EA Exam Lite
Part 2
Businesses - II
Figures
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Examples – Sec. 351 Transfers to a Controlled Corporation
The Dividends Received Deduction
Determining Qualifying Organization Costs and Start-up Costs
Examples of Corporate Capital Gain & Loss Nettings
Determining Earnings and Profits (E&P)
Examples – Determining Taxable Corporate Distributions and E&P
Examples - Redemptions
S Corporation Tax on Excessive Passive Income
Qualified Corporate Retirement Plans
Self-Employed Keogh (HR-10) Plans
Sole Proprietorship Entity – Key Factors Analysis
Partnership Entity – Key Factors Analysis
S Corporation Entity – Key Factors Analysis
C Corporation Entity – Key Factors Analysis
Choice of Entity – Other Tax Considerations
1
Figure 1
Examples - Sec. 351 Transfers to a Controlled Corporation
===============================================================
Example 1: In exchange for 70% of the stock of Hamilton Corporation valued at
$70,000, James contributed land with an adjusted basis to him of $36,000 and a fair
market value of $70,000. (The other 30% of the stock was issued to Jane for services.)
Realized Gain = $70,000 - $36,000 = $34,000
Recognized Gain = $34,000 (transaction does not meet 80% control test)
Basis of stock to James = $70,000 (taxable exchange - use fair market value)
Basis of land to Hamilton = $70,000 (taxable exchange - use fair market value)
Example 2: Assume the same facts as 1, except that the 30% stock interest issued to Jane
was also for property. (Answer is for James only.)
Realized Gain = $70,000 - $36,000 = $34,000
Recognized Gain = $0 (Sec. 351 exchange, no boot received)
Basis of stock to James = $36,000 ($36,000 + 0 - 0)
Basis of land to Hamilton = $36,000 ($36,000 + 0)
Example 3: Assume the same facts as 2, except that James received stock worth $60,000
and $10,000 cash.
Realized Gain = ($60,000 + $10,000) - $36,000 = $34,000
Recognized Gain = $10,000 (lesser of realized gain or $10,000 boot received)
Basis of stock to James = $36,000 ($36,000 + $10,000 gain - $10,000 boot rec’d)
Basis of land to Hamilton = $46,000 ($36,000 +$10,000 gain recog. by James)
Example 4: Assume the same facts as 2, except that Hamilton stock was worth $40,000
and the land was subject to a $30,000 mortgage, to be assumed by Hamilton Corporation.
Realized Gain = ($40,000 + $30,000) - $36,000 = $34,000
Recognized Gain = $0 (liabilities assumed are not treated as boot for gain)
Basis of stock to James = $6,000 ($36,000 + $0 - $30,000 boot rec’d < liab>)
Basis of land to Hamilton = $36,000 ($36,000 basis to James)
Example 5: Assume the same facts as 4, except that Hamilton stock was worth $30,000
and the land was subject to a $40,000 mortgage, to be assumed by Hamilton Corporation.
Realized Gain = ($30,000 + $40,000) - $36,000 = $34,000
Recognized Gain = $4,000 (liabilities exceeding basis are taxable as gain)
Basis of stock to James = $0 ($36,000 + $4,000 - $40,000 boot rec’d < liab>)
Basis of land to Hamilton = $40,000 ($36,000 James basis + $4,000 James gain)
2
Figure 2
The Dividends Received Deduction
Anderson Company owns a 26% stock interest in Bell Corporation common
stock. During the current year, Anderson received $40,000 of gross dividends on
the Bell Corporation stock. Anderson’s dividends received deduction, assuming
operating incomes (losses) of $180,000, ($5,000), and ($15,000) would be
computed as follows:
Operating income (loss)
Dividend income
Taxable income before DRD
DRD
Taxable income (NOL)
General
Part (a)
$180,000
40,000
$220,000
(32,000)
$188,000
Limit
Part (b)
$ ( 5,000)
40,000
$35,000
(28,000)
$ 7,000
Exception
Part (c)
$(15,000)
40,000
$25,000
(32,000)
$ (7,000)
In Part (a), the general rule states that the DRD is the lesser of $32,000 (80
percent of the $40,000 dividend) or $176,000 (80 percent of $220,000 taxable
income before DRD). The exception to the general rule does not apply because
