Vol 01 chapter 20 2015

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes

1

Chapter 20

Corporations and Partnerships

2

The Big Picture (slide 1 of 2)

• The Todd sisters have decided to begin a catering business to handle private parties, weddings, anniversaries, and other large social events. – Their parents previously owned several restaurants so they

are familiar with food service operations. • All sisters will participate in the operation of the

business and will provide the funds for capital acquisitions (e.g., delivery trucks, kitchen equipment, and food preparation facilities) and working capital needs.

• Due to the cost of the premiums, the sisters plan on minimal liability insurance coverage.

3

The Big Picture (slide 2 of 2)

• In the first few years of operation, the sisters anticipate losses.

• When and if the business becomes profitable, however, they would consider expansion. – Any such expansion would require obtaining

additional capital from outside sources.

• In what type of entity should the Todd sisters conduct the business? – Read the chapter and formulate your response.

4

Corporations(slide 1 of 3)

• Compliance with state law is important for corporate tax treatment, but entity must also comply with Federal tax law

5


• Prior to 1997-An entity may be treated as a corporation depending on the corporate characteristics it possesses:– Continuity of life– Centralized management– Limited liability– Free transferability of interests

6


• After 1996—Check-the-box Regulations– Entity can elect to be taxed as corporation or

partnership regardless of attributes• Allows entities with more than 1 owner to elect to be

taxed as either a partnership or a corporation

• Entities with only 1 owner can elect to be taxed as a corporation or a sole proprietorship

7

Business Entities(slide 1 of 2)

• The following are the possible types of business entities– Sole proprietorship: Not a separate taxable entity– Partnership: Conduit entity (flow-through entity)

8

Business Entities(slide 2 of 2)

• Possible types of business entities– Regular corporation: Separate taxable entity– S corporation: Conduit entity– Limited liability company: Generally conduit

entity (i.e., partnership)

9

The Big Picture - Example 3Different Forms of Business Entities

• Return to the facts of The Big Picture on p. 20-1.

• The Todd sisters should consider a C or an S corp. to obtain limited liability for their business.– An LLC will also provide this result.

• On the other hand, the conduit effect of an S corp. or a partnership will allow them to use the initial losses anticipated for the business. – Under the conduit concept, such losses could be deducted

on their individual income tax returns

10

Similarities between Corporate and Individual Tax Rules (slide 1 of 3)

• The gross income and gains and losses from property transactions of a corp. are determined in much the same manner as for individuals– Both individuals and corporations are entitled to exclusions

from gross income• e.g., Interest on municipal bonds

• Business deductions of corporations parallel those available to individuals

• Corporate deductions are allowed for all ordinary and necessary expenses paid or incurred in carrying on a trade or business

11


• Corporations usually have the same choices of accounting periods as do individuals– May choose a calendar year or a fiscal year – Corporations enjoy greater flexibility in the

election of a tax year• For example, corporations usually can have different tax

years from those of their shareholders

• Also, a newly formed corporation generally has a free choice of any approved accounting period without having to obtain the consent of the IRS

12


• Both individuals and corporations must use the accrual method in determining cost of goods sold if they maintain inventory for sale to customers– The accrual method must also be used by large corporations (annual

gross receipts in excess of $5 million)• The cash method of accounting, however, is available to small

corporations and in the following additional situations:– An S election is in effect– The trade or business is farming or timber– A qualified personal service corporation is involved– A qualified service provider (e.g., plumbing business) is involved, and

annual gross receipts (for the past three years) do not exceed $10 million

• Even if the service provider is buying and selling inventory

13

Corporate Tax Differences(slide 1 of 3)

• The treatment of many items of income and expense are similar for corporations and individuals; however, differences include the following:

• Capital gains and losses for corporations– Long-term capital gains are taxed at the same rates

as ordinary income– Net capital losses are not currently deductible but

are carried back 3 and forward 5 years as short-term losses

14


• Depreciation recapture– Additional depreciation recapture under § 291 can

occur on disposition of real estate by corporations– The additional ordinary income element is 20% of

the excess of the § 1245 recapture potential over the § 1250 recapture

15


• Charitable contributions for corporations– Limit on deduction is 10% of taxable income

