"Forms of Business Entities"
TAX PLANNING CASE #4 TAX COMPARISON OF THE FOUR BUSINESS ENTITIES Description The "choice of entity" decision is one of the most important decisions facing practitioners and their clients who own and operate businesses. There are several forms to choo se from, each of which generates different legal and tax consequences. There is no single form of entity that is appropriate for every type of business owner or entity that a practitioner is likely to encounter. Choosing the appropriate form of entity in which to operate is a complex decision. It depends upon many non-tax factors, including the owners' needs and desires and the particular characteristics and needs of the business in question. The federal tax consequences of each type of entity also play an important role, especially in closely held entities where the parties' combined tax liabilities should be analyzed as part of the decision- making process. This case study includes is an extension of the facts of Davidson Company discussed in Chapter 12, in that the projected tax results are rolled forward through Year 5, with a liquidation of the entity occurring at the end of Year 5. The spreadsheet necessary to make these computations, ENTITY-2008.xls, is included with this case. These questions involve manipulations of key input variables for purposes of analyzing the tax consequences associated with each type of entity. Learning Objectives 1. Determine the key tax differences in the treatment of business income for the four major types of taxable entities. 2. Distinguish the role of payroll taxes in each of the four types of entities. 3. Distinguish the treatment of payments to business owners under each of the four types of entities. 4. Determine the differing tax effects of liquidations of the business for each of the four types of entities. 5. Assess the effects of changes in key input variables on the present value of the total tax costs associated with each type of business entity. 6. Assess the relative effects on the results assuming that the 15% preferential rate on qualifying dividends is no longer available for individual taxpayers; in other words, dividend income is taxed at ordinary income rates. TAX PLANNING CASE #4 TAX COMPARISON OF THE FOUR BUSINESS ENTITIES QUESTIONS This assignment utilizes an Excel spreadsheet to extend the analysis of the four entities for four additional years and incorporates the effects of liquidating the entity at the end of Year 5. The spreadsheet allows for alternative inputs of each of the initial year variables used in Case Study #1. Instructions for utilizing this spreadsheet are included on the next page. 1. In the original spreadsheet analysis based on the curre nt inputs, the “Reasonable Compensation” variable (cell D20) is $55,000, and the “Other Payments/ Withdrawals” variable (cell D21 of the spreadsheet) is $30,000. Redetermine the total taxes paid under each of the following changes in these two variables, and explain the relative changes in results: Total Taxes Paid by Entity $55,000/$30,000 $70,000/$15,000 $40,000/$45,000 Comp/Other Pay Comp/Other Pay Comp/Other Pay Sole Proprietorship $420,044 $ $ Partnership $420,044 $ $ S Corporation $390,014 $ $ C Corporation $534,264 $ $ Explanation____________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2. In the original analysis, the “Sales/CGS Growth Percentage” variable (cell H7 of the spreadsheet) is 20%. Redetermine the total taxes paid under each of the following changes in this growth pe rcentage, and explain the relative changes in the results: Total Taxes Paid by Entity 20% 12% 28% Sales/CGS Growth Sales/CGS Growth Sales/CGS Growth Sole Proprietorship $420,044 $ $ Partnership $420,044 $ $ S Corporation $390,014 $ $ C Corporation $534,264 $ $ Explanation____________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 3. In the original analysis, the “Land/Building Appreciation” variable (cell H27 of the spreadsheet) is 10%. Redetermine the total taxes paid under each of the following changes in appreciation rates, and explain the relative changes in the results: Total Taxes Paid by Entity 10% 2% 18% Appreciation Rate Appreciation Rate Appreciation Rate Sole Proprietorship $420,044 $ $ Partnership $420,044 $ $ S Corporation $390,014 $ $ C Corporation $534,264 $ $ Explanation____________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 4. In the original analysis, the dividends received by the individual taxpayers qualified for a 15% maximum rate. Redetermine the total taxes paid assuming that the preferential dividend rate sunsets as proposed, and dividends are taxed fully as ordinary income (change the input for cell H43 to reflect this). Explain the relative changes in results. Total Taxes Paid by Entity No Preference - No Preference - Current $55,000/$30,000 $70,000/$15,000 Preferential