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					                                     CHAPTER 15

     COMPARATIVE FORMS OF DOING BUSINESS



                                            NOTES


FORMS OF DOING BUSINESS

PRINCIPAL FORMS

1.   Legal Forms. Business entities can be organized into the following principal legal forms:

     a.     Sole proprietorship.

     b.     Partnership.

     c.     Corporation.

2.   Tax Forms. For Federal tax purposes, the same forms are available.

     a.     The corporation further can be structured in either of the following forms:

            (1)     C (regular) corporation.

            (2)     S corporation.

     b.     While the tax form usually is the same as the legal form, differences can occur.

            (1)     The IRS may ignore the corporate form and tax the owners directly (i.e.,
                    the corporate entity lacks substance).

            (2)     The IRS may ignore the partnership form and tax the partnership as if it
                    were a corporation.

3.   Reporting. The different tax entities report the results of operations as follows:

     a.     Sole proprietorship: Schedule C of Form 1040.

     b.     Partnership: Form 1065.


                                               15-1
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       c.    Corporation: Form 1120.

       d.    S corporation: Form 1120S.

 4.    Limited Liability Company.

       a.    Hybrid business form.

             (1)    Has corporate characteristic of limited liability for the owners.

             (2)    Has tax characteristics of the partnership.


       b.    All of the states now permit this legal form for conducting a business (i.e., as a
             limited liability corporation, a limited liability partnership, or both).

       c.    Major accounting firms now operate as LLCs (i.e., each is now a limited liability
             partnership).

       d.    Other benefits of LLCs when compared with other forms of ownership:

             (1)    S corporation.

                    (a)     Greater flexibility in terms of the number of owners, types of
                            owners, special allocation opportunities, and capital structure.

                    (b)     Inclusion of entity debt in the owner’s basis for an ownership
                            interest.

                    (c)     More liberal requirements on recognition of gain on contributions
                            of appreciated property by an owner (determined under § 721
                            rather than § 351).

                    (d)     For securities law purposes, an ownership in a limited liability
                            company is not necessarily a security.

             (2)    C corporation.

                    (a)     Ability to pass tax attributes through to the owners.

                    (b)     Absence of double taxation.

             (3)    Limited partnership.
      Comparative Forms of Doing Business                            15-3


(a)    Right of all owners to participate in the management of the
       business.
15-4


                      (b)    Ability of all owners to have limited liability (no need for a general
                             partner).

                      (c)    For securities law purposes, an ownership interest in a limited
                             liability company is not necessarily a security (the interest of a
                             limited partner normally is classified as a security).

              (4)     General partnership.

                      (a)    Ability of owners to have limited liability.

                      (b)    Greater continuity of life.

                      (c)    Able to limit the ability of the owner to withdraw from the
                             business.

       f.     Disadvantages of LLCs.

              (1)     Absence of a developed body of case law on limited liability companies.

              (2)     Frequent absence of continuity of life (e.g., limited to 30 years by many
                      states) and free transferability of interests.

              (3)     Requirement in most states that there be at least two owners.

              (4)     Inability to qualify for § 1244 ordinary loss treatment.

       g.     Revenue Ruling 88-76 provided initial authority for tax treatment.

NONTAX FACTORS

 5.    Tax Versus Nontax Factors. In selecting an entity form, nontax, as well as tax, factors
       must be considered.

       a.     The reduction of tax rates by TRA of 1986 has lessened the relevance of taxation
              as a significant factor. The rate increases in RRA of 1990 and in RRA of 1993
              have restored some of this reduced relevance.

       b.     Any business decision should make economic sense.

       c.     The ease of capital formation may be an important factor.

       d.     The ability to limit the owner’s ultimate financial liability may be a relevant
              factor.
            Comparative Forms of Doing Business                               15-5


(1)   Both the regular corporation and the S corporation forms possess this
      attribute.
15-6


              (2)     A limited partnership can achieve this objective for the limited partners.

              (3)     Neither the sole proprietorship nor the general partnership possesses this
                      attribute.

       e.     Other nontax factors include:

              (1)     Estimated life of the business.

              (2)     Number of owners and their roles in the management of the business.

              (3)     Freedom of choice in transferring ownership interests.

              (4)     Organizational formality including the related cost and extent of
                      governmental regulation.

