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Advanced Federal Income Tax
Texas Tech School of Law
Outenreath, Alyson

Advanced Income Taxation

Spring 2013

Alyson Outenreath

1/15/13

Choice of Entity Decision & Check-the-Box Regulations (Plus: Basis Refresher)

· Considerations in Determining What Type of Entity to Use

o There are:

§ Non-Tax Factors (e.g., liability protection)

· Costs

§ Tax Factors

· Federal

· State

· Main Choices When Forming An Entity

o Sole Proprietorship

§ No separate entity

§ No filing document or fees

§ Generally inadvisable

§ Easy to do b/c no filings

o General Partnership

§ Two or more people with no liability protection

§ Generally inadvisable

§ Easy to do b/c no filings

o Corporation (Corp)

§ Pros

· Liability protection for owners

§ Cons

· Filing fees

· Time

§ Non-Tax Characteristics

· Liability protection

· Must be owned by at least one shareholder

· Governed and run by Board of Directors

· Must make filing w/ Texas Secretary of State and pay filing fee

· Bylaws

· If public company, SEC filing requirements

§ Tax Characteristics

· Double Tax

o “Entity-level” tax paid by corporation

o Distributions to individual shareholders (dividends) taxed again at shareholder level

· Double tax systems lead to same money being taxed twice

· Corporations governed by Subchapter C of the IRC (that is why called “C corps”)

o Exception: If make “S election” to be classified and taxed as an S corporation

· Double Tax is Why Other Limited Liability Entities are Popular

o The main other limited liability entities are:

§ Limited Liability Company (LLC)

§ Limited Partnership (LP)

o Limited Partnership (LP)

§ Require a general partner (generally an LLC) Ltd Part.

§ Pros

· Liability protection for owners

§ Cons

· Filing fees General Partner

· Time

§ Non-Tax Characteristics

· Limited liability to limited partners

· Must have at least one general partner

· Must have at least one limited partner

· Limited partners have no role in management

· Must make filing w/ the Texas Secretary of State and pay filing fee

· Governed by Limited Partnership Agreement

§ Tax Characteristics

· Not quite this simple, but for now just think “flow-through” or “pass-through”

· Term “flow-through” or “pass-through” means entity not taxed

o Instead, all income, deductions, losses, credits “flow-through” or “pass-through” the entity to the owners and are only taxed at the owner level

o Limited Liability Company (LLC)

§ Pros

· Liability protection for owners

§ Cons

· Filing fees

· Time

§ Non-Tax Characteristics

· Liability protection to all members

· Must be owned by at least one member

· Governed and run by either members or designated managers

· Must make filing w/ Texas Secretary of State and pay filing fee

· Company agreement

§ Tax Characteristics

· Not quite this simple, but for now just think “flow-through” or “pass-through”

· Term “flow-through” or “pass-through” means entity not taxed

o Instead, all income, deductions, losses, credits “flow-through” or “pass-through” the entity to the owners and are only taxed at the owner level

· If Double Tax, Why Use Corporation?

o Too complex and cumbersome for company to comply w/ Subchapter K

o Credibility to outside investors

o Established corporate law

o Finality for shareholders in filing their returns each year

o Company pays out everything to employees as compensation each year (so no double tax)

Check the Box Regulations

· Check-the-Box Regulations: Entity Classification for FIT Purposes

o The check-the-box Treasury Regulations tell you how your entity is going to be classified and taxed for federal income tax purposes (See Treas. Reg. Section 301.7701)

o What an entity is for state law purposes is not necessarily what the entity will be classified as for federal income tax purposes

§ Example: LLC

· Check-the-Box Regulations

o Check-the-box regulations classify an entity for FIT purposes as either: (1) Corporation: (2) Partnership; or (3) Disregarded (Sole Proprietorship / Division of Owner)

o Default Rules:

§ State law corporation: Corporation for FIT purposes (governed by subchapter C)

· Unless make “S corp elections,” in which case governed by subchapter S

§ Non-corporate entity w/ two or more owners: partnership for FIT purposes (governed by subchapter K)

§ Non-corporate entity w/ one owner: disregarded for FIT purposes (means a tax nothing! Doesn’t exist!)

o Entities can change their tax status if they don’t like the default classification – except for corporations

o This is done by timely filing IRS Form 8832, Entity Classification Election

§ For example, LLC or LP could elect to be treated as a corporation for federal income tax purposes

§ Changing default election can create tax consequences

o Classification also can change due to subsequent event

§ Example: Owner leaves or new owner joins company

· More on Disregarded Entities

o Described as “tax nothing”; as if don’t exist for federal income tax purposes

o The LLCs do not exist for tax purposes

§ Report taxes on individual or corp. return

· What about S Corporations?

o S corporation is a s

just the starting cost basis: “adjusted basis”

o Adjusted basis is your unrecovered investment in the property

o Example:

§ Samantha buys an apartment building for $400K

§ IRC allows her to take depreciation deductions. Over 10 years she takes $100K in depreciation deductions.

§ Adjusted basis: $300K

§ If Samantha sells the property for $2M, her realized gain is $1.7M

· Substituted Basis: Exchanged Basis & Transferred Basis

o Oftentimes, not a taxpayer’s No. 1 choice

o Appreciated property acquired by gift

§ Sally receives investment property worth $1M as a gift from Paul

§ Paul’s basis in the property is $200K

§ Sally’s basis is $200K

§ 10 years later, Sally sells the property for $1.5M

§ Sally’s realized gain is $1.3M

o FN: basic rule w/ gifts is that you use the basis of the previous owner

· Stepped-Up Basis

o Everyone wants this

o Property acquired by inheritance

§ Sally receives investment property worth $1M as inheritance from Paul

§ Paul’s basis in the property is $200K

§ Sally’s basis is stepped-up to $1M

§ 10 years later, Sally sells the property for $1.5M

§ Sally’s realized gain is $500K

o But basis also can be stepped-down

· The Real Significance For Us Is Substituted Basis

o Terminology

§ (42) Substituted Basis: The term “substituted basis property” means property which is—(A) transferred basis property, or (B) exchanged basis property.

§ (44) Exchanged Basis: The term “exchanged basis property” means property having a basis determined under any provision of subtitle A (or under any corresponding provision of prior income tax law) providing that the basis shall be determined in whole or in part by reference to other property held at any time by the person for whom the basis is to be determined.

§ (43) Transferred Basis: The term “transferred basis property” means having a basis determined under any provision of subtitle A (or under any corresponding provision of prior income tax law) providing that the basis shall be determined in whole or in part by reference to the basis in the hands of the donor, grantor, or other transferor

§ In practice: carryover basis