T3: Entity Formation & Liquidation

4 business entity types for federal income tax purposes

1. C corp (Form 1120)

2. S corp (Form 1120S)

3. Partnership (Form 1065)

4. Sole proprietorship (Form 1040, Sch. C)

LLCs & other unincorporated entities

• LLC is treated as 1 of the 4 business entity categories

• 2 or more owners: default treatment is partnership

• 1 owner:

  • if owner is an individual, default treatment is a Sch C

  • is owner isn’t an individual, income/loss is included in the owner’s taxable income

contribution of property by owners: C & S corps

nontaxable transfer if meets requirements of Sec 351:

1. property (including cash) is transferred to the corporation

2. solely in exchange for stock (no boot)

3. transferors have >80% control of the corporation immediately after the exchange

• SH’s basis → NBV - liabilities assumed

• corp basis → adj. basis of the property contributed

*requirements of Sec 351 not met → gain/loss is recognized by the SH

• SH basis & corp basis increased by any gain

contribution of property by owners: partnerships

*no requirement of >80% control; non-taxable transfer

• SH basis → adj. basis in contributed property adjusted for liabilities

• partnership basis → adj. basis of property contributed

• when a partnership later disposes of property contributed by a partner, any built-in G/Ls are allocated to the contributing partner

  • post-contribution G/Ls are allocated among all partners

most advantageous entity type of property contributions

tends to favor partnership or sole proprietorship b/c the taxpayer isn’t required to meet the control requirements to avoid recognizing a gain 

C corp taxation of income

• the only business entity whose income is taxed @ the entity level (flat rate of 21%) 

• double taxation → once @ entity level, once @ individual level

  • dividends are taxed at cap gain rates for individuals

  • 0% for low-income

  • 15% for most

  • 20% for high income

• additional 3.8% tax on investments if AGI > $200k for single, $250k for MFJ

flow-through entities taxation of income

• income is taxed only once, when it’s earned, not when it’s distributed

• entity income, losses, & deductions are generally allocated based on ownership % (always go based on partnership agreement) 

• net investment income tax

• QBI deduction available (usually 20%)

SE tax for flow-through entities

15.3% tax paid on 92.35% of SE income

• sole proprietorship → SE tax on all Sch C income

• partnership → SE tax on income if the partner is actively involved in business operations

• S corp → no SE tax

most advantageous entity type for taxation purposes

• C corp may be more advantageous if earnings aren’t distributed as dividends bc of the flat 21% rate

• flow-through entity may be more advantageous bc QBI deduction is available

*important to look at the owners’ individual marginal tax rates relative to the C corp rate of 21%

most advantageous entity type for deduction business entity losses

• advantage of flow-through entities allows losses to flow through to the individual return & offset income from other sources

  • particularly advantageous for new businesses, which usually have start-up losses

• an owner in a partnership may be able to flow through & deduct more in business losses than an S corp SH due to basis in the ownership interest

compensation of owners: C & S corp

• C & S corp SHs can be employees of the corporation & are paid a salary for their services to the corporation

• salary is ordinary income to the SHs

• salary & FICA is deductible to the corporation

• corporation pays ½ of FICA tax

compensation of owners: partnership

• partners can’t be employees of a partnership, so they can’t be paid a salary

• instead they are paid guaranteed payments

• GP is ordinary income to the partner & is also treated as SE income

• GP is deductible to the partnership

• partnership doesn’t pay ½ of FICA tax

fringe benefits

• partnership → fringe benefits included in GPs

  • deductible by the partnership

• C corp → fringe benefits non-taxable to SH-employees

• S corp → deductible by the corporation

  • >2% ownership: taxable to SH

  • <2% ownership: non-taxable to SH 

operating (non-liquidating) distributions to owners (not salaries): C corp

• C corp distributions to SHs are taxable dividends to the extent of the corporation’s E&P

• dividends taxed at preferential rates (0%, 15%, 20%)

• property distributions

  • amt. is FMV of the property @ date of distribution

  • C corp recognizes a gain on appreciated property (but not a loss on depreciated property)

  • SH recognizes a taxable dividend = FMV of the property (basis in property distributed is also FMV of property) 

operating (non-liquidating) distributions to owners (not salaries): S corp

• S corp distributions are treated as coming from S corp E&P first (non-taxable), this decreases SH’s stock basis

• distributions are then treated as coming from C corp E&P from prior C corp years if any

• distributions are then non-taxable to the extent of the SH’s remaining stock basis

• distributions in excess of the SH’s stock basis are taxed as a capital gain

• tax treatment of S corp property distributions is the same as C corp

  • gain is flowed through & allocated to the SHs pro rata based on ownership

operating (non-liquidating) distributions to owners (not salaries): partnerships

• partnership distributions to partners are nontaxable to the extent of the partner’s basis in the partnership interest

• cash distributions in excess of partner’s basis is taxed as a capital gain

• property distributions → no G/L recognized by the partnership or partner

  • property distribution is nontaxable to the extent of the partner’s basis in partnership interest

  • basis in property distributed = partnership’s adj. basis in the property

liquidating distributions to owners: C & S corp

• recognize G/L on difference between FMV & adj. basis

  • FMV - basis > 0, cap gain

  • FMV - basis < 0, cap loss 

• for S corps the G/L is flowed through & allocated to the SHs pro rata based on ownership 

liquidating distributions to owners: partnerships

• no G/L recognized

• partner’s basis is assigned to the noncash property distributed to the partner

• partner only recognizes G/L in limited circumstances where cash distributed is more or less than partner’s basis 

conversion from flow-through entity to C corp (easier)

• S corp to C corp: revoke S election

• Partnership or sole proprietorship to C corp:

  • check-the-box election for unincorporated entities to be taxed as a C corp

  • form a new corporation & contribute partnership/Sch C assets to new corp in a nontaxable Sec 351 exchange

conversion from C corp to flow-through entity (more complex)

• C corp to S corp: make S election

• C corp to partnership or sole proprietorship:

  • liquidate C corp, form new entity

  • C corp recognizes G/L on the difference between FMV & adj. basis of property on the date of liquidating distribution to SHs 

  • SHs receive capital gain or loss for the difference between the FMV of the property received & the SH’s basis in the stock