Chapter 12
Choice of Entity- General
Fall, 2016
Howard Godfrey, Ph.D., CPA
UNC Charlotte
Copyright © 2013, Dr. Howard Godfrey
Edited July 27, 2016.
T16F-Chp-12-1-Entity-Choice-General
1
Nontax Factors
Sole Proprietorship
Partnership
Corporation
S Corporation
Ltd. Liability Company
Ltd. Liability Partnership
2
General Tax Factors
Incidence of Income Tax
Sole proprietorship
Partnership
Corporation
Personal Service Corp.
3
Non-Tax Factors- choice of a form for a
business entity
• Is the number of owners restricted?
• Do owners have limited liability?
• Can ownership interest be freely
transferred?
• Do owners have a large degree of
management control?
• Does entity continue regardless of ownership
changes?
• Is there a high cost of organizing the entity?
• Does the entity have an ability to raise
additional capital?
4
Sole Proprietorship: A business owned by
one individual.
The owner:
 Has unlimited liability
 Can easily transfer ownership interest
 Has full management control
The entity:
 Ceases to exist when ownership
changes
 Has a low cost of formation
 Has a limited ability to raise capital
5
Partnership -two or more persons engage
collectively in a profit making activity.
The owners:
 Are fully liable (except for limited
partners)
 Cannot easily transfer ownership interest
 Have full management control
The entity:
 Ceases to exist if >50% ownership
changes
 Has a moderate cost of formation
 Has a good ability to raise capital
6
Corporation: an artificial entity created
under the auspices of state law.
The owners:




Have limited liability
Can easily transfer ownership interest
Have no right to direct management
No limit on number of shareholders
The entity:
 Continues to exist when ownership changes
 Has a relatively high cost of formation
 Has an excellent ability to raise capital
7
S Corporation: a regular corporation
with special tax attributes.
The owners:




Have limited liability
Can easily transfer ownership interest
Have no right to direct management
Are limited to a maximum number of 100
The entity:
 Continues to exist when ownership changes
 Has a relatively high cost of formation
 Has an excellent ability to raise capital
8
S Corporation Election
• Requirements for electing S status
–No more than 100 shareholders
–Shareholders must be individuals,
estates, tax-exempt organizations, or
certain trusts
–Shareholders may not be nonresident
aliens
–Only one class of outstanding stock is
allowed
–All shareholders must consent to election
S Corporation Election Termination
• Terminating election
–May be voluntarily terminated by
consent of >50% of shareholders
–Involuntary termination occurs
when any requirements are
violated
• Must wait 5 years before applying
for S status again
Limited Liability Company: corporate
characteristics with the conduit tax
treatment of partnerships.
The owners:
 Have limited liability
 Cannot easily transfer ownership interest
 Have full management control
 No limit on number of owners
The entity:
 Ceases to exist when ownership changes
 Has a moderate cost of formation
 Has a good ability to raise capital
Limited Liability Partnership is a general
partnership with limited liability for owners.
The owners:
 Have liability only for their own acts
 Cannot easily transfer ownership interest
 Have full management control
 Must have at least 2 owners
The entity:
 Ceases to exist when ownership changes
 Has a moderate cost of formation
 Has a good ability to raise capital
Tax Factors-Continued
Double Taxation
Employee vs Owner
Fringe Benefits
Social Security Taxes
Planning
13
General Income Tax Factors
• Three tax factors also influence choice of
entity
Incidence of Income Taxation
• Who pays the tax, the entity or the owner?
Double Taxation
• Is the same income taxed to the entity and the
owner?
Employee versus Owner
• Can owners be treated as employees of the
entity?
#1: Who Pays the Tax?
• Sole Proprietorship: conduit to
owner
–Form 1040, Schedule C
• Partnership: conduit to partners
–Form 1065, Schedule K-1
–Items that receive special tax
treatment are reported separately
from operations
#1: Who Pays the Tax?
• S Corporation: conduit to
shareholders
–Form 1120S, Schedule K-1
–Separable items like partnership
• C Corporation: Corporation pays
–Form 1120
–Owners pay income tax on div.
The following slide shows
the corporate tax rates
in the shagged area.
They are applied for a
corporation with taxable
income of $400,000
Corp distributes after-tax Income
Corporation has taxable income of $1,500,000.
All after-tax income is paid out as dividends
Shareholders are individuals
What is combined effective tax rate?
Corp. taxable income $1,500,000
Corp. income tax rate
34%
Corp. after-tax income
Shareholder tax rate
20%
Total income tax
Total Tax as % of Taxable Income
Corp distributes after-tax Income
Corp. has taxable income of $1,500,000.
All after-tax income is paid out as dividends
Shareholders are individuals
What is combined effective tax rate?
Corp. taxable income $1,500,000
Corp. Income tax rate
34%
$510,000
Corp. after-tax income $990,000
Shareholder tax rate
20%
198,000
Total income tax
708,000
Total Tax as % of Taxable Income 47.20%
#1: Who Pays the Tax?
Personal Service Corporation
• A corporation is a personal service
corporation (PSC) if
– The principal activity is performance of
personal services
– The services are performed by owneremployees, those who own > 10% of the stock
• PSC’s pay tax on the income at a 35% rate
– Encourages payment of salary to owners
– How will Jan’s computer repair company tax
differ if it is a PSC? (2 slides forward)
#2: Is Double Taxation a Problem?
