Business Entity Tax Outline
Spring 2008
Section I: Introduction to Business Entity Taxation
—Legal Forms or Business Enterprises—
Types of Enterprises
(1) Sole Proprietorship
Business owned and controlled by a single individual
SP’s are personally liable for debts and claims against the business
Must report income and expenses on individual tax return (Schedule C)
(2) Partnerships
Traditional general partnership
Every partner is an agent of the firm for purposes of its business
Each general partner has the right to participate in management as well as share in profits of the partnership
General partners are also jointly and severally liable for all debts and obligations of the partnership
Each partner has unlimited liability for the other partners
Limited Liability Partnership (LLP)
Operated as a general partnership but all the partners obtain full or partial limited liability by filing a registration and complying with other statutory requirements
Required to have at least one general partner
Allows passive investors to invest without liability
Limited partners cannot participate in the active management of the business
This led to many types of abuse
A partnership is NOT treated as a separate entity
Exposed to only one level of income tax at the partner level
Taxable income is with the partners themselves
Net losses also pass through on the partner’s return
When is a partnership a tax entity?
Must file a tax return
Shows the partnerships gains, losses, deductions, etc…
Issues to each partner a form K1 to attach to his 1040
Tells each partner what his share of profits and losses are
Audits
Dealt with at the partnership level
You may hire a partner for salary
Treated as a salary, not a distribution
Partnerships are wonderful vehicle for tax shelters
Partnership tax status has also been applied to LLP, LLLP, and LLC’s
Prior to 1954, partnership taxation was a total hotchpot of various rulings
1954 Code changes all that
(3) Limited Liability Company (LLC)
Unincorporated entity in which the owners (“members”) have limited liability for the enterprises debts and claims even if they participate in management
Flexibility in structuring the management
Governing document is an “operating agreement”
(4) Corporation
Legal entity formed under state law
Artificial entity created by states
Management is vested in a board of directors
Shareholders do not participate in management and are not personally liable for debts
A corporation is a separate taxable entity
The taxable income stays within the corporation
Shareholder does not take that into account in his income
Shareholder only counts
Dividends
If he sells
Complicated rules as a result of abuse
Policy considerations – “The double taxation” dilemma
Corporations are subject to two levels of tax
(1) Tax on the corporation income
(2) Tax on the shareholder’s dividends
Example
1000 of income
Must pay tax of 350 leaving 650
If that 650 is paid out in dividends, it is taxed as well
In a partnership or S corporation, only the 350 would be paid
How do some corporations try to get around this?
Example
Starting out a corporation
1000 in a share of stock and 99,000 in a note at 5%
Interest is deductible to the corporation
Only taxed once
But shareholders must bared some risk of loss
The IRS calls that note a stock
“Double tax encourages debt”
To help alleviate this, for 2003-2009 dividends are only taxed at 15%
Why does it end?
2001 tax bill – US Senate – “Bird rule”
To have a tax bill that goes on for more than 10 years you need 60%
A corporations net losses may be deducted ONLYby the corporation and NOTby the shareholders
§7701 – elements of an S Corp.
Associates
Objective to carry on business and divide profits
Continuity of life
Centralization of management
Limited liability
Free transferability of interest
How does the IRS tell the difference between partnerships and corporations?
Everyone wants the limited liability of a corporation with the tax benefits of a partnership
The IRS had a set of characteristics they thought fit corporations
If the majority of the characteristics fit, they called it a corporation and not a partnership
The determination of state law was not conclusive
The characteristics
(1) Associates
Two or more persons jointed together in shared control or ownership of a venture
(2) Objective to carry on business and divide the gains therefrom
But this sounds like both partnerships and corporations, why do they need these?
This helps differentiate corporations from trusts
(3) Continuity of life
Generally, the death of a partner terminates the partnership
Corporations continue on despite the death
(4) Centralization of management
Theoretically, all partners have a say-so in the practice of the business
Limited partnerships are not this way
(5) Limited liability
(6) Free transferability of ownership interests
As a partner in a firm you can just sell your share to whoever you want
Corporation shareholders can sell to whomever they want
If you had 3 out of 4 characteristics that were considered corporate, you are a corporation
If it’s a split (2-2) then you are still a partnership
1997
The IRS gave up
Adopted the “Check the box treatment”
The taxpayer chooses whether he wants to be taxed as a c
ot take capital gains on selling houses
Podell claims he is not in the business
IRS says this is a joint venture
They have pooled their assets for a joint profit motive
A joint venture to split profits is a joint venture for tax purposes
Must be taxed as a partnership
This is a joint venture who business it is to sell real estate
The key is that they are sharing in profits
*Allison v. Commissoner
FACTS
Issue of whether a joint venture existed between Acceptance and Investment
HOLDING
Whether a joint venture has been created by the parties is essentially factual with specific emphasis placed upon the intentions of the parties
The project in question is described as being “limited to the purchase and subdivision of the property”
There is no indication that the parties contemplated the subsequent joint sale of the lots or agreed to a procedure of dividing the possible profits
It does not appear that the parties jointly sought a profit or that there was any agreement to pursue a business venture and to divide the profits as such therefrom.
Acceptance fulfilled its obligation by providing and arranging for the financial requirements of the project
Investment was primarily liable for the outstanding debts which apparently were intended to be repaid from its own profits
Investment had no control over the ultimate disposition of the lots
Acceptance and Investment did not enter into a joint venture
NOTES
Same issue as Podell
Plaintiffs are arguing in favor of a joint venture
Why?
When a partnership makes a distribution to its partners it is tax free to the extent of your basis
Example
Gingiss invests $100 in a partnership
The partnership gains $30 the first year
Gingiss must report the $30 on his tax return
His new basis in partnership is $130
Now the partnership distributes to Gingiss $130
That is all tax free
But it decreases Gingiss’s basis back to $100
Income increases your basis
Distributions decrease it
Acceptance is providing services
In the business of procuring loans
Investment made a payment to Acceptance
Acceptance claims it is a distribution from a partnership
If there is no joint venture how is the payment characterized?
Compensation for services rendered
In this case, Acceptance and Investment DID NOT share in profits
Therefore, there was no joint venture
Acceptance simply did what it was in the business to do