– Accrual basis corporation allowed deduction for the accrual of a donation made in following tax year (under certain circumstances)

– Contribution of certain inventory produces a deduction equal to basis plus 50% X (FMV – basis)

• To qualify for this treatment, the inventory must be used by the charity in its exempt purpose for the care of children, the ill, or the needy

16

Domestic ProductionActivities Deduction

• Applies equally to C corporations and individuals– The deduction is limited to 9% of the lesser of :

• Qualified production activities income or

• Taxable income

– The deduction cannot exceed 50% of W–2 wages included in production costs

17

Corporate Deductions

• Certain deductions are available only to corporations, such as:– Dividends received deduction (DRD)– Organizational expenditures

18

Dividends Received Deduction (DRD) (slide 1 of 2)

• Purpose of deduction is to mitigate multiple taxation– Amount of DRD depends on both the percentage of stock

ownership and the taxable income of the recipient corporation

Percentage of Ownership by

Corporate Shareholder Deduction Percentage

Less than 20% 70%

20% or more (but less than 80%) 80%

80% or more 100%

19

Dividends Received Deduction (DRD) (slide 2 of 2)

1. Multiply dividends received by deduction percentage

2. Multiply taxable income by deduction percentage

3. The deduction is limited to the lesser of Step 1 or Step 2, unless subtracting the amount derived from Step 1 from taxable income generates a negative number

-If so, the amount derived in step 1 should be used

20

DRD Examples

Z Corp owns 60% of X Corp’s stock in years 1, 2 & 3. Dividend of $200 is received each year. Limit (Step 1) is 80% × $200 = $160.

1 2 3_ Income 400 301 299Dividend rec’d 200 200 200Expenses (340) (340) (340)Income before DRD 260 161 15980% of income 208 129 127

Year #1 $208 > $160, so $160 DRDYear #2 $129 < $160, so $129 DRDYear #3 DRD causes NOL ($159-$160), so $160 DRD is used.

$2 less income results in $31 more DRD.

21

Organizational Expenditures (slide 1 of 2)

• A corporation may elect to amortize organizational expenses over a period of 15 years or more– A special exception allows the corporation to

immediately expense the first $5,000 of these costs• Phased out on a dollar-for-dollar basis when these

expenses exceed $50,000

22

Organizational Expenditures (slide 2 of 2)

• Organizational expenditures include the following:– Legal services incident to organization – Necessary accounting services– Expenses of temporary directors and of organizational

meetings of directors and shareholders– Fees paid to the state of incorporation

• Expenditures connected with issuing or selling shares of stock or other securities or with the transfer of assets to a corporation do not qualify– These expenditures are generally added to the capital

account and are not subject to amortization

23

Corporate Tax RatesTaxable Income Tax Rate Not over $50,000 15%Over $50,000 but not over $75,000 25%Over $75,000 but not over $100,000 34%Over $100,000 but not over $335,000 39%*Over $335,000 but not over $10,000,000 34%Over $10,000,000 but not over $15,000,000 35%Over $15,000,000 but not over $18,333,333 38%**Over $18,333,333 35%

*5% of this rate represents a phaseout of the benefits of the lower tax rates on the first $75,000 of taxable income.**3% of this rate represents a phaseout of the benefits of the lower tax rate (34% rather than 35%) on the first $10 million of taxable income.

24

Corporate Tax Returns(slide 1 of 2)

• Form 1120 must be filed whether the corporation has taxable income or not

• Due date for the return is the 15th day of the third month following year-end– Automatic extension of 6 months can be obtained

by filing Form 7004

25

Corporate Tax Returns(slide 2 of 2)

• Taxable Income and accounting net income is reconciled using Schedule M-1

• Schedule M-2 is used to reconcile beginning and ending retained earnings

• Schedule M–3 must be filed by certain corporations– Designated “Net Income (Loss) Reconciliation for

Corporations With Total Assets of $10 Million or More”• Prepared in lieu of Schedule M–1• Because it will reveal significant differences between book and

taxable income, Schedule M–3 will enable the IRS to more quickly identify possible abusive transactions

26

Corporate Formation(slide 1 of 3)

