Chapter 14 Choice of Business Entity: Operations and Distributions Choice of Business Entity: Operations and Distributions ©2007 South-Western Kevin Murphy

Chapter 14Chapter 14

Choice of Business Entity:Operations and Distributions

Choice of Business Entity:Operations and Distributions

©2007 South-Western©2007 South-Western©2007 South-Western©2007 South-Western

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Transparency 14-2Transparency 14-2© 2007 South-Western© 2007 South-Western

Taxation of OperationsTaxation of Operations

The general formula for computing income tax is:

Gross Incomeless: Deductions

Taxable Incometimes:Tax rate (for entity)

Income taxless: Tax prepayments and Tax credits

Tax (refund) due with return


Let’s concentrate on the exceptions to the general formula common to each entity.


Sole ProprietorshipSole Proprietorship

Many items are reported elsewhere on the owner’s return and not reported as part of the proprietorship’s income Investment income and expense Capital gains and losses Section 1231 gains and losses Passive activity items Charitable contributions Owner’s personal expenses Tax credits Net operating losses


PartnershipPartnership

Income and expenses are reported by the partners according to their ownership interest

Items which would receive special treatment on a partner’s return are reported separatelyAll items listed separately for sole proprietorshipsAmounts expensed under Section 179Alternative minimum tax itemsNondeductible expenses


Losses are deductible subject to three limitationsLimited to the amount of a partner’s basis

(capital recovery concept)Limited to the partner’s at-risk amountLimited by passive activity rules



Partner’s basis is adjusted to reflect partnership income and losses reportedIncreased for income or gains

Designed to prevent double taxation

Decreased for losses Designed to prevent double benefit and reflect

capital recovery



Transactions between a partner and partnership are subject to related-party rulesPartner who has > 50% interest in a

partnership is a related partyLosses on sales are disallowed

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CorporationCorporation

Taxable income is determined at the corporate level under the general formula

Exceptions:Net capital losses are not deductibleCorporations must recapture additional

depreciation for Sec. 1250 property = 20% of straight-line depreciation taken



Dividends-Received deductionDesigned to relieve triple taxation problemCorporation may deduct a % of the

dividends received from other corporations

Percent owned Deduction %

< 20% 70%

> 20% and < 80% 80%

> 80% 100%



Passive activity losses Corporations are not subject to the passive activity

rulesPersonal service corporations must follow themClosely-held corporations may use passive losses to

offset active income but not portfolio income

Charitable contributions are limited to 10% of taxable income Before dividend-received deductions and any

carryovers Excess contributions may be carried forward 5

years



Net operating loss cannot be used in the current year or distributed to shareholders May be carried back 2 years and forward 20 until

used May elect to forego the carry back


S CorporationS Corporation

Income and expenses are reported by the shareholders according to their ownership interest Items which would receive special treatment on a

shareholder’s return are reported separatelyLosses are deductible subject to the three

limitations faced by partnerships

S corporations are also subject to the corporate depreciation recapture rules for Section 1250 property


May not use take the dividend-received deduction

NOLs are subject to three limitationsBasis limitationAt-risk limitationPassive activity loss limitation



Entity DistributionsEntity Distributions

The tax treatment of distributions to an owner depends on the amount and kind of the distribution and the entity making the distribution.

Distributions are eitherLiquidating Nonliquidating


What are the effects of nonliquidating distributions

made by each entity?



Distribute cashNo tax consequences to owner / entity

Distribute propertyNo gain or loss recognized until owner

sells the property



Distribute cashPartner recognizes no gain unless amount

exceeds partner’s basis; excess is capital gain

No tax consequences to partnership

Distribute propertyPartner recognizes no gain or loss; Basis is

the lesser of carryover basis or partner's basis

No tax consequences to the entity


C CorporationC Corporation

Distribute cashShareholder reports

Dividend income to the extent of earnings and profits or corporation, then

Return of capital to the extent of basis, then Capital gain

No tax consequences to corporation

Distribute propertyShareholder reports same as cashCorporation reports gain “as if the property was

sold” for its FMV. No loss allowed.



Distribute cashShareholder recognizes no gain unless

amount exceeds basis; excess is capital gain

No tax consequences to corporation

Distribute propertySame as for cashCorporation reports gain “as if the property

was sold” for its FMV. No loss allowed.


What are the effects of liquidating distributions

made by each entity?



Distribute cashNo tax consequences to owner / entity

Distribute propertyWhen property is sold; gain or loss = FMV

less basis



Distribute cashPartner recognizes

No gain unless amount exceeds partner’s basis; excess is capital gain

If only cash is distributed, loss may be recognized

No tax consequences to partnership

Distribute propertyPartner recognizes no gain or loss; Basis is the

lesser of carryover basis or partner's basisNo tax consequences to the entity


C CorporationC Corporation

Distribute cashShareholder reports capital gain or loss =

amount less basisNo tax consequences to corporation

Distribute propertyShareholder reports same as cashCorporation reports gain or loss “as if the

property was sold” for its FMV



Distribute cashShareholder recognizes capital gain or loss

equal to distribution amount less basisNo tax consequences to corporation

Distribute propertyShareholder reports same as for cashCorporation reports gain or loss “as if the

property was sold” for its FMV


Tax PlanningTax Planning

With proper tax planning, owners of entities can minimize their overall tax liability by taking full advantage of the progressive tax rate structure.

Income splittingChildren as employeesFamily entities


End of Chapter 14End of Chapter 14

Documents

Chapter 14 Choice of Business Entity: Operations and Distributions Choice of Business Entity: Operations and Distributions ©2007 South-Western Kevin Murphy