Essentials of taxation 2016 cengage chapter 12

Chapter 12 Corporations: Organization, Capital Structure, and Operating Rules Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 3) • Amber has operated her business for 10 years as a sole proprietorship, but has decided to incorporate the business as Garden, Inc – She understands that the corporate form offers several important nontax advantages (e.g., limited liability) – Also, the incorporation would enable her husband, Jimmy, to become a part owner in the business • Amber expects to transfer her business assets in exchange for her Garden stock, while Jimmy will provide accounting and legal services for his interest The Big Picture (slide of 3) • Amber’s sole proprietorship assets available for transfer to the new corporation are: The Big Picture (slide of 3) • Aware of the double taxation problem associated with operating as a regular corporation, Amber is considering receiving some corporate debt at the time of incorporation – The interest expense on the debt will then provide a deduction for Garden, Inc • Amber’s main concern, however, is that the incorporation will be a taxable transaction – Can the transaction be structured to avoid tax? • Read the chapter and formulate your response Various Business Forms • Business operations can be conducted in a number of different forms including – – – – – Sole proprietorships Partnerships Trusts and estates S corporations Regular corporations (also called C corporations) Sole Proprietorship • Not a separate taxable entity • Income reported on owner’s Sch C Partnership (slide of 2) • Separate entity, but does not pay tax – Files information return (Form 1065) • Most income and expense items are aggregated in computing the ordinary business income (loss) of the partnership – Certain income and expense items are reported separately to the partners – e.g., Interest and dividend income, long term capital gain, charitable contributions and investment expenses Partnership (slide of 2) • Partnership ordinary business income (loss) and separately reported items are allocated to partners according to their profit and loss sharing ratios – Each partner receives a Schedule K–1 • Reports partner’s share of partnership ordinary business income (loss) and separately stated items – Each partner reports these items on his or her own tax return S Corporation • Separate entity, only pays special taxes (e.g., built-in gains) – Files information return Form 1120S • Similar to partnership taxation – Ordinary business income (loss) flows through to the shareholders to be reported on their separate returns – Certain items flow through to the shareholders and retain their separate character when reported on the shareholders’ returns • The S corporation ordinary business income (loss) and the separately reported items are allocated to the shareholders according to their stock ownership interests C Corporation • C corporations are subject to an entity-level Federal income tax which results in what is known as a double taxation effect – C corporation reports its income and expenses and computes tax on the taxable income reported on its Form 1120 • Uses tax rate schedule applicable to corporations – When corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns • Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level Parent-Subsidiary Controlled Group • Consists of one or more chains of corporations connected through stock ownership with a common parent – Ownership is established through either: • Voting power test: requires ownership of stock with at least 80% of total voting power of all classes of stock entitled to vote • Value test: requires ownership of at least 80% of total value of all classes of stock 79 Parent-Subsidiary Controlled Group 80 Application of Đ482 Đ482 permits IRS to reallocate income, deductions, and credits between two or more businesses owned or controlled by the same interests • Used to prevent avoidance of taxes or to reflect income properly – Controlled groups of corps are especially vulnerable to §482 81 Corporate Filing Requirements (slide of 2) • Must file Form 1120 on or before the 15th day of 3rd month following close of tax year even if it has no taxable income – Automatic month extensions are available by filing Form 7004 Corporate Filing Requirements (slide of 2) • Must make estimated tax payments equal to lesser of: – 100% of corporation’s tax for the current year, or – 100% of tax for preceding year • No estimated tax payments required if tax liability expected to be less than $500 Schedule M-1 • Corporations must reconcile financial accounting income with taxable income on Sch M-1, Form 1120 – Common reconciling items include: • Federal income tax per books • Net capital losses • Income reported for tax but not book income (e.g., prepaid income) and vice versa • Expenses deducted for book income but not tax (e.g., excess charitable contributions) and vice versa Schedule M-2 • Corporations must reconcile retained earnings at beginning of year with retained earnings at end of year using Sch M-2, Form 1120 – Schedule L (balance sheet), Schedules M–1 and M–2 of Form 1120 are not required for corporations with less than $250,000 of gross receipts and less than $250,000 in assets Schedule M-3 • Corporate taxpayers with total assets of $10 million or more are now required to report much greater detail regarding differences in financial accounting income (loss) and taxable income (loss) – Reported on Schedule M–3 • Schedule M–3 should – Create greater transparency between corporate financial statements and tax returns – Help the IRS identify corporations that engage in aggressive tax practices Refocus On The Big Picture (slide of 6) • Amber, the sole property transferor, must acquire at least 80% of the stock issued by Garden, Inc in order for the transaction to receive tax-deferred treatment under § 351 – Otherwise, a tremendous amount of gain (up to $600,000) will be recognized • As a corollary, Jimmy must not receive more than 20% of Garden’s stock in exchange for his services Refocus On The Big Picture (slide of 6) • However, even if § 351 is available, any corporate debt issued by the corporation will be treated as boot and will trigger gain recognition to Amber – Therefore, she must evaluate the cost of recognizing gain now versus the benefit of Garden obtaining an interest deduction later Refocus On The Big Picture (slide of 6) What If? • Can the § 351 transaction be modified to further reduce personal and business tax costs, both at the time of formation and in future years? – Several strategies may be worth considering • Have Jimmy transfer some property along with the services rendered to Garden – As long as Jimmy transfers property with more than a relatively small value compared to the value of services performed, Jimmy will be considered part of the control group – This would allow Amber to own less than 80% of the new corporation and still qualify under § 351 Refocus On The Big Picture (slide of 6) What If? • Instead of having Garden issue debt on formation, Amber might withhold certain assets – If the building is not transferred, for example, it can be leased to the corporation • The resulting rent payment would mitigate the double tax problem by producing a tax deduction for Garden Refocus On The Big Picture (slide of 6) What If? • An additional benefit results if Amber does not transfer the cash basis receivables to Garden – This approach avoids a tax at the corporate level and a further tax when the receipts are distributed to Amber in the form of a dividend – If the receivables are withheld, their collection is taxed only to Amber Refocus On The Big Picture (slide of 6) What If? • No mention is made as to the existence of any accounts payable outstanding at the time of corporate formation – If they exist, which is likely, it could be wise for Amber to transfer them to the corporation – The subsequent corporate payment of the liability produces a corporate deduction that will reduce any corporate tax If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr Donald R Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 93 ... must own: • 80% of total combined voting power of all classes of stock entitled to vote, and • 80% of total number of shares of all other classes of stock Issues re: Formation (slide of 7) • “Immediately... Đ351: gain of $100,000 With Đ351: no gain or loss Rons economic status has not changed Consequences of §351 (slide of 2) • In general, no gain or loss to transferors: – On transfer of property... transferors are in control of corporation Consequences of §351 (slide of 2) • If boot (property other than stock) received by transferors – Gain recognized up to lesser of: • Boot received or •