Choice of Business Entity –
Tax Factors
double-taxation of regular (C) corporate earnings
single level of tax on earnings of pass-through
entities, assessed on entity owners

not all pass-through entities are created equally
 Partnerships, LLPs
S
and LLCs
Corporations
tax treatment of start-up losses

Losses incurred by pass-through entities are deductible
against owners’ income from other sources
 limitations: PAL and
at-risk limitations (chapter 15)
 losses incurred in corporate form may be carried back/forward
tax reporting requirements
11-1
Choice of Business Entity –
Non-Tax Factors
legal liability
ease and costs of formation
cash flow needs of owners
Interaction of tax and non-tax factors
taxation of income and payment of tax liability
 taxable versus non-taxable cash flows to owners

11-2
Changes in Ownership and
Organizational Form
Changes in ownership
 expanding
the business to include additional
owners/investors is more complicated in
partnership form than in corporate form
Changes in organizational form
 termination
of a corporation results in double
taxation
 taxable versus nontaxable restructurings
 costs of restructuring
11-3
Important Differences between
Partnerships and S Corporations
S corporations provide limited liability to all
shareholders, while partnerships must have at
least one general partner
 LLPs
provide general partners protection from
liability for malpractice of other general partners
Partnerships can make special allocations of
taxable items among partners; all S corporation
allocations must be based on stock ownership
share
11-4
Partnership and S Corporation
Differences continued
Partners cannot be employees of their
partnerships, while S corporation shareholders
can be employees of their corporations
Partnership guaranteed payments and general
partners’ share of partnership ordinary income
are subject to SE tax, while S corporation
shareholders’ share of corporation income is
not
11-5
Partnership and S Corporation
Differences continued
Partnerships can involve greater numbers and
types of owners than S corporations
Contributions (distributions) of property to
(from) S corporations are more likely to result
in taxable gain than contributions
(distributions) to (from) partnerships
11-6
LLCs
Provide the limited liability not available to
general partners, without the participation
restrictions of limited partners
Membership unrestricted versus S corporation
shareholder restrictions
Special allocations possible
Contributions and distributions of property
subject to partnership treatment versus S
corporation treatment
11-7
Closely-Held Corporations as
Tax Shelters
Avoid double taxation by distributing cash flow in
tax-deductible or nontaxable ways

salary payments, interest and principal on debt
Potential benefactors: high-income taxpayers
willing to reinvest after-tax cash flow from
business activities
goal: obtain tax benefit from lower corporate tax rates
on initial increments of business taxable income
 defer second level of tax into the future by avoiding
dividend distributions

11-8
Issues for Closely-Held
Corporations
Constructive Dividends - Indirect distributions
of earnings treated as dividends for income tax
purposes
 examples:
excessive compensation, loans
which are never repaid
 intent: prevent owners of closely-held corporations
from avoiding double taxation by taking cash out
of the business disguised as deductible or
nontaxable payments
11-9
Issues for Closely-Held
Corporations continued
Accumulated Earnings Tax - penalty tax
on accumulations of earnings beyond
‘reasonable needs’ of the business
 tax
rate of 38.6%
 intended to discourage retention of funds not
reinvested in business activities
Personal Holding Company Tax - penalty tax
on undistributed income of a PHC
 tax
11-10
rate of 38.6%
 PHCs not subject to Accum. Earnings Tax
Income Shifting
As previously discussed, the progressive
nature of our tax rate system creates incentive
to shift income to (usually related) taxpayers
subject to lower marginal tax rates
Strategies for income shifting in closely-held
businesses:
 gift
partnership interests or shares of stock to
children or other family members
 employ children/family members in the business
activity
11-11
Limits on Income Shifting
Assignment of income doctrine - income is
taxed to the provider of services or owner of
capital generating the income
 if
a partnership business is based on services
provided by partners, a gift of a partnership
interest to non-service providers will be ineffective
Kiddie tax - unearned income of children
under 14 taxed at parents’ marginal tax rate
11-12
Limits on Income Shifting
continued
Controlled groups - corporate progressive rate
schedule applied only once to entire group
 parent-subsidiary
controlled group - applies even if
consolidated return not filed
 brother-sister controlled group exists if 5 or fewer
individuals control 2 or more corporations
Sec. 482 - gives IRS authority to re-allocate
income of businesses under common control as
necessary to prevent tax evasion
11-13