SINGLE VERSUS DOUBLE TAXATION

OVERALL IMPACT ON ENTITY AND OWNERS

 6.    Double Taxation. Double taxation occurs when both the entity and the owners are taxed
       on the entity’s earnings.

       a.     The regular corporate form may be subject to double taxation, in that the
              corporation is taxed on its earnings and the shareholders of the corporation are
              taxed on the corporate earnings which are distributed to the shareholders as
              dividends. Further, Personal Service Corporations are taxed at a flat rate of 35%.

       b.     S corporations, partnerships, and sole proprietorships are subject to single
              taxation.

              (1)     The owners of these entities, and not the business itself, are taxed on the
                      entity earnings (i.e., the entity is a tax reporter rather than a taxpayer).

              (2)     This approach is an application of the conduit theory.

              (3)     In limited circumstances, the S corporation may be subject to taxation at
                      the corporate level (e.g., built-in gains tax, passive investment income
                      tax).

 7.    In calculating the corporate tax liability, consideration must be given to the alternative
       minimum tax.

       a.     The corporate rate is 20% as compared to the noncorporate rates of 26%/28%.
                   Comparative Forms of Doing Business                              15-7


b.   The corporation is subject to a special adjustment for adjusted current earnings
     (ACE adjustment).
15-8


       c.     Repeal for small corporations. TRA of 1997 has repealed the AMT for small
              corporations for tax years beginning after December 31, 1997.

              (1)     A corporation is classified as a small corporation if it had average annual
                      gross receipts of less than $5 million for the three-year period after
                      December 1993.

              (2)     A corporation will continue to be classified as a small corporation if its
                      average annual gross receipts for the three-year period preceding the
                      current tax year and any intervening three-year periods do not exceed $7.5
                      million.

              (3)     Automatic classification as a small corporation in first year of existence.
                      This automatic classification was provided in the IRS Restructuring and
                      Reform Act of 1998.

 8.    State and Local Taxation Effects. Consideration should also be given to the effect of state
       income taxes, and, if applicable, to local income taxes (e.g., S corporation status at the
       state level).

MINIMIZING DOUBLE TAXATION

 9.    A technique for the corporation to use to avoid double taxation is to get assets out of the
       entity to the owners with payments which are deductible at the corporate level. Ideally,
       this technique is used to reduce the corporate taxable income to zero and effectively
       convert the potential for double taxation to single taxation.

       a.     Salaries can be paid to shareholder-employees.

       b.     Interest payments can be made on loans made by the shareholders to the
              corporation.

       c.     Lease rental payments can be made on assets owned outside the corporation by the
              shareholders and leased to the corporation.

       d.     All of the above items are subject to the test of reasonableness.

10.    Another technique for the corporation to use to avoid double taxation is to not make
       distributions to the shareholders.

       a.     Applied to the ultimate, taxation would never occur at the shareholder level, as the
              result of the step-up in basis rules for inherited property (i.e., at the time of the
              shareholder’s death).
                  Comparative Forms of Doing Business                             15-9


b.   Closely held corporations must be aware of the potential assessment of the
     accumulated earnings tax (AET) by the IRS.
15-10


               (1)     The accumulated earnings tax is assessed at the rate of 15% on the current
                       year’s addition to E&P.

               (2)     The 15% rate has applied since 2003. It was formerly 35%. Because of the
                       rate change the impact of the AET has been substantially decreased.

11.     A distribution that is a return of capital can also avoid double taxation.

        a.     When earnings and profits are low or negative a distribution may be a tax free
               return of capital.

        b.     Qualified stock redemptions may also result in some return of capital.

               (1)     Redemption price in excess of stock basis is capital gain for a qualified
                       stock redemption

               (2)     Care must be taken in structuring the stock redemption. Transactions that
                       do not qualify as stock redemptions are treated as dividends.

12.     Another technique for the corporation to use to avoid double taxation is to elect S
        corporation status. In addition to avoiding double taxation, subchapter S status also
        avoids any potential accumulated earnings tax and personal holding company tax.

CONDUIT VERSUS ENTITY TREATMENT

EFFECT ON RECOGNITION AT TIME OF CONTRIBUTION
TO THE ENTITY

13.     Partnership. Since the conduit concept is applied under § 721 for contributions by a
        partner to a partnership, realized gain or loss is not recognized on property contributions.

        a.     Partnership and partner level. The nonrecognition applies at both the partnership
               and the partner level.

        b.     Basis for partnership interest. Section 722 provides that the partner’s basis (i.e.,
               outside basis) for his or her ownership interest is a carryover basis.

        c.     Basis for partnership assets. Section 723 provides that the partnership’s basis (i.e.,
               inside basis) for its assets is a carryover basis.

        d.     Effect of liabilities. Partnership liabilities affect the partner’s basis for his or her
               partnership interest.

