Federal Taxation of Business Entities
I. Choice of Form
A. Taxable Corporation
1. What is a taxable corporation?
C Corporation defined in §1361(a)(2)—means a corporation which is not an S corporation for such taxable year.
Double Tax Issue
2. How it is taxed?
On the entity level:
§11(b) provides that a corporation will be taxed applying the following rates:
(A) 15% if taxable income does not exceed $50,000;
(B) 25% if taxable income > $50,000 but < $75,000; (C) 34% if taxable income > $75,000 but < $100,000; (D) 35% if taxable income exceeds $100,000. §1201 provides that preferential tax rate only applies if taxed over 35%, which will not happen based on §11. On the shareholders lever: dividend income is taxed as Net Capital Gain applying §1(h) and §1411 Generally taxed at 15% if taxable income for such tax year is not in the 39.6% bracket; When there is Adjusted Gross Income for such tax year, additional 3.8% medical care tax; When taxable income for such tax year is in the 39.6% bracket, additional 5% on Net Capital Gain and dividend income, thus taxed at 20%. Leading to a maximum of 23.8% tax rate. 3. Distribution and Recognition of Gain or Loss On the entity level: §311. Taxability of corporation on distribution (a) Generally—no gain or loss shall be recognized to a corporation on the distribution with respect to its stocks (or rights to acquire its stock) or property. Except-- (b)(1) When a corporation distributes property (other than an obligation to do so) to a shareholder and the FMV of such property exceeds its AB (appreciated property), then gain shall be recognized by the corporation as if such property were sold to the shareholder as its FMV. §1032. Exchange of stock for property. (a) No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock of the corp., or with respect to any lapse or acquisition of an option or security by buy or sell its stock. When loss occurred, it is trapped and does not flow through to the shareholder, and deduction has to postpone when there is capital gain to sit it off. §1212(a)—Capital loss carrybacks for 3 years and carryovers for 5 years. If there is no dividend distributed to shareholders for the tax year, the corp.’s basis increases and the value of shareholders stock increases as well. On the shareholder level: §331(a)—Liquidations: amounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock. §351(a)—Transfer of property: generally, no gain or loss shall be recognized if property is transferred to a corporation by shareholders solely in exchange for stock in such corporation and the shareholder is immediately in control of this corporation. When shareholder sole those stocks, capital gain will be recognized. §1202 (benefits): shareholder can exclude some or all gains (up to 100% of 10 millions) when (1) shareholder sold certain stocks of C corp. that qualifies as a small business,(2) the stocks were issued directly by the corp. to the shareholder, and (3) they were held for more than 5 years. *Small Business Corporation: has assets of 50 millions or less immediately after sold of stock. §1211-12 governs when shareholders sold their stocks and incurred loss. B. Partnership and LLC 1. Differences Partnership: each partner is personally liable for the indebtedness incurred in the business. LLC: members have limited liability and is treated as a partnership for tax purpose. 2. How they are taxed? Who to tax--§701. Partners, not partnership, subject to tax. (Gain and loss flow through to partners and members, and reported on their individual tax return for such tax year.) Character of gain and loss--§702(a). Each partner shall take into account separately his distributive share of the partnership’s gain or loss of capital assets for long-term or short-term, or property used in trade or business. (b) Character of gain or loss would be characterized as the incurred in the same manner as incurred by the partnership. (Incomes would pass-through to owners as capital gain taxed at preferential tax rates under §1(h) and subject to additional 3.8% medicare tax.) How to distribute gain and loss between partners--§704. (a) A partner’s distributive share of gain, loss, deduction, or credit shall be determined by the partnership agreement. (b) A partner’s distributive share of gain, loss, deduction, or credit shall be determined in accordance with the partner’s interest in the partnership if— (1) the partnership does not provide such provision, or (2) allocation under the agreement has no substantial economic effect. Nonrecognition of gain or loss on contribution--§721. (a) Generally, no gain or loss shall be recognized to a partnership or its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. (b) Does not apply to property transferred to corporation. (c) Does not apply if transferred from a foreign person. Loss deductions--§172. Net operation loss deduction carryback to 2 years and carryover to 20 years. Ways to diminish tax shelter to restrict individual to allocate loss to off against unrelated income. (Does not apply to widely hold corp.) §465. Partners can only off set unrelated income when there is a risk of loss (e.g., take a recourse debt). §469. Limited partners’ ability to off set passive loss, which use loss generated by passive activity only to the extent the partner has income from other passive activity. 3. §7704. (a) A publicly traded partnership shall be treated as a corporation, (b) means— (1) interests in such partnership are traded on an established securities market, or (2) interest in such partnership are readily tradable on a secondary market. Due to the public trading, the character of partnership is so closely as corporation, thus will be treated accordingly for tax purpose. Except—if 90% or more of income is from investment or other passive activities. Usually, closely held business would change status once goes public if presume to be successful. C. S Corporation 1. Taxed similarly as a partnership. 2. Combine the pass-through tax structure and limited liability. 3. §1361(a)—Definition. S corp. is a small business corporation for which an election under section 1362(b) is in effect for each year. (b)—Small business corp. means a domestic corporation which does not— (A) have more than 100 shareholders, (B) have an entity as a shareholder, (C) have a non-resident (not a citizen or legal resident) as shareholder, and (D) have more than 1 class of stock—common stock, no preferential stock (can have different voting rights). 4. Distribution of property subject to the same rules as C corp., which is a tax generate action, but gains flow to the shareholders. D. Class
rtner elected before contribution occurred.
Example: If a partner contributed a land to the partnership and he has been deducting depreciation using straight-line method for 3 years already, after the transaction occurs, the partnership will continue using straight-line method to calculate depreciation for the rest of the deduction period.
Treatment of Liabilities
Treatment of certain liability (changing in the outside basis of partners)
(a) Increase in partner’s liabilities—Any increase in a partner’s share of the liabilities of a partnership, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership. [Any dollar increase, will be considered as contribution of cash to the partnership and will increase that partners outside basis.] (b) Decrease in partner’s liabilities—Any decrease in a partner’s share of the liabilities of a partnership, or any decrease in a partner’s individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership. [any decrease in a partnership or partner’s liability, will be considered as cash distribution from partnership to partner and will decrease that partner’s outside basis.] (c) Liability to which property is subject—For purposes of this section, a liability to which property is subject shall, to the extent of the fair market value of such property, be considered as a liability of the owner of the property.
(d) Sale or exchange of an interest—In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships.
Thus, when a partner contributes an encumbered property to the partnership, other partners have a increase of basis in the partnership by assuming that liability based on their respective share. On the other hand, the contributing partner was released from liability thus considered cash distributing based on his respective share.
What is Liability–§1.752-1(a)(4):
3 Step Calculation:
(3) – §752(b) in the amount equal to debt relief for that partner
Partner Share of partnership liability: based on whether the debt is recourse or non-recourse liability
Recourse Liability §1.752-1(a)(1)—any partner bears economic risk of loss
(A) §1.752-2(a): in general, a partner’s share of a recourse partnership liability equals the portion of that liability for which the partner or related person bears the (loss of book value). (b) Such share of liability shall be determined as if the business is terminated and all assets became worthless.