"Nj Legal Business Entities"
Chapter 9 Corporations: Organization, Capital Structure, and Operating Rules Taxation of Business Entities C9-1 Various Business Forms • Sole proprietorships • Partnerships • Trusts and estates • S corporations • Regular corporations (also called C corporations) Taxation of Business Entities C9-2 Sole Proprietorship • Not a separate taxable entity • Income reported on owner’s Sch. C Taxation of Business Entities C9-3 Partnership • Separate entity, but does not pay tax • Allocates partnership income to partners – Partners report partnership income on personal tax returns • Files information return (Form 1065) Taxation of Business Entities C9-4 S Corporation • Separate entity, only pays special taxes (e.g., built-in gains) • Allocates entity income to shareholders – Shareholders report entity income on personal tax return • Files information return (Form 1120S) Taxation of Business Entities C9-5 C Corporation • Separate tax-paying entity – Reports income and expenses on Form 1120 (or Form 1120-A) • Income taxed at corporate level and again at owner level when distributed as a dividend Taxation of Business Entities C9-6 Dividends • Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate income – Generally, dividends received in taxable years beginning after 2002 are taxed at same marginal rate applicable to a net capital gain • Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 0% tax on qualified dividends received • Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends Taxation of Business Entities C9-7 Corporate Income Tax Rates $50,000 or less 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% Taxation of Business Entities C9-8 Nontax Issues in Selecting Entity Form (slide 1 of 3) • Liability – Sole proprietors and some partners have unlimited liability for claims against the entity • Capital-raising – Corporations and partnerships to a lesser extent can raise large amounts of capital for entity ventures Taxation of Business Entities C9-9 Nontax Issues in Selecting Entity Form (slide 2 of 3) • Transferability – Corporate stock is easily sold, but partners must approve partnership interest transfer • Continuity of life – Corporations exist indefinitely Taxation of Business Entities C9-10 Nontax Issues in Selecting Entity Form (slide 3 of 3) • Centralized management – Corporate actions are governed by a board of directors – Partnership operations may be conducted by each partner without approval by other partners Taxation of Business Entities C9-11 Limited Liability Companies (LLC) • LLCs have proliferated since 1988 when IRS ruled it would treat qualifying LLCs as partnerships – Major nontax advantage • Allows entity to avoid unlimited liability – Major tax advantage • Allows qualifying business to be treated as a partnership for tax purposes, thereby avoiding double taxation associated with C corporations Taxation of Business Entities C9-12 Entity Classification After 1996 (slide 1 of 2) • Check-the-box Regulations – Allows taxpayer to choose tax status of entity without regard to corporate or noncorporate characteristics – Entities with > 1 owner can elect to be classified as partnership or corporation – Entities with only 1 owner can elect to be classified as sole proprietorship or as corporation Taxation of Business Entities C9-13 Entity Classification After 1996 (slide 2 of 2) • Check-the-box Regulations (cont’d) – If no election is made, multi-owner entities treated as partnerships, single person businesses treated as sole proprietorships – Election is not available to: • Entities incorporated under state law, or • Entities required to be corporations under federal law (e.g., certain publicly traded partnerships) Taxation of Business Entities C9-14 Consequences of §351 (slide 1 of 2) • In general, no gain or loss to transferors: – On transfer of property to corporation – In exchange for stock – IF immediately after transfer, transferors are in control of corporation Taxation of Business Entities C9-15 Consequences of §351 (slide 2 of 2) • If boot (property other than stock) received by transferors – Gain recognized up to lesser of: • Boot received or • Realized gain – No loss is recognized Taxation of Business Entities C9-16 Formation Example Ron will incorporate his donut shop: Asset Fair Mkt Tax Basis Value . Cash $10,000 $ 10,000 Furniture & Fixtures 20,000 60,000 Building 40,000 100,000 Total $70,000 $170,000 • Without §351: gain of $100,000. • With §351: no gain or loss. Ron’s economic status has not changed. Taxation of Business Entities C9-17 Issues re: Formation (slide 1 of 7) • Definition of property includes: – Cash – Secret processes and formulas – Unrealized accounts receivable (for cash basis taxpayer) – Installment obligations • Code specifically excludes services from definition of