               (1)     Partner’s basis is increased by his or her share of partnership liability
                       increases.
Comparative Forms of Doing Business   15-11
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               (2)     Partner’s basis is decreased by his or her share of partnership liability
                       decreases.

        e.     Special allocation. A mandatory special allocation is provided under § 704(c) for
               contributed assets whose basis and fair market value are not equal.

14.     Corporation. Since the entity concept generally applies for the corporation, contributions
        by a shareholder to the corporation would result in recognized gain or loss to the extent of
        the difference in the asset basis and the fair market value.

        a.     Section 351 exception. However, if the requirements of § 351 can be satisfied, the
               conduit concept is applied instead and the tax consequences are the same as for
               the partnership under § 721 with respect to the recognition of realized gains and
               losses.

        b.     Control requirement. The critical requirement of § 351 is the 80% control
               requirement under § 368(c).

        c.     Basis for stock. If the § 351 requirements are satisfied, the shareholder’s stock
               basis is a carryover basis. If § 351 does not apply, the shareholder’s stock basis is
               equal to the fair market value of the contributed property. See § 358.

        d.     Basis for corporate assets. If the § 351 requirements are satisfied, the
               corporation’s basis for its assets is a carryover basis. If § 351 does not apply, the
               corporation’s basis for its assets is equal to the fair market value. See § 362.

        e.     Effect of liabilities. Corporate liabilities do not affect the shareholder’s stock
               basis.

15.     S Corporation. Since the S corporation legally is a corporation, the corporate contribution
        rules apply.

        a.     Recognition. Recognition is determined under § 351.

        b.     Basis for stock. Stock basis is determined under § 358.

               (1)     Initially, the stock basis is a carryover basis increased by any gain
                       recognized by the shareholder on the contribution.

               (2)     Subsequently, the stock has a basis which contains attributes of both the
                       partnership rules and the corporation rules. Like the partnership rules, the
                       shareholder’s stock basis is increased (or decreased) by his or her share of
                       S corporation profits (or losses). Like the corporation rules, the
                       shareholder’s stock basis is not affected by the entity liability increases and
                       decreases.
                   Comparative Forms of Doing Business                    15-13



c.   Basis for corporate assets. Asset basis is determined under § 362.
15-14


EFFECT ON BASIS OF OWNERSHIP INTEREST

16.     For an LLC, contributions of property in return for an ownership interest are not taxable
        under § 721. Therefore, the owner takes a carryover basis.

EFFECT ON RESULTS OF OPERATIONS

17.     Partnership. The conduit concept applies and the partnership is a tax reporter, and the
        partners are the taxpayers.

        a.     Special items. Any item that is subject to special treatment on the partner’s tax
               return is reported separately to the partners rather than being reported as part of
               partnership taxable income.

        b.     Effect on outside basis. Since the partner is taxed on the distributive share of the
               profits, such amount increases the partner’s basis for the partnership interest.

18.     Corporation. The entity concept applies and the corporation is the taxpayer.

        a.     Effect on shareholder. The shareholder is subject to taxation only if the earnings
               are distributed in the form of dividends.

        b.     Effect on shareholder’s stock basis. The shareholder’s stock basis is not affected
               by the corporate earnings.

               (1)     Dividend distributions have no effect on the shareholder’s stock basis.

               (2)     If the amount of the distribution exceeds the corporation’s earnings and
                       profits, the shareholder’s stock basis is reduced by the amount of the
                       excess. Since stock basis cannot be negative, once a shareholder’s stock
                       basis is reduced to zero, any excess amount remaining is treated as capital
                       gain.

19.     S Corporation. The conduit concept generally applies and the S corporation is a tax
        reporter, and the shareholders are the taxpayers.

        a.     Special items. Any item that is subject to special treatment at the shareholder level
               is reported separately to the shareholder rather than being reported as part of the
               corporate taxable income.

        b.     Effect on shareholder’s basis. Since the shareholder is taxed on his or her pro rata
               share of the profits, such amount increases the shareholder’s stock basis.

        c.     S corporation as taxpayer. Potential taxes levied at the corporate level include the
               following:
Comparative Forms of Doing Business   15-15
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               (1)     Tax on built-in gains.

               (2)     Tax on certain net capital gains.

               (3)     Tax on certain passive investment income.

EFFECT ON RECOGNITION AT TIME OF DISTRIBUTIONS

20.     Partnership. Since the conduit concept applies, the general objective is for recognition of
        gain or loss not to occur at the time of the distribution.

        a.     Nonliquidating distribution. A distribution is made that does not terminate the
               partner’s ownership interest in the partnership. Such distributions are also referred
               to as current distributions.

