Tax Implications of Entity
Selection
Andrew J. Malone, CPA
Fesnak and Associates, LLP
MACE Presentation
January 16, 2014
S Corporation vs. Partnership
• Types and amounts of Shareholders/Partners
allowed
• Types of Partnerships
• Income Allocation
• Corporate Liabilities
• Double taxation
• Self-employment tax
C corporation converting to an
S corporation
• Built in Gains
• Distribution of subchapter C earnings and
profits
• Accumulated earnings and excess net passive
investment income
Treatment of Losses
• Partnerships – Losses limited to basis in
partnership interest
• S Corporation – Losses limited to basis in stock
and indebtedness of corporation to shareholder.
Even if the shareholder received a K-1 that
reflects a loss, the shareholder is not
automatically entitled to claim the loss.
Debt Restructuring and Cancellations
•
•
•
•
Transfer of equity interests
Debt for equity exchanges
Termination of Entity
Cancellation of Debt
Future Profits Interest
• Commonly referred to as “carried interest.”
Example: Adam, Joe and Dan wish to form a private equity fund.
Dan has significant expertise in choosing investments that Adam
and Joe would like to profit from. They form an LLC, with Adam and
Joe each contributing $100,000 for a 50% capital interest in the
LLC. In exchange for managing the fund, Dan is given a 20%
interest in future profits, which may or may not materialize. Dan’s
20% interest in future profits is a “carried interest.”
• So what’s the big deal?
• Dan did not have to contribute any capital upfront.
• Dan does not have a taxable event upon formation.
• If profits are realized, Dan will only pay 20% tax on his
profits .
Capital Account Maintenance
• The IRS requires capital account maintenance as
part of the Partnership Agreement.
• The capital account analysis is based on the
following three requirements:
1. Capital account requirement
2. Distribution requirement
3. Deficit makeup requirement
• Qualified Income Offset (“QIO”)
• Deficit Restoration Obligation (“DRO”)
Minimum Gain Chargebacks
• Created as a partnership claims deductions (such as
depreciation) that decrease the partnership’s book basis in the
property below the balance of the non-recourse debt on the
property. Sometimes referred to as 704(b) minimum gain.
Example: ABC partnership purchased property for $100,000 and depreciates the
property using the straight line method over 10 years. The minimum gain for year 2
would be $10,000. The minimum gain is calculated by taking the difference
between the NBV at the end of Year 2 and the balance of the nonrecourse debt
(assuming no payments have been made). ($80,000 NBV - $90,000 debt = $10,000
minimum gain). The minimum gain chargeback is allocated in the same manner in
which the partner’s shared the nonrecourse deductions.
• Value equals basis concept.
• Exceptions to minimum gain chargeback requirement.
• 704(c ) minimum gain (“Built in gain”)
Equity Based Compensation
• Nonqualified Stock Options (“NSO”) and
Incentive Stock Options (“ISO”).
• When NSO is exercised the “spread” is included
in your wages.
• When ISO is exercised the spread is not included
in your wages if certain criteria is met.
Incentive Stock Options
The stock acquired by exercising the options must be held
until the later of:
• 1 year following the day the stock was transferred to you
on exercise.
• 2 years after the date the option was granted.
If these requirements are met when the stock is sold, any
gain or loss is taxed as at the preferential capital gain rate
as opposed to the higher ordinary income rate.
If these requirements are not met the gain will be divided
into two buckets:
• The “spread” will be ordinary income and taxed as such.
• The amount over the “spread” will be treated as a capital
gain.
ISO Example
• Mary was granted an ISO on May 12, 2012 with the option to buy 100
shares of JKL company stock at $10 a share, which was the FMV of the
stock on May 12. Mary exercises the option on March 6, 2013, when the
stock is trading at $12 per share. Mary then sells the stock on March 26,
2014, for $15 per share. Mary did hold the stock for more than a year but 2
years had not elapsed from the date the stock was granted until the stock
was sold. Therefore in 2014, Mary must report the “spread” as wages. The
rest will be treated as capital gain.
Transaction
Amount
Selling Price ($15 X100 shares)
$1,500
Purchase Price ($10 X100
Shares)
$1,000
Gain
$500
Amount reported as
wages(($12X100 shares)$1000)
$200
Amount reported as capital gain $300
Non-Liquidating Distributions and
Dividends
• Partner’s basis for distributed property (nonliquidation).
• Distributions by an S corporation to a corporate
officer.
• When is a distribution taxable to a shareholder
of an S corporation and how is it taxed?
• Ordering rule for calculating shareholder basis.