there is no possible net operating loss. Thus, the DRD is $32,000 under the
general rule.
In Part (b), the general rule states that the DRD is the lesser of $32,000 (80
percent of the $40,000 dividend) or $28,000 (80 percent of $35,000 taxable
income before DRD). The exception to the general rule does not apply because a
$32,000 DRD would not create or increase a net operating loss (i.e, $35,000 $32,000 = $3,000 positive income). Thus, the DRD is $28,000 under the
limitation to the general rule.
In Part (c), the general rule states that the DRD is the lesser of $32,000 (80
percent of the $40,000 dividend) or $20,000 (80 percent of $25,000 taxable
income before DRD). However, the exception to the general rule applies in this
case because a $32,000 DRD would create a $6,000 net operating loss (i.e.,
$25,000 - $32,000 = $7,000 loss). Thus, the DRD is $32,000 under the exception
to the limitation.
3
Figure 3
Determining Qualifying Organization Costs and Start-up Costs
====================================================================
Bell Corporation, which opened its doors for business on June 1, and incurred the following
costs:
Sec. 248
Org. Cost
1. Bell paid an attorney $3,600 to draft its
articles of incorporation.
2. Bell paid $1,600 for printing the common
stock certificates.
3. Bell paid the Company President $8,000
salary per month for the entire year.
4. Bell paid utilities expense of $1,000 per
month for the entire year.
5. Bell paid $5,000 travel expenses in
establishing relationships with customers
and suppliers prior to opening, and
$2,000 on such travel for rest of the year
6. Bell paid Ace Accounting $5,000 to file
all necessary employment tax forms and
applications prior to opening.
7. Bell paid $2,500 to install machinery to
be used in producing inventory.
8. Bell paid Able Syndicators $6,000 for
issuing stock certificates.
9. Bell spent $3,000 on an ad in several
newspapers announcing their opening,
and then spent $2,000 on ads promoting
their first week sale.
Sec. 195
Startup Expense Capital
$ 3,600
______
______
______
______
______
______
$1,600
______
$40,000
$56,000
______
______
$ 5,000
$ 7,000
______
______
$ 5,000
$ 2,000
_____
$ 5,000
_____
______
_____
______
______
______
$2,500
______
______
______
$6,000
______
$3,000
$2,000
_____
Sec. 248 organization costs [$5,000 expense + ($3,600 x 7/180 amortization)… $ 5,140
Sec. 195 start-up costs [$2,000 expense + ($51,000 x 7/180)…………………… $ 1,983
4
Figure 4
Examples of Corporate Capital Gain and Loss Netting
2004
2005
2006
2007
2008
Current-Year Capital Transactions:
ST Gain
$16,000
$ 8,000
$ 3,000
2,000
$ 3,000
ST Loss
(18,000)
( 6,000)
( 2,000)
( 6,000)
( 7,000)
LT Gain
24,000
2,000
8,000
12,000
7,000
LT Loss
(12,000)
( 1,000)
( 2,000)
( 4,000)
(14,000)
Net Result Originally Reported:
Net St
( 2,000)
2,000
1,000
( 4,000)
( 4,000)
Net LT
12,000
1,000
6,000
8,000
( 7,000)
Effect of Capital Result on Taxable Income as Originally Reported:
Effect
$10,000
$ 3,000
$ 7,000
$ 4,000
$
0
0
0
(11,000)
Capital Loss Carryback Originally Reported:
ST
0
0
Net Capital Result After Carrybacks (CBs) and Carryforwards (CFs):
ST
No change
( 9,000)
( 7,000)
( 5,000)
0
LT
No change
1,000
6,000
8,000
0
( 7,000)
( 1,000)
0
( 1,000)
0
0
Net Effect on Original Taxable Income After CBs and CFs:
Effect
No change
( 3,000)
Recomputed Capital Loss Carryovers:
ST
No change
( 8,000)
5
Figure 5
Determining Earnings and Profits
ABC Corporation uses the calendar year for tax purposes, and had these items of income:
Revenue from sales of merchandise
$130,000
Dividends from domestic corporation (owns 25% of stock)
10,000
Interest from state of Kansas bonds
5,000
In addition, ABC incurred the following expenses:
Cost of merchandise sold
Other operating expenses (exclusive of depreciation)
Depreciation – MACRS (ADS S/L would be $3,000)
Contributions to public charities