               (1)     Realized losses are not recognized by the partner because the partner
                       remains a partner.

               (2)     Realized gains are not recognized by the partner except to the extent any
                       money received exceeds the partner’s basis for the partnership interest.

        b.     Liquidating distribution. A distribution is made that does terminate the partner’s
               ownership interest in the partnership.

               (1)     Realized losses are not recognized by the partner unless no property other
                       than money, unrealized receivables, and inventory are received by the
                       partner and the partner’s basis for the ownership interest exceeds the
                       partnership’s adjusted basis for such assets distributed.

               (2)     Realized gains are not recognized by the partner except to the extent any
                       money received exceeds the partner’s basis in the partnership interest.

21.     Corporation. Since the entity concept applies, distributions by the corporation to the
        shareholder generally are taxable to the shareholder.

        a.     Dividends. Distributions will be taxed as dividends to the extent of the current
               earnings and profits and the accumulated earnings and profits at the beginning of
               the taxable year.

        b.     Return of capital. To the extent that the distributions exceed the earnings and
               profits, such excess is treated as a return of capital.

               (1)     Initially, the shareholder’s stock basis is reduced to zero.

               (2)     Any remaining amount of the distribution is treated as capital gain.
Comparative Forms of Doing Business   15-17
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        c.     Stock redemptions and complete liquidations. Both qualifying stock redemptions
               and complete liquidations apply return of capital treatment.

22.     S Corporation. Since the conduit concept applies, the general objective is for recognition
        of gain or loss not to occur at the time of the distribution. The following distribution
        sequence applies.

        a.     Distributions are tax-free to the extent of the Accumulated Adjustments Account
               (AAA). The stock basis account is reduced by the same amount.

        b.     Distributions in excess of (a) above receive dividend treatment to the extent of
               accumulated earnings and profits (i.e., associated with regular corporation taxable
               years).

        c.     Distributions in excess of (a) and (b) are tax-free to the extent of the shareholder’s
               stock basis.

        d.     Distributions in excess of (a), (b), and (c) receive capital gain treatment.

EFFECT ON PASSIVE ACTIVITY LOSSES

23.     Partnership and S Corporation. The passive activity loss rules apply to both the
        partnership and the S corporation (i.e., at the owner level).

24.     Corporation. The passive activity rules generally do not apply to a regular corporation.
        However, they do apply to the following:

        a.     Personal service corporation.

              (1)      The usual § 469 rules apply in that passive activity losses cannot be offset
                       against either active income or portfolio income. Such losses can be offset
                       against passive income.

              (2)      A personal service corporation is one where:
                       - The principle activity is the performance of a service
                       - The service is substantially performed by owner-employees
                       - Owner-employees own more than 10% in value of the outstanding stock.

        b.     Closely held corporation.

               (1)     Passive activity losses cannot be offset against portfolio income. Such
                       losses can be offset against passive income and active income.
            Comparative Forms of Doing Business                            15-19


(2)   A closely held corporation exists when more than 50% of the value of the
      outstanding stock at any time during the last half of the taxable year is
      owned by or for not more than five individuals.
15-20


EFFECT OF AT-RISK RULES

25.     Partnership and S Corporation. The at-risk rules apply to both the partnership and the S
        corporation (i.e., at the owner level).

26.     Corporation. The at-risk rules generally do not apply to a C corporation. However, they
        do apply to certain closely held corporations.

EFFECT OF SPECIAL ALLOCATIONS

27.     Partnership Advantage. The opportunity to make special allocations is available only to
        the partnership form of business entity.

        a.     Included are the following opportunities.

               (1)     The ability to share profits and losses differently from the share in capital.

               (2)     The ability to share profits and losses differently.

               (3)     The special allocation required under § 704(c) for the difference between
                       the adjusted basis and the fair market value of contributed property.

               (4)     The special allocation of any item permitted under § 704(a) if the
                       substantial economic effect rule of § 704(b) is satisfied.

               (5)     The optional adjustment to basis permitted under § 734 that results from
                       partnership distributions (negative basis adjustment is mandatory if there
                       is a “substantial basis reduction”).

               (6)     The optional adjustment to basis permitted under § 743 that results from
                       an acquisition by purchase, taxable exchange, or inheritance (negative
                       basis adjustment is mandatory if there is a “substantial built-in loss”).

        b.     Note that most special allocations are elective rather than mandatory.