property Taxation of Business Entities C9-18 Issues re: Formation (slide 2 of 7) • Stock transferred – Includes common and most preferred stock • Does not include nonqualified preferred stock which possesses many attributes of debt – Does not include stock rights or stock warrants – Does not include corporate debt or securities (e.g., corporate bonds) • Treated as boot Taxation of Business Entities C9-19 Issues re: Formation (slide 3 of 7) • Transferors must be in control immediately after exchange to qualify for nontaxable treatment – To have control, transferors must own: • 80% of total combined voting power of all classes of stock entitled to vote, and • 80% of total number of shares of all other classes of stock Taxation of Business Entities C9-20 Issues re: Formation (slide 4 of 7) • “Immediately after” the transfer – Does not require simultaneous transfers if more than one transferor – Rights of parties should be outlined before first transfer – Transfers should occur as close together as possible Taxation of Business Entities C9-21 Issues re: Formation (slide 5 of 7) • After control is achieved, it is not necessarily lost upon the sale or gift of stock received in the transfer to others not party to the initial exchange • But disposition might violate §351 if prearranged Taxation of Business Entities C9-22 Issues re: Formation (slide 6 of 7) • Transfers for property and services – May result in service provider being treated as a member of the 80% control group • Taxed on value of stock issued for services • Not taxed on value of stock received for property contributions – Service provider should transfer property having more than “a relatively small value” Taxation of Business Entities C9-23 Issues re: Formation (slide 7 of 7) • Subsequent transfers to existing corporation – Tax-free treatment still applies as long as transferors in subsequent transfer own 80% following exchange Taxation of Business Entities C9-24 Assumption of Liabilities (slide 1 of 2) • Assumption of liabilities by corp DOES NOT result in boot to the transferor shareholder for gain recognition purposes – Liabilities ARE treated as boot for determining basis in acquired stock • Basis of stock received is reduced by amount of liabilities assumed by the corp Taxation of Business Entities C9-25 Assumption of Liabilities (slide 2 of 2) • Liabilities are NOT treated as boot for gain recognition unless: – Liabilities incurred for no business purpose or as tax avoidance mechanism • Boot = Entire amount of liability – Liabilities > basis in assets transferred • Gain recognized = Excess amount (liabilities - basis) Taxation of Business Entities C9-26 Formation with Liabilities Example (slide 1 of 2) Property transferred has: Fair market value = $150,000 Basis = 100,000 Realized Gain = $ 50,000 Taxation of Business Entities C9-27 Formation with Liabilities Example (slide 2 of 2) Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $80,000 $120,000 $120,000 Boot None $ 20,000 $120,000 Gain Recognized None $20,000 $ 50,000* *(Gain is lesser of $50,000 realized gain or boot) Taxation of Business Entities C9-28 Basis Computation for §351 Exchange (slide 1 of 2) • Shareholder’s basis in stock: Adjusted basis of transferred assets + Gain recognized on exchange - Boot received - Liabilities transferred to corporation - Minus: Adjustment for loss property (if elected) = Basis of stock received by shareholder Taxation of Business Entities C9-29 Basis Computation for §351 Exchange (slide 2 of 2) • Corporation’s basis in assets: Adjusted basis of transferred assets + Gain recognized by transferor shareholder - Adjustment for loss property (if required) = Basis of assets to corporation Taxation of Business Entities C9-30 Basis in Stock in Last Example Adjusted Basis of transferred assets: $100,000 Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose . Liability: $ 80,000 $120,000 $120,000 Basis in assets Transferred $100,000 $ 100,000 $100,000 + Gain recognized None 20,000 50,000 - Liab. Transferred (80,000) (120,000) (120,000) Basis in stock $ 20,000 -0- $ 30,000 Taxation of Business Entities C9-31 Corporation’s Basis in Assets Received in Last Example Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $ 80,000 $120,000 $120,000 Basis of trans- ferred assets: $100,000 $100,000 $100,000 Gain recognized by shareholder None 20,000 50,000 Basis to Corp. $100,000 $120,000 $150,000 Taxation of Business Entities C9-32 Basis Adjustment for Loss Property (slide 1 of 2) • When built-in loss property is contributed to a corporation – Aggregate basis in property may have to be stepped down so basis does not exceed the F.M.V. of property transferred • Necessary to prevent parties from obtaining double benefit from losses involved Taxation of Business Entities C9-33 Basis Adjustment for Loss