80,000
8,000 *
4,000
5,000
Includes a deduction for $1,000 meals and entertainment expenses, representing 50% of the
$2,000 actually spent
Computation of Taxable Income:
Revenues ($130,000 + $10,000 + $0)
Expenses other than contributions ($80,000 + $8,000 + $4,000)
Contributions ($5,000, limited to [($140,000 - $92,000) x .10]
Dividends received deduction ($10,000 x .80)
Taxable income
Tax liability ($43,200 x .15)
$140,000
( 92,000)
( 4,800)
( 8,000)
$ 35,200
=====
$ 5,280
=====
Computation of Current Earnings and Profits:
Taxable income as determined above
Add: Tax-exempt interest income
Dividends received deduction
Depreciation differential ($4,000 - $3,000)
Less: Nondeducted charitable contributions ($5,000 - $4,800)
Nondeducted meals and entertainment ($2,000 x .50)
Federal income taxes paid
Current Earnings and Profits
$ 35,200
5,000
8,000
1,000
( 200)
( 1,000)
( 5,280)
$ 42,720
=====
6
Figure 6
Examples – Determining Taxable Corporate Distributions
In each of the following independent cases, determining how much (if any) of the September
distribution would be taxable to the recipient 100% shareholder:
A
Current E&P (Deficit)
Accumulated E&P (Deficit)
February 1st Property Distribution
(Adjusted Basis $60,000)
March 1st Cash Distribution
September 1st Cash Distribution
C
D
$800,000 $600,000 ($120,000) $120,000
( $940,000) $150,000
80,000
100,000
-$300,000
$450,000
Portion of 9/1 Distribution Taxable
as Ordinary Dividend Income
________
a.
B
-$700,000
$300,000
-$100,000
$100,000
$100,000
$100,000
$100,000
_______
_______
_______
$450,000. The entire distribution is taxable, since current E&P exceeds the total
distributions for the year (the accumulated deficit is ignored).
b. $180,000. Current E&P ($600,000) is 60% of the total distributions during the year
($1,000,000), so 60% of the 2/1 distribution, or $420,000 is from current E&P and $150,000
is from accumulated E&P (allocated on a chronological basis). The remaining $130,000 is a
nontaxable return of capital. Therefore, the only E&P left for the 9/1 distribution is the 60%
pro rata portion of current E&P, or $180,000.
c.
$
0 At the time of the $100,000 distribution on 3/1, the ratable portion of current E&P
allocable to the first two months results is ($20,000), or 2/12 x $120,000 allocated on a daily
basis; this is offset against the $80,000 accumulated E&P balance, so that $60,000 of the 3/1
distribution is taxable. None of the 9/1 distribution would be taxable, since accumulated
E&P has been fully utilized.
d. $40,000. The 2/1 distribution is fully taxable and is presumed to consist of $40,000 current
E&P (allocated pro rata across all distributions), and $60,000 from accumulated E&P
(utilized chronologically). Note that the FMV of the property is taxed to the shareholder, and
the net effect on E&P of the property distribution is a $60,000 decrease (+$40,000 for the
gain and -$100,000 for FMV of the distribution). The 3/1 distribution consists of $40,000
current E&P (pro rata across distributions), $40,000 from accumulated E&P (remainder
utilized), and $20,000 return of capital. Finally, the 9/1 distribution consists of $40,000 from
current E&P, and the remainder is a tax-free recovery of capital.
7
Figure 7
Examples – Redemptions
The 1,000 shares of stock of ABC Company is owned by the following taxpayers:
Adam Ant
Alice Ant (Adam’s wife)
Ace Ant (Adam’s grandfather)
Bitty Ant (Adam and Alice’s son)
Billy Bug (Alice’s father)
Betty Grasshopper (unrelated to anyone above)
300 shares
100 shares
100 shares
150 shares
150 shares
200 shares
a. ABC redeems 200 of Adam’s shares of stock ($40,000 adjusted basis) for $60,000.
Before the redemption, Adam is treated as owning 550 (300 + 100 + 0 + 150 + 0 + 0) of the
1,000 outstanding shares (55%), and after the redemption is treated as owning 350 (100+ 100 +
0 + 150 + 0 + 0) of the 800 outstanding shares (43.75%). Since Adam meets both the 50% test
(less than 50% interest after the redemption) and the 80% test (less than 80% of his 55% former
interest, or 44%), the redemption is treated as a sale or exchange and Adam will report a
$20,000 capital gain on the transaction.
b. Assume instead that ABC redeems all 100 of Alice’s shares of stock ($40,000 adjusted
basis) for $60,000.
Before the redemption, Alice is treated as owning 700 (300 + 100 + 0 + 150 +150 + 0) of the
1,000 outstanding shares (70%), and after the redemption is treated as owning 600 (300 + 0 + 0
+ 150 + 150 + 0) of the 900 outstanding shares (66.7%). Since Alice fails the 50% test (more
than 50% interest after the redemption) and also the 80% test (not less than 80% of her 70%
former interest, or 56%), the redemption is treated as a taxable dividend of $60,000 to Alice.
