Tax Implications of Entity Selection

Tax Implications of Entity SelectionAndrew J. Malone, CPAFesnak and Associates, LLPMACE PresentationJanuary 16, 2014

S Corporation vs. Partnership•Types and amounts of

Shareholders/Partners allowed•Types of Partnerships•Income Allocation•Corporate Liabilities•Double taxation•Self-employment tax

C corporation converting to an S corporation

•Built in Gains•Distribution of subchapter C earnings and

profits •Accumulated earnings and excess net

passive investment income

Treatment of Losses•Partnerships – Losses limited to basis in

partnership interest•S Corporation – Losses limited to basis in

stock and indebtedness of corporation to shareholder. Even if the shareholder received a K-1 that reflects a loss, the shareholder is not automatically entitled to claim the loss.

Debt Restructuring and Cancellations•Transfer of equity interests•Debt for equity exchanges•Termination of Entity•Cancellation of Debt

Future Profits Interest• Commonly referred to as “carried interest.”

Example: Adam, Joe and Dan wish to form a private equity fund. Dan has significant expertise in choosing investments that Adam and Joe would like to profit from. They form an LLC, with Adam and Joe each contributing $100,000 for a 50% capital interest in the LLC. In exchange for managing the fund, Dan is given a 20% interest in future profits, which may or may not materialize. Dan’s 20% interest in future profits is a “carried interest.”

• So what’s the big deal?

• Dan did not have to contribute any capital upfront.• Dan does not have a taxable event upon formation.• If profits are realized, Dan will only pay 20% tax

on his profits .

Capital Account Maintenance•The IRS requires capital account maintenance

as part of the Partnership Agreement. •The capital account analysis is based on the

following three requirements:1. Capital account requirement2. Distribution requirement 3. Deficit makeup requirement

•Qualified Income Offset (“QIO”)•Deficit Restoration Obligation (“DRO”)

Minimum Gain Chargebacks• Created as a partnership claims deductions (such as

depreciation) that decrease the partnership’s book basis in the property below the balance of the non-recourse debt on the property. Sometimes referred to as 704(b) minimum gain.

Example: ABC partnership purchased property for $100,000 and depreciates the property using the straight line method over 10 years. The minimum gain for year 2 would be $10,000. The minimum gain is calculated by taking the difference between the NBV at the end of Year 2 and the balance of the nonrecourse debt (assuming no payments have been made). ($80,000 NBV - $90,000 debt = $10,000 minimum gain). The minimum gain chargeback is allocated in the same manner in which the partner’s shared the nonrecourse deductions.

• Value equals basis concept. • Exceptions to minimum gain chargeback

requirement.• 704(c ) minimum gain (“Built in gain”)

Equity Based Compensation

•Nonqualified Stock Options (“NSO”) and Incentive Stock Options (“ISO”).

•When NSO is exercised the “spread” is included in your wages.

•When ISO is exercised the spread is not included in your wages if certain criteria is met.

Incentive Stock OptionsThe stock acquired by exercising the options must be held until the later of:• 1 year following the day the stock was transferred to you

on exercise. • 2 years after the date the option was granted.

If these requirements are met when the stock is sold, any gain or loss is taxed as at the preferential capital gain rate as opposed to the higher ordinary income rate. If these requirements are not met the gain will be divided into two buckets: • The “spread” will be ordinary income and taxed as such.• The amount over the “spread” will be treated as a capital

gain.

ISO Example• Mary was granted an ISO on May 12, 2012 with the option to buy

100 shares of JKL company stock at $10 a share, which was the FMV of the stock on May 12. Mary exercises the option on March 6, 2013, when the stock is trading at $12 per share. Mary then sells the stock on March 26, 2014, for $15 per share. Mary did hold the stock for more than a year but 2 years had not elapsed from the date the stock was granted until the stock was sold. Therefore in 2014, Mary must report the “spread” as wages. The rest will be treated as capital gain. Transaction Amount

Selling Price ($15 X100 shares)

$1,500

Purchase Price ($10 X100 Shares)

$1,000

Gain $500Amount reported as wages(($12X100 shares)-$1000)

$200

Amount reported as capital gain

$300

Non-Liquidating Distributions and Dividends•Partner’s basis for distributed property

(non-liquidation).• Distributions by an S corporation to a

corporate officer.•When is a distribution taxable to a

shareholder of an S corporation and how is it taxed?

•Ordering rule for calculating shareholder basis.

