2013 cch basic principles ch16 pi

Chapter 16

Partnerships, Corporations, and S Corporations

Part I: Overview

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CCH Federal Taxation Basic Principles 2 of 25

Chapter 16 Exhibits

1. What Entity Form Is Best for a New Business? 2. Selecting an Entity (Table 1)—Nontax Differences 3. Selecting an Entity (Table 2)—General Tax Differences 4. Selecting an Entity (Table 3)—Differences in Eligibility 5. Selecting an Entity (Table 4)—Differences in Tax Treatment 6. Formation of Entities—Owner Perspective 7. Effect of Operations on Owners 8. Effect of Nonstock Distributions on Owners 9. Effect of Nonstock Distributions on Entities

Chapter 16, Exhibit Contents


What Entity Form Is Best for a New Business?

General rules for small businesses:

Taxes should not be a motivator unless there are no nontax differences.

If no need to incorporate, generally better to be a limited liability company taxed as a partnership.

If there is a need to incorporate, generally better to be an S corporation.

If there is a need to go public, a C corporation is usually the only choice.

Chapter 16, Exhibit 1


Selecting an Entity (Table 1)—Nontax Differences

Actual rights to individual P/S assets; can bind partnership; each GP has equal right to run business.

Same as C corps

Rights to investment in stock, but not corporate assets; cannot bind corp.

Rights of owners

P/S dissolves after

1. Departure of 50% GP(s); or

2. Operations cease.

Same as C corps

Going concern Continuity of ownership

Each general partner (GP) has personal liability for P/S debt, & a direct interest in the P/S assets.

Owners of LLCs have limited liability; but may not appoint 3rd parties to board of directors.

Same as C corps

Limited liability to extent of investment.

Exposure of owners

General Partnerships (G P/S)S CorpsC Corps

Chapter 16, Exhibit 2a


Cannot trade a general partnership interest on a public exchange, but can trade a limited partnership interest publicly; more flexible than corporations with forms of equity (e.g., can give out common or preferred P/S interest with no tax consequences.)

Cannot go public.

Equity capital can be raised through public stock offerings; however, less flexible in bringing in different forms of ownership (i.e., must maintain preemptive ownership %. the preemptive restrictions are waived if employees are offered equity participation through treasury stock.)

Raising equity capital


Chapter 16, Exhibit 2b



Only if nontax differences weigh equally should one weigh the tax differences.

Can be too cumbersome to operate effectively without centralized management like corporation, since G P/Ss may exceed 100. G P/Ss are subject to jurisdiction of the state. (For LLC partners, control by states not yet tested in the courts.)

Same as C corps

Simplified with centralized management.

General administration

Can more easily write custom financing instruments (e.g., preferred debt with conversion rights).

Same as C corps

Banks may be more willing to lend to corporations.

Raising debt capital


Chapter 16, Exhibit 2c



Selecting an Entity (Table 2)—General Tax Differences

15% on TI up to $35,350 in 2012 for individuals; $70,700 for joint filers

Same as general partnership

15% on taxable income (TI) up to $50,000.

Lowest Marginal Tax Rate

15% whether or not income is distributed.


35% if income is not distributed (but 15% accumulated earnings tax or personal holding company penalty possible);

44.75% if income is distributed. (35% + 15% x 65%) possibly higher if corporate shareholder receives dividends, then distributes them again.

Highest Marginal tax Rate

General Partnerships

S CorpsC Corps



Cash, accrual or hybrid, unless partner is a “non-qualified” C corporation. Then accrual method required.

Cash, accrual or hybrid (all three available, regardless of size).

Personal Service Corporations (PSCs) and Qualified C corporation (i.e., annual gross receipts $5mm in 3 preceding years) may use cash, accrual or hybrid; non-qualified C corps must use accrual only.

Tax accounting. methods

General Partnerships

S CorpsC Corps




Very complex. With no limits on # of general partners (GPs), large partnerships (P/Ss) would require very complicated tax administration. Also, IRS can now audit P/Ss at P/S levels; each partner (P) is put on notice to toll the 3 year statute of limitations.

Complex if owned by many shareholders.

Easier to administer with centralized management. (However, conflicts of interest may arise between shareholders and management e.g., management may prefer tax methods that maximize earnings while shareholders may prefer tax methods that postpone earnings and taxes.)