Property (slide 2 of 2) • Step-down in basis is allocated among assets with built-in loss – Alternatively, if shareholder and corporation both elect, the basis reduction can be made to the shareholder’s stock • Built-in loss adjustment places loss with either the shareholder or the corporation but not both Taxation of Business Entities C9-34 Stock Issued for Services Rendered • Corporation may be able to deduct the fair market value of stock issued in exchange for services as a business expense – e.g., Performance of management services – May claim a compensation expense deduction under § 162 • If the services are such that the payment is characterized as a capital expenditure (e.g., legal services in organizing the corporation) – Must capitalize the amount as an organizational expenditure Taxation of Business Entities C9-35 Holding Period • Holding period of stock received – For capital assets or §1231 property, includes holding period of property transferred to corporation – For other property, begins on day after exchange • Corp’s holding period for property acquired in the transfer is holding period of transferor Taxation of Business Entities C9-36 Recapture Considerations • In a § 351 transfer where no gain is recognized, the depreciation recapture rules do not apply – Recapture potential associated with the property carries over to the corporation Taxation of Business Entities C9-37 Capital Contributions (slide 1 of 3) • No gain or loss is recognized by corp on receipt of money or property in exchange for its stock – Also applies to additional voluntary pro rata contributions of money or property to a corp even though no additional shares are issued Taxation of Business Entities C9-38 Capital Contributions (slide 2 of 3) • Capital contributions of property by nonshareholders – Not taxable to corporation – Basis of property received from nonshareholder is -0- Taxation of Business Entities C9-39 Capital Contributions (slide 3 of 3) • Capital contributions of cash by nonshareholder – Must reduce basis of assets acquired during 12 month period following contribution – Any remaining amount reduces basis of other property owned by the corp • Applied in the following order to depreciable property, amortizable property, assets subject to depletion, and other remaining assets Taxation of Business Entities C9-40 Debt vs. Equity (slide 1 of 2) • Debt – Corporation pays interest to debt holder which is deductible by corporation – Interest paid is taxable as ordinary income to individual or corporate recipient – Loan repayments are not taxable to investors unless repayments exceed basis Taxation of Business Entities C9-41 Debt vs. Equity (slide 2 of 2) • Equity: – Corporation pays dividends which are not deductible • Taxable to individuals at low capital gain rates to extent corp has E & P • Corporate shareholder may receive dividends received deduction Taxation of Business Entities C9-42 Reclassification of Debt as Equity • If corp is “thinly capitalized,” i.e., has too much debt and too little equity – IRS may argue that debt is really equity and deny tax advantages of debt financing – If debt has too many features of stock, principal and interest payments may be treated as dividends Taxation of Business Entities C9-43 Thin Capitalization Factors (slide 1 of 2) • Debt instrument documentation • Debt terms (e.g., reasonable rate of interest and definite maturity date) • Timeliness of repayment of debt • Whether payments are contingent on earnings Taxation of Business Entities C9-44 Thin Capitalization Factors (slide 2 of 2) • Subordination of debt to other liabilities • Whether debt and stock holdings are proportionate • Use of funds (if used to finance initial operations or to acquire capital assets, looks like equity) • Debt to equity ratio Taxation of Business Entities C9-45 Dividends Received Deduction (slide 1 of 3) – If corporation owns stock in another corporation and receives dividends, a portion of dividends may be deducted from income: % owned Deduction Percent Less than 20% 70% 20% but < 80% 80% 80% or more, and affiliated 100% Taxation of Business Entities Dividends Received Deduction (slide 2 of 3) • The dividends received deduction is limited to a percentage of the taxable income of a corporation – For this purpose, taxable income is computed without regard to • The NOL • The domestic production activities deduction • The dividends received deduction, and • Any capital loss carryback to the current tax year – The percentage of taxable income limitation corresponds to the deduction percentage Taxation of Business Entities Dividends Received Deduction (slide 3 of 3) The following steps are useful in calculating the dividends received deduction 1. Multiply dividends received by deduction percentage 2. Multiply taxable income by deduction