S Corporation Shareholder BasisBen is a shareholder in an S corporation

and has $15,000 of stock basis on 1/1/12. He received a K-1 reflecting the following from the S corporation:• Ordinary Loss (20,000)• Net Sec. 1231 gain 4,000• Cash Contributions (50%) 5,000• Non-deductible expenses 1,000• Non-dividend distribution 12,000

What is Ben’s basis at the end of the year and how much income should he report on his personal return?

• 1/1/12 stock basis 15,000• Plus: Net Sec. 1231 gain 4,000• Less: Non-dividend distribution (12,000)• Less: Non-deductible expenses (1,000) • Equals: basis before loss & deductions 6,000

Since Ben’s loss & deduction items exceed his stock basis, the loss items must be prorated to determine the amount currently available to Ben:• 20,000/25,000 * 6,000 = 4,800 Ordinary Loss• 5,000/25,000 * 6,000 = 1,200 charitable

contribution

The 4,800 ordinary loss and 1,200 in charitable contributions reduces Ben’s basis down to zero. Ben should report ($4,800) on his Schedule E and $1,200 on Schedule A due to his stock basis limitations.

The loss and deduction items in excess of stock basis retain their character and are suspended indefinitely or until all of Ben’s stock is disposed of.

Self Employment Tax•Partnership – Generally each partner’s

share of net business income is net earnings from self-employment.

•Partnership exceptions to self-employment tax.

•S Corporation – Self-employment tax avoidance?

Self Employment Tax - Example• Susan has a 35% interest in ABC Partners. For

2013 she estimates her total self employment earnings from the partnership will be $35,000. What would her 2013 SE taxes be?

Net Business income $35,000Income subject to self-employment taxes (NBI * 92.35%) 32,322Medicare Tax (2.9% for 2013) 937FICA Tax (12.4% for 2013) 4,008Total self-employment taxes for 2013 4,945Tax deductible portion for 2013 (50% of SE Tax) $2,473Susan should include the total amount of self employment taxes

she expects to owe with her 2013 quarterly estimates. She should also update her estimated income tax calculation to include the SE tax benefit against income tax.

Capital Contributions •Partnership – Tax-Free; BIG or loss

allocated to contributing partner.•When would a partner have to recognize a

gain on a contribution?•The S corporation’s basis in contributed

property is the smaller of (1) the FMV or (2) the contributing shareholder’s adjusted basis.

When must a partner recognize gain on contributed property

• Disguised Sale – Bill contributed land having a FMV of $50,000 to the XYZ partnership in return for a 50% interest. After 9 months, the partnership distributed $50,000 cash to Bill. The distribution was not contingent on the partnership’s earnings or loans. The distribution and contribution will be treated as a sale of land by Bill to the partnership.

• Contribution to a partnership treated as an investment company - John and Fred decide to form J&F partnership. John contributes IBM stock with a FMV of $50,000 with an adjusted basis of $10,000 and Fred contributes Microsoft stock with a FMV of $50,000 with an adjusted basis of $40,000. J&F partnership is considered an investment company and upon contribution John must recognize a gain of $40,000 and Fred must recognize a gain of $10,000.

• Partner’s liabilities assumed by partnership - Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis of $8,000 and a $12,000 mortgage. The partnership assumed payment of the mortgage. Adjusted basis of contributed property $8,000

Minus: Mortgage assumed by other partners (80% of $12,000)

(9,600)

Capital gain from sale of partnership interest 1,600

Basis of Ivan’s partnership interest -0-

Distribution of appreciated and depreciated property

•Identifying § 751 “Hot” Assets•Carryover basis of property as long as

adjusted basis of property doesn’t exceed partner’s basis.

•S corporations – deemed sale

Death or Retirement of a Member•Liquidating payments•Unrealized receivables•Partner’s valuation•Gain or loss on distribution•Technical termination•Section 754 Step-up

Sale, Exchange or Transfer of a Partner’s Interest

•Sale or exchange usually results in a capital gain or loss.

•An exchange of partnership interests generally does not qualify as a nontaxable exchange but under certain circumstances can qualify as a tax free contribution.

•Section 754 step-up/down.

Sale, Exchange or Transfer of S corporation stock•Basis and Gain or loss when sold.•When do allocations to the purchasing

shareholder begin?•Allocating pass-through items upon

complete disposition of stock (specific accounting method vs. pro rata basis).

•What happens to a shareholder’s stock when they die?

Tax Implications of Entity Selection•Summary

•Questions?