S Corporation Shareholder Basis
Ben is a shareholder in an S corporation and has
$15,000 of stock basis on 1/1/12. He received a
K-1 reflecting the following from the S
corporation:
• Ordinary Loss
(20,000)
• Net Sec. 1231 gain
4,000
• Cash Contributions (50%)
5,000
• Non-deductible expenses
1,000
• Non-dividend distribution 12,000
What is Ben’s basis at the end of the year and
how much income should he report on his
personal return?
•
•
•
•
•
1/1/12 stock basis
15,000
Plus: Net Sec. 1231 gain
4,000
Less: Non-dividend distribution
(12,000)
Less: Non-deductible expenses
(1,000)
Equals: basis before loss & deductions 6,000
Since Ben’s loss & deduction items exceed his stock
basis, the loss items must be prorated to determine the
amount currently available to Ben:
• 20,000/25,000 * 6,000 = 4,800 Ordinary Loss
• 5,000/25,000 * 6,000 = 1,200 charitable
contribution
The 4,800 ordinary loss and 1,200 in charitable
contributions reduces Ben’s basis down to zero. Ben
should report ($4,800) on his Schedule E and $1,200
on Schedule A due to his stock basis limitations.
The loss and deduction items in excess of stock basis
retain their character and are suspended indefinitely
or until all of Ben’s stock is disposed of.
Self Employment Tax
• Partnership – Generally each partner’s share of
net business income is net earnings from selfemployment.
• Partnership exceptions to self-employment tax.
• S Corporation – Self-employment tax
avoidance?
Self Employment Tax - Example
• Susan has a 35% interest in ABC Partners. For 2013 she
estimates her total self employment earnings from the
partnership will be $35,000. What would her 2013 SE
taxes be?
Net Business income
Income subject to self-employment taxes (NBI * 92.35%)
Medicare Tax (2.9% for 2013)
FICA Tax (12.4% for 2013)
Total self-employment taxes for 2013
Tax deductible portion for 2013 (50% of SE Tax)
$35,000
32,322
937
4,008
4,945
$2,473
Susan should include the total amount of self employment taxes she
expects to owe with her 2013 quarterly estimates. She should also update
her estimated income tax calculation to include the SE tax benefit against
income tax.
Capital Contributions
• Partnership – Tax-Free; BIG or loss allocated to
contributing partner.
• When would a partner have to recognize a gain
on a contribution?
• The S corporation’s basis in contributed
property is the smaller of (1) the FMV or (2) the
contributing shareholder’s adjusted basis.
When must a partner recognize gain
on contributed property
•
Disguised Sale – Bill contributed land having a FMV of $50,000 to the XYZ partnership in
return for a 50% interest. After 9 months, the partnership distributed $50,000 cash to Bill. The
distribution was not contingent on the partnership’s earnings or loans. The distribution and
contribution will be treated as a sale of land by Bill to the partnership.
•
Contribution to a partnership treated as an investment company - John and Fred
decide to form J&F partnership. John contributes IBM stock with a FMV of $50,000 with an
adjusted basis of $10,000 and Fred contributes Microsoft stock with a FMV of $50,000 with an
adjusted basis of $40,000. J&F partnership is considered an investment company and upon
contribution John must recognize a gain of $40,000 and Fred must recognize a gain of $10,000.
•
Partner’s liabilities assumed by partnership - Ivan acquired a 20% interest in a
partnership by contributing property that had an adjusted basis of $8,000 and a $12,000
mortgage. The partnership assumed payment of the mortgage.
Adjusted basis of contributed property
$8,000
Minus: Mortgage assumed by other partners (80% of $12,000)
(9,600)
Capital gain from sale of partnership interest
1,600
Basis of Ivan’s partnership interest
-0-
Distribution of appreciated and
depreciated property
• Identifying § 751 “Hot” Assets
• Carryover basis of property as long as adjusted
basis of property doesn’t exceed partner’s basis.
• S corporations – deemed sale
Death or Retirement of a Member
•
•
•
•
•
•
Liquidating payments
Unrealized receivables
Partner’s valuation
Gain or loss on distribution
Technical termination
Section 754 Step-up
Sale, Exchange or Transfer of a
Partner’s Interest
• Sale or exchange usually results in a capital gain
or loss.
• An exchange of partnership interests generally
does not qualify as a nontaxable exchange but
under certain circumstances can qualify as a tax
free contribution.
• Section 754 step-up/down.
Sale, Exchange or Transfer of S
corporation stock
• Basis and Gain or loss when sold.
• When do allocations to the purchasing
shareholder begin?
• Allocating pass-through items upon complete
disposition of stock (specific accounting method
vs. pro rata basis).
• What happens to a shareholder’s stock when
they die?
Tax Implications of Entity Selection
• Summary
• Questions?