percentage 3. Subtract 1. from taxable income - If entity has income before DRD, but DRD creates NOL, amount in 1. is DRD -If DRD does not create NOL, deduction is limited to lesser of 1. or 2. Taxation of Business Entities 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 400 301 299 Dividend rec’d 200 200 200 Expenses (340) (340) (340) Income before DRD 260 161 159 80% of income 208 129 127 Year #1 $208 > $160, so $160 DRD Year #2 $129 < $160, so $129 DRD Year #3 DRD causes NOL ($159-$160), so $160 DRD is used. $2 less income results in $31 more DRD. Taxation of Business Entities C9-49 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 Taxation of Business Entities C9-50 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 – Such expenditures reduce the amount of capital raised and are not deductible at all Taxation of Business Entities C9-51 Start-up Expenditures (slide 1 of 2) • Start-up expenditures include: – Various investigation expenses involved in entering a new business • e.g., Travel, market surveys, financial audits, legal fees – Also includes operating expenses, such as rent and payroll, that are incurred by a corporation before it actually begins to produce any gross income Taxation of Business Entities C9-52 Start-up Expenditures (slide 2 of 2) • At the election of the taxpayer, such expenditures can be treated in the same manner as organizational expenditures – Up to $5,000 can be immediately expensed (subject to the dollar cap and excess-of-$50,000 phaseout) – Any remaining amounts are amortized over a period of 180 months or longer Taxation of Business Entities C9-53 Corporate Tax Formula Gross income Less: Deductions (except charitable, Div. Rec’d, NOL carryback, STCL carryback) Taxable income for charitable limitation Less: Charitable contributions (< = 10% of above) Taxable income for div. rec’d deduction Less: Dividends received deduction Taxable income before carrybacks Less: NOL carryback and STCL carryback TAXABLE INCOME Taxation of Business Entities C9-54 Tax Liability of Related Corporations • Subject to special rules for computing income tax – Limits controlled group’s taxable income in tax brackets below 35% to amount corporations in group would have if they were one corporation • Controlled group includes: – Parent-subsidiary groups – Brother-sister groups – Combined groups Taxation of Business Entities C9-55 Parent-Subsidiary Controlled Group • Consists of one or more chains of corporations connected through stock ownership with a common parent – Ownership is established through either: • Voting power test: requires ownership of stock with at least 80% of total voting power of all classes of stock entitled to vote • Value test: requires ownership of at least 80% of total value of all classes of stock Taxation of Business Entities C9-56 Parent-Subsidiary Controlled Group Taxation of Business Entities C9-57 Application of §482 • §482 permits IRS to reallocate income, deductions, and credits between two or more businesses owned or controlled by the same interests • Used to prevent avoidance of taxes or to reflect income properly – Controlled groups of corps are especially vulnerable to §482 Taxation of Business Entities C9-58 Corporate Filing Requirements (slide 1 of 2) • Must file Form 1120 on or before the 15th day of 3rd month following close of tax year even if it has no taxable income – Automatic 6 month extensions are available by filing Form 7004 Taxation of Business Entities C9-59 Corporate Filing Requirements (slide 2 of 2) • Must make estimated tax payments equal to lesser of: – 100% of corporation’s final tax, or – 100% of tax for preceding year – No estimated tax payments required if tax liability expected to be less than $500 Taxation of Business Entities C9-60 Schedule M-1 • Corporations must reconcile financial accounting income with taxable income on Sch M-1, Form 1120 – Common reconciling items include: • Federal tax liability • Net capital losses • Income reported for tax but not book income (e.g., prepaid income) and vice versa • Expenses deducted for book income but not tax (e.g., excess charitable contributions) and vice versa Taxation of Business Entities C9-61 Schedule M-2 • Corporations must reconcile retained earnings at beginning of year with retained earnings at end of year using Sch M-2, Form 1120 Taxation of Business Entities C9-62 Schedule M-3 • Corporate taxpayers with total assets of $10 million or more are now required to report much greater detail regarding differences in financial accounting income (loss) and taxable income (loss) – Reported on Schedule M–3 • Schedule M–3 should – Create greater transparency between corporate financial statements and tax returns – Help the IRS identify corporations that engage in aggressive tax practices Taxation of Business Entities C9-63