Rate Comp/Other Pay Comp/Other Pay Sole Proprietorship $420,044 $ $ Partnership $420,044 $ $ S Corporation $390,014 $ $ C Corporation $534,264 $ $ Explanation___________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Spreadsheet Instructions The spreadsheet Entity-2008 is included with this case. The first page of the spreadsheet consists of input information, and the first column of input variables matches the assumed information in Phase I (with the exception of the detailed business assets information; in Case Study #1, the total Year 1 MACRS deduction of $35,748 is given). The second column of inputs reflect the assumed growth rates in business and personal items, the pension plan contribution percentages, the annual appreciation or depreciation rates in values of business assets, the present value discount rate used in each analysis, and information on business loans on the building and the equipment. The second page of the spreadsheet discloses the projected business income and expense amounts for the five years (as adjusted by growth rates), the computed MACRS deductions for each year, and the computation and character of the gains (losses) realized on the sale of all business assets at liquidation in the fifth year. Note that the estimated amounts realized for each asset reflects the assumed appreciation/depreciation input rates. The remaining pages summarize the total taxes paid over the five years for each entity. In each case, it is assumed that the business assets are sold by the entity for cash, and that any cash remaining (including accumulations of cash for the five years) is distributed to the owner in final liquidation of the entity. In order to provide rough approximations of the double taxation possibility of liquidating the C corporate entity, it is necessary to estimate the final assets on hand for the corporation (all converted to cash) immediately prior to liquidation. This estimate is not really needed for the other three entity types since there is no double taxation at liquidation, i.e., gains or losses on sales of business assets are taxed at the individual owner level only and no consequences arise when the net cash is distributed to the owner of the business. On the other hand, all distributions from a C Corporation, a separate legal entity, have tax consequences. Any gains and losses on business asset sales are taxable to the C Corporation, a sep arate taxable entity. Additionally, after all business assets have been converted to cash, the distributions to shareholders in liquidation of their shares are taxable events. And these distributions include not just the proceeds from asset sales but also any assets accumulated over the life of the business that have not been distributed to shareholders. Thus, to obtain a more realistic picture of the tax consequences of liquidating a corporation, it is necessary to estimate the total accumulated (undistributed) corporate assets on hand at the time of liquidation. This estimate is provided in the spreadsheet by converting each year’s taxable income to a cash flow figure by adding back noncash flow items (e.g., depreciation) and subtracting nondeductible cash flow items (e.g., loan principal payments, dividend payments, and federal income taxes paid). These cash flows are then accumulated across all five years. In each case, for simplicity it is assumed that the net cash inflows for each year are invested in a tax-exempt source at the discount rate (which increases the following year’s cash inflows). Note particularly the cash flow results in the last year: the cash flow adjustments omit the taxable gains on disposing of business assets and instead substitute the cash realized on such sales. The last year cash flow is also decreased for the hypothetical payoff of loan balances on the building and the equipment. The final cash accumulation at the end of Year 5 is used as an estimate of the total corporate assets (all converted to cash) that are available to distribute to the shareholders (Dave Davidson, the sole shareholder in this case). This number is compared to the shareholder’s adjusted basis in the shares (based on original capital contributions), and any resulting gain or loss is capital gain and loss upon final liquidation of the corporation, reportable on the shareholder’s individual tax return. The following exercise requires changing three key input variables in the spreadsheet analysis, comparing the projected results with the original spreadsheet results, and analyzing the results for possible reasons for the differences. In each case, the results for the current iteration are given in a table. You are to complete the table with changes in a key input variable, and then explain why the results changed. (In each case, remember to reset the variables to the original amounts before changing a new variable.)