members who work for the LLC will be subject to FICA tax and income tax withholding
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Employment Tax Treatment
If the LLC elects to be taxed as a corporation, the LLC will be subject to FICA tax and unemployment taxes
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Employment Tax Treatment
If an LLC owned by one individual is taxed as a disregarded entity, all of the net income will be subject to self-employment tax
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Employment Tax Treatment
If an LLC is taxed as a partnership, the members who are equivalent to general partners will be subject to self-employment tax on their distributive share and on any guaranteed payments
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Employment Tax Treatment
Members who are equivalent to limited partners will be subject to self-employment tax only on their guaranteed payments
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LLCs Taxed as Partnerships
• The flexibility of a partnership
• The limited liability of a corporation
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LLCs vs. S Corporations
• LLCs are NOT subject to the taxes on built-in gains and excessive passive income
• LLCs are NOT limited as to the number of members
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Selling the Assets of the Business and Liquidating the LLC• The gain or loss on each
asset must be calculated and characterized
• The treatment of liquidating distributions depends on how the LLC is taxed
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Sale of a Membership in the LLC
• If the LLC is taxed as a partnership, the interest in the LLC is a capital asset
• Capital gain or loss results, except to the extent of the sale of “hot assets”
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Sale of a Membership in the LLC
A loss on the sale of a membership in an LLC taxed as a partnership or disregarded entity cannot qualify for ordinary loss treatment under Section 1244
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Sale of a Membership in the LLC
• If the LLC is taxed as a corporation, the sale of the LLC membership should result in capital gain or loss
• Possible limited ordinary loss treatment under Section 1244
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S Corporation
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Eligibility Requirements
• Must be a domestic (USA) corporation
• Must be eligible to elect S status (not an insurance company or non-qualifying bank)
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Eligibility Requirements
• Shareholders are only– Individuals – Estates – Tax-exempt organizations,
and – Seven kinds of trusts
• No more than 100 shareholders
Eligibility Requirements
• A husband and wife count as one shareholder
• Certain family members may elect to be treated as one shareholder, up to six generations
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Eligibility Requirements
• Only one class of stock
• Stock with different voting rights is allowed
• Disproportionate distributions can be deemed to indicate that the corporation has more than one class of stock
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Eligibility Requirements
• Generally, nonresident alien shareholders are NOT allowed
• An exception applies if the nonresident alien is married to a U.S. citizen or resident alien and elects to be taxed as a resident alien
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Trusts That Can Own S Corporation Stock
• Grantor trusts• Voting trusts• Testamentary trusts• Qualified Subchapter S trusts• Qualified retirement plan
trusts• Small business trusts• Beneficiary-controlled trusts
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Characteristics
• Limited liability
• Unlimited life
• Centralized management
• Limited transferability of interests without losing the S election
• Subject to more government regulation
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Formation• The transfer of assets in
exchange for the corporation’s stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer
• The transfer of assets for the debt of the corporation is taxable
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Formation• The receipt of stock in
exchange for services is taxable as determined under Section 83
• Service provider may make election under Section 83(b) if stock is restricted
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Making the S Election
• File Form 2553 with the IRS
• All shareholders must consent
• The election must be timely and properly filed
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Deadline for the S Election• The corporation may make
the S election at any time in the year before it is to become effective
• The corporation may make the S election on or before the 15th day of the third month of the tax year of the year it is to be effective
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Deadline for the S Election• A new corporation may
make the S election on or before the 15th day of the third month of its first tax year
• The first tax year begins on the day the corporation has assets, shareholders, or begins business
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Deadline for the S ElectionIf the corporation makes the S election late, the IRS may treat the election as timely if the corporation had reasonable cause
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Deadline for the S Election• The election is faulty if
the corporation failed to qualify or did not obtain shareholder consents
• However, the IRS may honor the election if the corporation corrects the problem within a reasonable time
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Tax Year• An S corporation generally
must use the calendar year
• A fiscal year is allowed if it has a business purpose
• The corporation may also use the same year as used by shareholders who own more than 50% of its stock
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Tax Year
• The S corporation may also elect to use a different tax year
• The maximum deferral of income is three months
• Requires payments to the IRS to compensate for the deferral
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Ownership of C Corporations• A C corporation may
NOT own stock in an S corporation
• However, an S corporation may own stock in a C corporation
• No consolidated return allowed with a C corporation
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QSubs
• An S corporation may have qualified S corporation subsidiaries (QSubs)
• The QSubs are disregarded for tax purposes
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QSub Criteria
• Must qualify as an S corporation
• The S corporation parent must own all of its stock
• The parent elects to treat it as a QSub
