T2-M6 Tax Implications of Entity Formation and Liquidation

Question 1

what are the key tax points to consider when choosing the type of business entity for tax purposes?

Answer 1

• tax treatment of contributions of appreciated property by owners (consider built-in-gain/loss)
• taxation of business entity income (flow through vs. double taxation)
• deduction of business entity losses
• compensation of owners
• tax treatment of operating (non-liquidating) distributions to owners
• tax treatment of liquating distributions
• conversion from one entity type to another

Question 2

what are characteristics of contributing property to a C corp?

Answer 2

• sec 351 requirements applied: NOT recognize any gain/loss if shareholders who contributed property own 80% or more of the corp
• if sect 351 requirements not met and gain recognized by shareholder, shareholder’s basis and corp’s basis are INCREASED by the gain recognized
• shareholder’s basis in stock: adjusted basis of property - liabilities assumed by the corp
• corp’s basis: greater of NBV or liabilities assumed by corp

Question 3

what are characteristics of contributing property to a Partnership?

Answer 3

• NO sec 351 requirements, so no taxable exchange
• partner’s basis: NBV of property - liabilities assumed by the other partners portion (not 100% like C corp)
• partnership’s basis in the property: adjusted basis
• pre-contribution gain/loss or called built-in-gain/loss is specifically allocated to contributing partner
• post-contribution gain/loss is allocated to ALL partners

Question 4

what is taxation of C corps?

Answer 4

• entity tax level
• shareholder tax level: depends on type of shareholder. for individual shareholders, qualified dividends are taxed at capital gain preferential rates:
  + 0% for lower income taxpayers
  + 15% for most taxpayers
  + 20% for higher income taxpayers
• individual taxpayers may also be subject to additional 3.8% net investment income (NII is passive income) tax on dividend income. This tax is only applied to higher-income individuals whose AGI exceeds $200K ($250K for MFJ) in C corp. This applies to partner/sharehodler in partnership and S corp if NOT actively involved in operations

Question 5

what is taxation of Partnerships?

Answer 5

• only partner level
• subject to self-employment tax

Question 6

what effects of self-employment tax on different types of entities?

Answer 6

• SE tax is generally 15.3% of SE earnings:
  + 7.65% of employer share
  + 7.65% of employee share
• SE tax is calculate on 92.35% of SE income
  + 100% SE earnings - 7.65% employer share SE tax = 92.35%
  + employer’s portion 7.65% = 6.2% SS + 1.45% Medicare
  + employee’s portion 7.65% = 6.2% SS + 1.45% Medicare
• Sole proprietorship: SE income to sole proprietor
• Partnership: SE income to partners if they actively involved in business operations
• S corp: NOT SE income to shareholder (whether active or inactive)

Question 7

what effects of QBI deductions on different entities?

Answer 7

• applies to flow through entities only, including partnerships, S corps, and sole proprietorships
• deduction is generally 20% of owner’s share of qualified business income, subject to certain limitations
• the deduction is taken on individual’s TR as a below-the-line deduction

Question 8

what are the 2 general factors to consider when deciding to form a C corp or a flow-through entity?

Answer 8

1. the owner’s individual marginal tax rate relative to the C corp tax rate (10% - 37%); and
2. the extent to which the business retains earnings or distributes earnings to the owners

• C corps is the best option if:
  + shareholder’s marginal tax rate is HIGHER than corp tax rate 21%
  + shareholders plan to keep retained earnings in the C corp for further operations. No distribution to shareholders
• Flow-through is the best option if:
  + shareholder’s marginal tax rate is LOWER than corp tax rate 21%
  + shareholders plan to take distributions
  + flow-through entities are eligible for QBI deduction, which does not apply to C corp
• deciding which flow-through entities to choose:
  + S corp: does not subject to SE income tax
  + partnership: is good for complex and flexible allocation of income among partners

Question 9

what is most advantageous entity type for deduction of business LOSS?