Tax

administration

General PartnershipsS CorpsC Corps




Yes, to Ps (except PALs do not apply if the general partner (GP) materially participates and business is a non-rental activity).


No, (except for personal holding companies or personal service corporations.)

Subject to at-risk and passive activity loss (PAL) rules?


Chapter 16, Exhibit 3d



None Only one class of common stock. Code Sec. 1361(b)(1)(D). However, differences in voting rights among common shares are OK.

None Capital structure limits

None None after 1996. Before 1997, could not own > 80% stock of another corporation.

None Affiliate limits

S corp. S/Hs allowed:

1. Individuals;

2. Estates;

3. Qualified trusts.

None S corp. S/Hs NOT allowed:1. Nonresident aliens;2. C corporations;3. Partnerships.4. Banks;5. Insurance cos.

None Owner

identity limits

At least 2. 100 (related taxpayers can be treated as one taxpayer).

No limit # Owners



Selecting an Entity (Table 3)—Differences in Eligibility

CCH Federal Taxation Basic Principles 12 of 25Chapter 16, Exhibit 4b

Current deduction

Outside basis at risk

Outside basis AND at-risk amount affected (Code Sec. 752)

None (neither basis nor AAA affected; only “at-risk” amt)

Adjusted annually Adjusted annually Constant (unaffected by corporate activity)

None

Owner’s basis:

General

Effect of entity debt

Yes Yes (Code Sec. 1366(b))

No Character conduit

Current deduction

Outside basis at risk

No deduction

N/A

Current losses:

General

Limit

Treatment of Equity Owner

Current tax Current tax No tax to shareholder

Undistributed income


Selecting an Entity (Table 3)—Differences in Eligibility


Limited:

1. Calendar year; or

2. Majority interest; or

3. 5-Percenters’; or

4. Min. deferral rules; or

5. Business purpose.

Code Sec. 706.

Limited:

1. Calendar year; or

2. Business purpose satisfied if 25% gross rev. earned during last two month of adopted FYE during past 3 years.

Code Sec. 1378

Any fiscal year end is OK.

Entity taxable year



Selecting an Entity (Table 4)—Differences in Tax Treatment


Formation of Entities—Owner Perspective

Always ordinary income. Always ordinary income. Tax treatment for services contributed in exchange for ownership.

No control requirement 80% control after exchange. Control requirement for tax-free treatment:

General Partnerships C and S Corporations Formation



Disguised sale rules: Gains: Yes; Losses: Yes except losses are not recognized if the disguised sale involving a 50% + partner.Recognized Gain or Loss =[(a) - (b)] x [(c) (a)], where,(a) = FMV of P/S interest received;(b) = AB of property contributed;(c) = FMV of other property received within two years of new ownership. [Note: (a) - (b)] = realized gain.

Gain = Lesser of (a) or (b):

(a) = Realized gain;

(b) = Boot rec’d, where boot is any property received other than common stock. Debt relief is also boot to the extent it exceeds the basis of all property contributed.

Realized losses are never recognized in a Code Sec. 351 exchange; realized losses are always recognized in a non-Code Sec. 351 exchange.

How is an owner’s recognized gain or loss on “tax-free” formation determined?






Basis in partnership interest =

(b) x {[(a) – (c)] (a)}

(a) = FMV of P/S interest received;(b) = AB of property contributed;(c) = FMV of other property received within 2 years of new ownership.

The following formula applies to both tax-free and taxable exchanges: AB in corp. stock =

+ AB in contributed prop.;

+ Shareholder’s recog. gain;

– FMV of boot rec’d, including debt relief that is boot;

– Debt relief that is not boot;

– Shareholder’s recog. loss.

What is an owner’s basis in the ownership interest?




HP begins on the day AFTER receipt.

HP begins on the day AFTER receipt.

What is an owner’s holding period in property other than equity received from an entity?

FMV of prop. received. (Plus postponed loss in the rare case of a 50%+ owner who postpones a realized loss on a disguised sale)

Same as the corporation’s adjusted basis (not FMV, as in like-kind exchanges).

What is an owner’s basis in property other than equity received from an entity?

Same as property contributed. Split HPs may be necessary.

Same as property contributed. Split HPs may be necessary.

What is an owner’s holding period (HP) in the ownership received?