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Income Tax Treatment
• No corporate income tax except for– Built-in gains– Excessive net passive
income– LIFO recapture tax– Recapture of
investment tax credit
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Penalty Taxes
• An S corporation Is NOT subject to– The accumulated
earnings tax or– The personal
holding company tax
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Income Tax Treatment
• The S corporation must file Form 1120S by March 15th
• Income is allocated to the shareholders on Schedule K-1
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Income Tax Treatment
• Income is taxed to the shareholders at their marginal tax rates
• Capital gains, tax-exempt income, and other separately stated items retain their character
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Income Tax Treatment
• Income is taxed to the shareholders on a per share per day basis
• Therefore, S corporations are not as flexible as partnerships
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Splitting Income• S corporation stock can be
given to family members to split income among the family members
• However, the S corporation must pay reasonable compensation to family members who provide services or capital to the corporation
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Splitting IncomeThe IRS may ignore gifts of stock to family members if the IRS determines that the donor retains the economic benefits and control of the stock
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Dividends Received Deduction
Unlike a C corporation, an S corporation is NOT entitled to the dividends received deduction
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Treatment of Certain Fringe Benefits
• Statutory fringe benefits are included in the gross income of more than 2% shareholders
• The S corporation may deduct the fringe benefits as business expenses
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Employment Tax Treatment
• Shareholders who work for the corporation are employees
• Salaries are subject to FICA tax and income tax withholding
• The corporation Is subject to FICA tax and unemployment taxes
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Reducing Employment Taxes
The S corporation can reduce employment taxes by paying the lowest amount of a range of reasonable salaries to shareholder-employees
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Treatment of Losses• Losses flow through
to the shareholders to extent of each shareholder’s:
– Basis in stock
– Basis in loans to the S corporation
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Tax Planning for Loss Deductibility
The shareholder can loan money to the S corporation or make a contribution to capital before the end of the year if necessary to deduct the loss currently
103
Treatment of Losses• The treatment of losses
is favorable for new businesses that are likely to incur losses
• When the corporation becomes very profitable, the shareholders can revoke the S election
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Treatment of Losses
• Losses subject to
– Amount at risk rules
– Passive activity loss rules
– Hobby loss rules
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Treatment of Losses• Losses of an S
corporation are often more limited than are losses of a partnership
• The basis in a partnership interest includes the partner’s share of the debts of the partnership
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Treatment of Distributions
• Distributions are a tax free recovery of basis to the extent of the shareholder’s basis in the stock
• The basis in debt does NOT absorb distributions
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Treatment of Distributions
Distributions in excess of the basis of a shareholder’s stock result in gain recognition to the shareholder
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Treatment of Distributions of Property
• Distributions of appreciated property result in gain recognition by the corporation
• However, no losses may be recognized
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Treatment of Distributions of Property
• The amount of the distribution of property is its – Fair market value– Minus any debts
assumed or taken subject to by the shareholder
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Former C Corporations• Former C corporations
with accumulated earnings and profits (E&P) keep an accumulated adjustments account (AAA)
• AAA is the total of income and loss from the S period (except tax-exempt income and related expenses)
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Former C Corporations
• Distributions come first from the AAA and reduce the basis in the shareholder’s stock
• Distributions come next from E&P and are taxable
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S Election Remains Until Revoked or Lost
• Voluntary revocation is easy and requires the approval of a majority of the shareholders
• Involuntary revocation occurs when– A new shareholder with over one half of the stock
refuses to consent to the election– The corporation no longer qualifies as a small business
corporation– The corporation does not meet the passive investment
income limitation
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Termination of the S Election for Excessive Passive Income
• Passive income greater than 25% of its gross receipts for three consecutive years and
• C corporation earnings and profits exist for each of the three years
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Preserving the S Election
• Management and shareholders should know the factors that affect S status
• Avoid passive investment income limitation violations
• Restrict transfer of stock to avoid loss of S status
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Inadvertent Terminations
• The IRS may continue to allow the S election if – The termination is
inadvertent and – The corporation takes
the necessary steps to meet the eligibility criteria within a reasonable time
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New Election
• If the S election is terminated, the corporation must – Wait five years to
make a new election or
– Obtain the consent of the IRS
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Sale of the Business
• You can structure the sale of the business as – A sale of stock or– A sale of assets
followed by a corporate liquidation
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Sale of the Business
• A sale of the stock should result in capital gain or loss
• Possible limited ordinary loss treatment under Section 1244
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Liquidation
• Liquidation of an S corporation is governed by the provisions of Subchapter C
• No double tax occurs except to the extent of built-in gains
120
C Corporation
121