• No
–Sole Proprietorships
–Partnerships
–S Corporations
• Yes
–C Corporations
#3: Owners Treated as Employees?
• Sole Proprietors - No
• Partners - No
– But may receive guaranteed payments and
fringe benefits
• S Corporation shareholders - Yes
– Salary and fringe benefits are deductible by
the corporation
• C Corporation shareholders - Yes
– All payments made to/for owner-employees
allowable
Fringe Benefits
Legislative grace allows employers to
deduct amounts paid as fringe benefits
but does not require employees to
report income.
–Owner-employees
• Related party concerns
• Nondiscriminatory rules
• Sole proprietors are not employees
–No deduction allowed for salary or
benefits
Fringe Benefit Limitations
• Partners and > 2% shareholders of S
Corporations must include in income:
– Employer-provided group term life of $50,000
or less
– Employer sponsored accident and health-care
plans
• Owner/employee can deduct for AGI
– Cafeteria plans, and
– Meals and lodging provided by employer
Willie is the director of golf for Rooney
Corp. Willie owns a 20% interest in Rooney.
He receives a salary of $60,000 and fringe
benefits costing $6,000. Rooney's taxable
income before considering the payments to
and on behalf of Willie is $250,000. Rooney
distributes a $50,000 dividend to its
shareholders. How much income does
Willie have from Rooney?
a. $ 60,000 b. $ 70,000
c. $ 76,000 d. $ 96,800 e. $102,800
Ans: B (Suppose Rooney is an S Corp or Ptshp.)
Social Security Taxes
The social security tax is imposed on the
wages of employees and the net selfemployment income of self-employed
individuals.
• Taxes are paid half by employee and half
by employer
– Total rate is 15.3% =
12.4% OASDI + 2.9% Medicare
– Maximum amount subject to OASDI is
$118,500 for 2016
Social Security Taxes
• Self-employed taxpayers (sole
proprietors and partners) pay both
halves
–Base is 92.35% of net self-employed
income
• Corporations and S corporations may
deduct the half paid for shareholderemployees
Mary’s salary is $120,000
per year. She has federal
income tax of $20,000
withheld. There is no state
income tax. What is her
take-home pay for the
year? See following slide.
Mary-2016
Salary
Federal income tax withheld:
Maximum for Soc. Sec. $118,500
Social Security base 118,500
Rate-Social Security
$120,000
(20,000)
6.20%
Social Security Tax
7,347
Medicare base
120,000
Rate-Medicare Tax
1.45%
Medicare Tax
1,740
FICA (Soc. Security & Medicare)
(9,087)
Take-home pay
$ 90,913
Employer pays to IRS $9,087 + $9,087.
Self-Employment Taxes. Pg. __.
• Self-employed individuals must pay both the
employer’s and the employee’s share of FICA
taxes for a combined rate of 15.3%
– 12.4 % (6.2% x 2) for Social Security on income
up to $118,500 in 2016
– 2.9% (1.45% x 2) for Medicare – no income
limit
• Deduction for employer portion simulated by
multiplying net income from self-employment
by 92.35% (100% - 7.65%) before calculating SE
tax
Self-Employment Taxes
• Tax computed on Schedule SE
• Self-employed individuals are also
allowed a deduction for AGI for the
employer’s half of self-employment taxes
– Calculated by multiplying net income from
self-employment by 92.35% (100% - 7.65%)
before calculating SE tax
• There is no deduction for the employee’s
half of the taxes
Self-Employment Tax
Carrie owns a business that she operates as a
sole proprietorship. The business had a net
profit of $25,000. This is Carrie’s only earned
income.
a. How much self-employment taxes will she
pay?
b. How much can she deduct on her tax return?
c. If the business had a net loss of $10,000
(instead of a $25,000 profit), how much in
self-employment taxes must Carrie pay?
Self-Employment Tax for Carrie [2]
Compute self-employment tax
Net profit on Schedule C $25,000
Factor for S.E. tax base
92.35%
S.E. Tax Rate
S.E. Tax
Deduct 50% of S.E. tax
Self-Employment Tax for Carrie [2]
Compute self-employment tax
Net profit on Schedule C $25,000
Factor for S.E. tax base
92.35%
23,088
S.E. Tax Rate
15.30%
S.E. Tax
3,532
Deduct 50% of S.E. tax
$ 1,766
No S.E. Tax for Loss Year.
Self-Employment Tax – George -1
George has net income from selfemployment of $43,000 (from his
week-end tax practice).
He has a salary of $72,000, earned as a
VP of a local corporation.
What is his self-employment tax?
What amount may he deduct?
Compute self-employ. tax for George - 2
Net profit on Schedule C
Factor for S.E. tax base
$43,000
Base for S.E. Tax
Limit for S.E. Tax
Salary
100,000
Limit on full rate
Excess
15.30%
2.90%
Totals
What amount may he deduct? [50% of S.E. Tax.]
Compute self-employment tax for George - 3
Net profit on Schedule C
Factor for S.E. tax base
Base for S.E. Tax
$43,000
92.35%
$ 39,711
Limit for S.E. Tax $118,500
Salary
Limit on full rate
Excess
Totals
100,000
$18,500
15.30% $2,831
21,211
2.90% 615.10
$39,711
$3,446
What amount may he deduct? [50%]
$1,723
Note: George has paid 7.65% on $72,000 salary above.
The
End