Chapter 16, Exhibit 6d



No, never. No, never. Does an entity recognize gain or loss on the exchange of an ownership interest for property in a tax-free exchange?

Basis in property = (c) + {[(a) – (c)] (a)] x (b)}, where,(a) = FMV of P/S interest received; (b) = AB of property contributed;(c) = FMV other prop. received w/in 2 yrs of new ownership.

Basis in property = (a) + (b), where,

(a) = Shareholder’s AB in contributed property;

(b) = Shareholder’s recognized gain (if any).

What is an entity’s adjusted basis (AB) in property contributed by a new owner?


Chapter 16, Exhibit 6e




Gains: Yes; Losses: Yes, except losses are not recognized if the disguised sale involves a 50%+ partner.

Gain or loss = [greater of: (a) or (b)] - (c), where:

(a) = FMV of property

distributed;

(b) = P/S’s debt relief

(if any);

(c) = P/S’s basis in property distributed.

Gains: Yes; Losses: No.

Gain = [greater of: (a) or (b)] – (c), where:


distributed;

(b) = Corporation’s debt relief

(if any);

(c) = Corporation’s basis in property distributed.

Does an entity compute recognized gain or loss on the exchange of property other than equity to new owners?


Chapter 16, Exhibit 6f


Effect of Operations on Owners

Outside basis AND at-risk amount affected (Code Sec. 752)

None (neither basis nor AAA affected; only “at-risk” amount)

NoneEffect of entity debt

Adjusted annually Adjusted annually Constant (unaffected by corporate activity)

Owner’s basis:

General

Yes Yes (Sec. 1366(b))No Character conduit:

Outside basis at risk Outside basis at risk N/A Limit

Current deduction

Current deduction

No deduction to shareholder

Current losses:

General

Current tax Current tax No tax to shareholder

Undistributed income:

General Partnerships S Corps C Corps Operating Item



Effect of Nonstock Distributions on Owners

Cash + debt relief

[i.e., for purposes of determining gain, only cash + debt relief are subject to capital gains. Other property received by a partner is tax-free.]

(a) – (b), where,

(a) = FMV of all prop. received by shareholder;

(b) = Corporate debt assumed by shareholder.

How is “amount distributed” to owners computed?

General Partnerships C and S Corporations



Cash + debt relief:

1. Tax-free up to outside basis;

2. Capital gain to a partner on the excess of cash or debt relief in excess of outside basis. (Loss is never recognized.)

3. Other property: Tax- free.

S Corps.

1. Tax-free up to the lesser of: AAA Bal. Stock Basis2. Ord. up to accum. E&P from prior life as a C corp. (if any) 3. Tax free up to any excess of stock basis over AAA balance.4. Cap. gain on remainder.

C Corps.

1. Ordinary up to current earnings & profits (E&P);

2. Ordinary up to accumulated E&P;

3. Tax-free up to outside basis

4. Capital gain on remainder.

What is the owners’ tax treatment for the “amount distributed?”






Same as the partnership’s inside basis. [However, if a partner’s outside basis is less than the partnership’s inside basis in property distributed to a partner, then the partner’s basis of property received is taken from his outside basis, not from the partnership’s inside basis. This makes sense, given that a partner’s outside basis must be reduced by the “amount” of distributions and that it cannot be negative]

Always FMV, even if an owner assumes corporate debt.

What is the basis of property distributed to an owner?




Effect of Nonstock Distributions on Entities


No gain or loss, unless it is part of a disguised sale. In a disguised sale, the partnership’s recognized gain or loss = (a) - (b), where:


distributed.

(b) = AB of prop. dist’d.

Gains: Yes (compute gain in the same way as if the property were sold)

Losses: No (except in complete liquidation).

Other property (other than its own stock)?

No. No. Cash or its own bonds to owners?

General PartnershipsC and S CorporationsDoes an entity recognize gain or loss on the distribution of:


Effect of Nonstock Distributions on Entities


The character of the partnership’s gain or loss on a disguised sale is the same as the character of the property before it is distributed.

If owner owns 50%, then the character of the entity’s gain is the same as the character of the property distributed.

If owner owns > 50%, then the entity’s gain is ordinary.

Losses are not recognized.

What is the character of the entity’s gain or loss on distribution of property to owners?

General PartnershipsC and S Corporations

2013 cch basic principles ch16 pi

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