Characteristics• Limited liability• Unlimited life• Centralized
management• Free transferability of
interests• Subject to more
government regulation
122
Characteristics
• Unlimited number of shareholders allowed
• Often used for a growing business that is reinvesting its profits in the business
123
Formation
The transfer of assets to the corporation in exchange for its stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer
124
Formation
• The transfer of services to the corporation in exchange for its stock is taxable as determined under Section 83
• The transfer of property in exchange for the corporation’s debt is taxable
125
Fringe Benefits
• Many fringe benefits are deductible by the corporation
• They are often tax free or tax deferred to the shareholders-employees
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Passive Activity Loss Rules
• Apply only to
– Personal service corporations
– Closely held corporations
127
Net Operating Losses
• Do NOT flow through to the shareholders
• Can generally be carried back two years and then forward for up to 20 years
128
Capital Losses
• Are deductible only to the extent of capital gains
• Are carried back three years and then carried forward for up to five years
129
Special Deductions
• Organization costs
• Dividends received deduction
• Charitable contributions
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Sale of the Business
• Sale of stock – No corporate tax– Shareholder
realizes capital gain or capital loss
– Possible limited ordinary loss treatment under Section 1244
131
Sale of the Business• Sale of assets
– Corporation recognizes gain or loss on sale of each asset
– Distributions are taxed to the shareholders as capital gain or capital loss
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Double Taxation
• Income is taxed at the corporate level
• Dividends are taxed to shareholders when distributed
133
Reducing Double Taxation
• Avoid distributing dividends
• Make cash payments to the shareholders that are deductible by the corporation
134
Reducing Double Taxation
• Make cash payments to the shareholder that are a tax free recovery of basis
• Make the S election
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Deductible Cash Payments
• Lease payments
• Reasonable compensation
• Interest
136
Cash Payments That Are a Tax Free Recovery of
Basis• Principal payments
on debt
• Stock redemptions treated as a sale
• Liquidating distributions
137
Penalty Taxes
• Accumulated earnings tax
• Personal holding company tax
138
Double Tax on the Sale of the Assets of the Business
• The corporation recognizes gain or loss on the sale of the assets
• The shareholders recognize capital gain on the distribution of the proceeds
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Conclusion• The best entity for a
your business depends on many factors, including state income tax rules
• You should make the decision with guidance from your attorney and tax professional
Bonus Material
11 Reasons You May
NOT Want to Incorporate
1. Banks Require Cosigners
• Banks will usually require major shareholder(s) to consign any corporate loans
• Thus, there would be no limited liability for bank loans
141
2. Piercing the Corporate Veil
• Most corporations keep poor records such as minutes and resolutions
• Many stockholders of small corporations commingle personal and corporate assets
142
Shareholders Become Liable
• A plaintiff’s attorney may be able to pierce the corporate veil
• If so, the shareholders could be personally liable for any corporate debt
143
3. Defending a Lawsuit Is Expensive
• Even if a corporation keeps good records and does not commingle assets
• The corporation would have to pay to defend a lawsuit, except to the extent that an insurance company will pay
144
4. Breach of Fiduciary Duty
• Even if the corporation keeps good records and does not commingle assets
• You can be sued individually for breach of fiduciary duty as a director or officer of the corporation
• You can insure such risk, but it can be expensive
145
5. Foreign Corporation Fees
• A corporation is an artificial person that has received a charter from a particular state
• To do business in another state, the corporation must register with that state and pay a fee as a “foreign corporation”
146
6. Few Additional Deductions
• Section 162 authorizes deductions for business expenses
• It applies to all types of businesses
• There are few deductions a corporation may claim that are not allowed to other types of business entities
147
7. Employment Taxes for Children Under Age 18
• If your children are under age 18 and they work for your sole proprietorship, their wages are not subject to employment taxes
• If your children work for your corporation, their wages are subject to employment taxes
148
8. More Government Forms to File
• If you operate as a corporation, you have to file more forms and pay more fees to federal and state governments
• Complying with all the rules takes additional time and money away from your business
149
9. Can Lose Stock to Personal Judgments
• A court may not force a creditor to be a partner with someone
• If someone gets a judgment against an LLC member or partner, usually all the creditor gets is a charging order
150
Judgment Creditor Can Seize Stock to Satisfy Judgment
• A personal judgment creditor of a shareholder may be able to take the stock to satisfy the judgment
• You can buy personal umbrella liability insurance to hedge against this risk
151
10. Payroll Tax Penalties on Your Own Salary
• If your corporation pays you a salary and does not deposit the payroll taxes timely, the corporation could be subject to large penalties
• And you as an individual could be subject to the trust fund recovery penalty
152
11. Possible Tax on Transfer of Appreciated Assets
• If you transfer appreciated assets to a corporation that you control and if you do not comply with Section 351
• You could owe income tax just for placing the assets in a corporation
153
Conclusion
• Think carefully and get excellent advice before you form a corporation
• Corporations do have some benefits
• But many of the alleged benefits are myths and half truths
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Credits
This presentation was created using PowerPoint® presentation graphics program, a Microsoft® software. PowerPoint® is a Windows®-based and Mac®-based application. All clip art is used with permission from Microsoft®. Microsoft®, Windows®, and PowerPoint® are either registered trademarks or trademarks of Microsoft Corporation in the United States and/or other countries.
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Disclaimers
Alan D. Campbell (d/b/a Campbell Education) is an independent entity and is not affiliated with, nor has he been authorized, sponsored, or otherwise approved by Microsoft Corporation.
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