• Transfers of property by shareholders to a newly-formed corp. in exchange for its stock receive nonrecognition treatment under §351 if transferors control (80%) the corp. immediately after the exchange– Receipt of boot by shareholders triggers gain

recognition– Receipt of stock for services is always taxable as

ordinary income

27


• Shareholder’s basis in shares received is calculated as follows:– Basis of property transferred + any gain

recognized – FMV of boot received• Basis of boot will be its FMV

• Corp’s basis in property transferred is calculated as follows:– Shareholder’s adjusted basis of property

transferred + gain recognized on the transfer

28


• Thin capitalization can be a problem if there is too much debt and not enough equity issued at formation– If debt has too many features of stock, it may be

treated as a form of stock• Results in principal and interest payments being treated

as dividend distributions

29

The Big Picture - Example 21

Minimum Capitalization• Return to the facts of The Big Picture on p. 20-1.

• Suppose that the Todd sisters decide to conduct their catering business in the corporate form—either a C or an S corp.

• In forming the corp., they should probably limit their capital investment to whatever state law requires. – Consider acquiring the capital assets needed to operate the business on

their own and leasing them to the corporation.• e.g., delivery trucks, kitchen equipment, location for food preparation.

– This allows the sisters to claim depreciation while providing the corp. with a deduction for the rent paid.

• This strategy forces the sisters to recognize rent income rather than preferentially taxed dividends.– However, no dividends are likely in the early years of the business.

30

Corporate Distributions(slide 1 of 5)

• Distributions to shareholders are treated as dividend income to the extent of current or accumulated earnings and profits (E&P)

• Distributions in excess of E&P are:– First, a return of capital (to the extent of basis) – Any excess is capital gain

31


• Qualified dividend income is taxed like net long-term capital gain– Consequently, the tax rate on such income cannot

exceed 20% • 0% for individual shareholders in the 15% or lower tax

bracket,• 15% for individual shareholders in the 25% to 35% tax

brackets, • 20% for individual shareholders in the 39.6% tax

bracket

32


• E & P is similar to the accounting concept of retained earnings, and is determined by making adjustments to taxable income including– As additions-

• Dividends received deduction• Domestic production activities deduction• Proceeds of life insurance policies on key employees

– As subtractions-• Federal income taxes paid• Charitable contributions in excess of the 10% limitation• Excess capital losses (no carryback available)• Nondeductible items (e.g., fines, penalties, losses between related parties)

• Accumulated E & P is the sum of the corporation’s past current E & P that has not been distributed as dividends

33


• Property distributions are measured by the FMV of the asset and taxed to recipient like cash dividends– Shareholder’s basis in property is FMV

• Corporation recognizes gain when appreciated property is distributed to shareholders

34


• Constructive dividends are taxed as dividends to the extent of the corporation’s E&P

• Examples of constructive dividends include:– Unreasonable salaries and rents paid to

shareholder/employees– Interest free loans to shareholders– Shareholder use of corporate property at less than

arm’s length rate

35


Constructive Dividends• Return to the facts of The Big Picture on p. 20-1 and the suggestions made

in Example 21.

• If they choose the corporate form, the Todd sisters need to take the following into account:– Any salaries the sisters pay themselves should satisfy the

reasonableness test.– Rent charged the corp. for the use of capital assets owned by the sisters

should meet the arm’s length standard.– Loans made to the corp. for working capital purposes should provide

for a market rate of interest to be charged.

• The constructive dividend issue should not arise until the corp. becomes profitable (and has E & P). – These procedures should be structured at the outset so that the parties

will be prepared for a possible future challenge by the IRS.