Answer 9

Flow-through entity advantages:
- the ability to flow through losses to the owner and offset income from other sources at individual level
- if owners have sufficient basis and is actively involved in operations, the owners can receive an immediate tax benefit from the losses
- even if the deduction of the losses is delayed due to basis or PAL limitations, the owner is NOT subject to 80% limitation that applies to the use of NOL carryforwards
- partnership’s owner has more advantages over S corp’s owner due to partnership’s owner’s basis higher (includes debt) while S corp stock does not (debt basis is separate.)

Question 10

what are characteristics of owner’s compensation and fringe benefits to different types of entities?

Answer 10

• C and S corp shareholder salaries is ordinary income to shareholder and deductions to corps. Corps can also deducts FICA taxes paid on behalf of employee
• Partnership pays salary to partner in form of guaranteed payment and can deduct it as ordinary expense. Guaranteed payment is ordinary income to partners and also subject to SE tax.
• Sole proprietorship CANNOT pay the owner a salary or fringe benefits. everything flows to sch C on form 1040
• Fringe benefits paid by partnership to partners such as health and life insurance are included in guaranteed payments
• For C corp, fringe benefits are expenses to the corp and NOT taxable to shareholder
• For S corp, fringe benefits are expenses to the corp but for shareholder, it depends:
  + if shareholder owns 2% or less, NO taxable income to shareholder
  + if shareholder owns more than 2%, taxable to shareholder

Question 11

what are characteristics of operating (non-liquating) distribution of property to different entities?

Answer 11

• distributions from C corps are taxable to the shareholders to the extent of corp’s E&P, whereas they are not for owners of other entities
• C and S corps: recognize gain only (NOT LOSS. DO NOT NET LOSS WITH GAIN) at entity level as if the corp sold the property and use FMV of property at date of distribution as amount of distribution. However, S corp’s distributions are nontaxable to the extent of the S corp E&P and shareholder’s stock basis
  + C corp: gain is taxable income to the corp
  + S corp: gain is nontaxable and flow through to shareholder
• Partnerships: NO gain/loss is recognized by the partnership or partners (to the extent of partner’s basis). the amount of distribution is adjusted basis in the property => most advantageous
• Sole proprietorship: any distributions are NOT taxable because owner and entity is one

Question 12

what are characteristics of liquating distribution of property to different entities?

Answer 12

• C and S corps:
  + the corps recognize gain/loss on the difference between FMV and NBV of the property at the date of distribution. S corp gain/loss will flow through to shareholders
  + the shareholders recognize capital gain/loss on the difference between FMV of property and shareholder’s basis in stock. Basis of the property received is FMV
• Partnerships:
  + No gain/loss is recognized by the partnership or partners
  + partner’s basis in the partnership interest is assigned to the noncash property distributed to the partner. In other words, basis of property received = partner’s remaining basis in partnership interest
  + a partner only recognizes GAIN/LOSS in limited circumstances where CASH distributed is MORE/LESS than partner’s basis

Question 13

what to consider when converting a flow-through entity to a C corp?

Answer 13

• From S corp to C corp: revoke S election (cannot re-elect S status for 5 years)
• From partnership or sole proprietorship to C corp:
  + check the box election for unincorporated entities to be taxed as a C corp; or
  + form a new corp and contribute partnership/sch C assets to new corp in a nontaxable section 351 exchange (80% or more ownership)
• easier and less tax cost for conversion

Question 14

what to consider when converting a C corp to a flow-through entity?

Answer 14

• From C corp to S corp: make S election (if meet eligibility requirements)
• From C corp to partnership/sole proprietorship: liquidate C corp, form a new entity, and pay tax at 2 levels
  + C corp: recognize gain/loss on difference b/w FMV and adjusted basis of property
  + Shareholders: recognize capital gain/loss for the difference b/w FMV of the property received and shareholder’s basis
• more complex and higher tax costs