DISPOSITION OF A BUSINESS OR AN OWNERSHIP INTEREST

28.     Sole Proprietorship.

        a.     Form is not critical. Regardless of the form of the transaction, the sale of a sole
               proprietorship is treated as the sale of individual assets.

               (1)     Form can be the sale of the assets.

               (2)     Form can also be the sale of the ownership interest.
Comparative Forms of Doing Business   15-21
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        b.     Resultant calculation. Gains and losses must be calculated separately for the
               different assets.

               (1)     Ordinary income property such as inventory results in ordinary gains and
                       losses.

               (2)     Section 1231 property such as land, buildings, and machinery used in the
                       business will produce § 1231 gains and losses (subject to §§ 1245 and
                       1250 depreciation recapture).

               (3)     Capital assets such as investment land and stocks qualify for capital gain
                       or loss treatment.

        c.     Goodwill versus a covenant not to compete.

               (1)     Seller prefers labeling the excess of amount received over the fair market
                       value of the identifiable assets as goodwill because such recognized gain is
                       classified as capital gain.

               (2)     Buyer traditionally preferred the excess being for a covenant not to
                       compete because the covenant could be amortized, whereas goodwill
                       could not.

               (3)     RRA of 1993 neutralized this negative tax consequence of goodwill for the
                       buyer by providing that both goodwill and covenants are to be amortized
                       over a 15-year statutory period.

29.     Partnership.

        a.     Form of sales transaction is relevant to sellers.

               (1)     If structured as the sale of assets, the treatment is the same as that
                       described above for the sale of a sole proprietorship.

               (2)     If structured as the sale of an ownership interest, the transaction is treated
                       as the sale of a capital asset under § 741 (subject to ordinary income
                       potential under § 751 for unrealized receivables and substantially
                       appreciated inventory).

        b.     Form of purchase transaction is not relevant to buyers if they purchase the entire
               partnership interests or partnership assets.

               (1)     Basis of assets to the partnership will be the fair market value (i.e., amount
                       paid by buyers).
            Comparative Forms of Doing Business                               15-23


(2)   If partnership interests are purchased, the old partnership will terminate
      and be replaced by a new partnership.
15-24


        c.     Form of sales transaction may be relevant to buyers if they do not purchase the
               entire partnership interests.

               (1)     Potential problem does not arise for an asset purchase, because the basis of
                       the assets purchased will be the fair market value (i.e., amount paid by
                       buyers). If buyer (or buyers) decides to contribute the assets to a
                       partnership, the fair market value basis will carry over to the partnership.

               (2)     If the buyer (or buyers) purchases a partnership interest from another
                       partner and the amount paid exceeds the new partner’s pro rata share of the
                       partnership’s basis for the assets, a basis problem may arise for the new
                       partner for the partnership assets.

                       (a)     If the new partner, in conjunction with the other new partners, does
                               not acquire at least a 50% capital and profits interest, the older
                               partnership may not terminate.

                       (b)     Thus, the partnership basis for its assets, with respect to the new
                               partner, will not change.

                       (c)     This problem can be eliminated for the new partner through the
                               election (made by the partnership) under § 754 which will activate
                               § 743 which will provide for a special basis adjustment for the new
                               partner.

30.     Corporation.

        a.     Form of the sales transaction is relevant to both the buyers and the sellers.

        b.     Seller prefers a stock sale.

               (1)     Seller qualifies for capital gain or loss treatment (i.e., for the difference
                       between the amount realized and the stock basis).

               (2)     No double taxation because the corporation is not included in the
                       transaction.

        c.     Buyer prefers an asset purchase.

               (1)     Purchased assets can be contributed to a corporation under § 351 and will
                       have a fair market value basis (i.e., amount paid by the buyer).

               (2)     If the corporate stock is purchased, the corporation is not involved in the
                       sales/purchase transaction. Thus, the corporate assets will have a carryover
                       basis.
Comparative Forms of Doing Business   15-25
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               (3)     Buyer who is forced to purchase the corporate stock can step up the asset
                       basis to the fair market value (i.e., amount paid for the stock) with an
                       election under § 338. However, this deemed sale/deemed purchase
                       approach will result in recognition to the buyer.

31.     S Corporation. Since the S corporation is a corporation, the provisions discussed above
        for a corporation apply.

OVERALL COMPARISON OF FORMS OF DOING BUSINESS

32.     Tax Attributes of Different Forms of Business.
        See Concept Summary 15-2. (Assume Partners and Shareholders Are All Individuals).

				
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