36

Subchapter S Corporations(slide 1 of 7)

• Requirements to qualify as a Subchapter S corporation:– Be a domestic corporation– Have no more than 100 shareholders– Shareholders must be individuals, estates, and

certain trusts– No nonresident alien shareholders– Have only one class of stock outstanding

37


• S corporation election– All shareholders must initially consent to the

election– To be effective for the current year, election must

be made either in the prior year or by the 15th day of the third month of the current year

38


• Loss of S corporation election– S election can be terminated voluntarily (e.g., by

majority of shareholders) or involuntarily (e.g., ceases to qualify as an S corporation or has excessive investment income)

– If the election is terminated, the corporation generally cannot reelect for 5 years

39


• Operations– S corporation generally applies the flow-through

concept (like partnerships), i.e., income is taxed only to the owners

– Income or loss and separately stated items are allocated to the owners on a per share per day basis

40


• Operations– Shareholders can deduct losses to the extent of

their basis in the S corp. stock and their loans to the corporation

– Any remaining loss can be carried forward and deducted when and if it is covered by basis

41


• Basis in stock– Original cost

• Plus: capital contributions and shareholder’s proportionate share of S income and gains

• Less: distributions and shareholder’s proportionate share of S losses and deductions

• If distributions exceed a shareholder’s basis, the excess normally receives capital gain treatment

42


• Corporation’s basis in contributed property– Generally a carryover basis from the contributing

shareholder

43


Treatment Of Losses• Return to the facts of The Big Picture on p. 20-1.

• Recall that the Todd sisters anticipate losses in the early years of their catering business. – If they form a C corp., such losses will be of no benefit to

the new corporation.• No carryback will be available, and

• There will be only a potential for a delayed carryover.

– With an S election, however, losses pass through currently.

• Thus, the sisters will secure limited liability for their business and the immediate tax benefit of any losses.

44

Partnerships(slide 1 of 6)

• Taxation– Partnerships are flow-through entities

• Thus, tax reporting rather than tax paying entities

– Tax return (Form 1065) is due on the 15th day of the fourth month following year-end

45


• Formation– Like corporations, partnerships can be formed with

no recognition of gains or losses by the partners or the partnership

– Exceptions to nonrecognition include:• Receipt of boot on partnership formation

• Receipt of partnership interest for services rendered

• Transfer of property subject to a liability in excess of basis

46


• Operations– Income or loss and separately stated items are

allocated to the partners based on their proportionate share of ownership

– Special allocations of income or expense items are allowed as long as they have substantial economic effect

– Partners can deduct losses to the extent of their basis in the partnership

47


• Partner’s basis– A partner’s basis in the partnership interest is

determined in a similar manner as a shareholder’s basis in an S corporation

– In addition, a partner’s share of the entity’s liabilities increases the partner’s basis

48


• Partnership’s basis in contributed property– Generally a carryover basis from the contributing

partner

49


• Related party transactions– Partners entering into transactions with their

partnership will, in most cases, be treated as an outsider (i.e., not a related party)

• Guaranteed payments are payments to partners for services or use of capital that are treated as payments to outsiders

– Certain exceptions exist

50

Refocus On The Big Picture (slide 1 of 3)

• A principal concern of the Todd sisters is limited liability. – A food preparation business involves potential liability.

• e.g., litigation resulting from food poisoning. – This hazard is further magnified by carrying minimal

liability insurance coverage. – To obtain limited liability, therefore, the choice of entity

cannot be a regular partnership• It must be a C or S corp. or a limited liability company (LLC).

• The next concern is the pass-through of losses in the early years of the business. – This cannot be achieved with a C corp. and is only

available with an S corp. or an LLC.

51


• In making the choice between a corporation and an LLC, the future must be considered.– If the business is successful, the sisters could expand.

– This is more easily accomplished with a corporation than an LLC.

– A corporation can raise additional capital for expansion by issuing more stock—even going public if necessary.

– Issuing additional stock may cause the S corporation election to be lost, but by then S status will have served its purpose (i.e., pass-through of losses).

52


• When forming the corporation, the sisters should take the following into account:– Key assets (e.g., food preparation facilities) might better be purchased

by the sisters and leased to the corporation. • This approach leads to a rent deduction for the corporation.

– A viable salary structure should be established for the services the sisters perform.

• This generates a salary deduction for the corporation.

– Interest should be charged for the funds the sisters loan to the corporation.

• This yields an interest deduction for the corporation.

– If the S corporation becomes a C corporation, these rent, salary, and interest deductions will reduce the taxable income of the corporation and thereby lower any corporate income tax imposed.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 53

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

Vol 01 chapter 20 2015

Documents

corporation entities

catering business

type of entity

conduit entity flow

big picture slide

todd sisters

box regulations entity

sisters plan