Alice will increase the adjusted basis of her remaining shares by $60,000. [Note – failing either
of the two tests will disqualify Alice from capital gains treatment.]
c. Assume the same facts as (b), except that Alice signs an agreement not hold an interest or
to participate in the affairs of ABC Corporation for the next 10 years.
This agreement meets the conditions of Sec. 302(b)(3) regarding a complete termination of
interest, so the family attribution rules are waived. Thus, Alice is treated as owning zero shares
after the complete redemption, and may report the transaction as a sale or exchange, recognizing
a $20,000 capital gain.
8
Figure 8
S Corporation Tax on Excessive Passive Income
Macy Corporation, an S corporation with $80,000 E&P from C corporation years, had the
following results in the current year:
Consulting services (active, nonpassive income)
Interest income
Dividend income
Expenses directly related to passive income
$180,000
180,000
120,000
60,000
The excess net passive income of Macy is computed as follows:
ENPI = Net Passive Income x Passive investment income – 25% of gross receipts
Passive investment income
ENPI = ($300,000 – 60,000) x $300,000 – (0.25 x $480,000)
$300,000
ENPI = $144,000
======
The tax on excessive net passive income is $50,400 ($144,000 x .35). This amount is
paid by the S corporation. The $50,400 is then allocated between the interest and
dividend incomes based on total sources of each ($180,000 and $120,000,
respectively).
Thus, $30,240 ($50,400 x 18/30) is allocated to interest and reduces the passthrough
to shareholders to $149,760 ($180,000 - $30,240), and $20,160 ($50,400 x 12/30) is
allocated to dividends and reduced the passthrough to shareholders to $99,840
($120,000 - $20,160).
9
Figure 9
Qualified Corporate Retirement Plans
Type of Plan
Pension Plan
[Defined Benefit]
Money Purchase Plan
[Defined Contribution]
Profit-Sharing or StockBonus Plan (Defined
Contribution)
More Than One Plan
Existing at One Time
Maximum Amount
Contributable on Behalf of
Employee
The lesser of (1) 100% of the
employee's compensation
(average of highest 3 years,
limited to $225,000 in 2007) or
(2) present amount to fund an
annual retirement benefit of
$180,000 (2007)
The lesser of $45,000 or 100%
of the employee's compensation
($225,000 limit)
The lesser of $45,000 or 25% of
the employee's compensation
($225,000 limit)
Individual Limits As Specified
Above
Maximum Amount
Deductible by the
Employer
Actuarial calculation of the
amount necessary to fund the
normal stated contract benefit
(plus up to 10% of past service
costs)
25% of total annual aggregate
compensation of employees
25% of total annual aggregate
compensation of employees
25% of total annual aggregate
compensation of employees
10
Figure 10
Self-Employed Keogh (HR-10) Plans
Type of Plan
Pension Plan (Defined
Benefit Plan)
Profit-Sharing or Stock
Bonus Plan (Defined
Contribution Plan)
Money-Purchase Plan
(Defined Contribution Plan)
Maximum Amount
Contributable on Behalf of
S/E Owner
The lesser of (1) 100% of S/E
compensation (average of
highest 3 years, limited to
$225,000 in 2007), or (2) the
present amount to fund an
annual retirement benefit of
$180,000 (2007)
The lesser of $45,000 or 25%
of S/E income
Maximum Amount
Deductible for
S/E Owner
Actuarial calculation of the
amount necessary to fund the
stated contract benefit
The lesser of $45,000 or 100%
of S/E income
The lesser of $45,000 or 100%
of S/E income
The lesser of $45,000 or 25%
of S/E income
11
Figure 11
Sole Proprietorship Entity -Key Factors Analysis
Non-tax Factors:

Formalities of Existence – Few legal formalities are necessary when forming a sole proprietorship,
since the business and the owner are treated as a single entity under the law. An employment
identification number must be secured if employees will be used in the business.

Limited Liability of Owners – A sole proprietor has unlimited personal liability in regards to business
debts. This is a primary disadvantage of this entity type; creditors can attach personal assets.

Ability to Raise Capital – A sole proprietor may face difficulty in raising capital for the business,
since other owners are not involved. Bringing in partners or incorporating may be the only practical
means of raising additional capital.

Participation in Management – The sole proprietor has total control in managing the business, as
there are no other owners to answer to.

Transferability of Interests – The sole proprietor can easily transfer the business through sale or
exchange. A sole proprietorship may be easily dissolved, with assets converted to personal use.
Tax Factors:

Tax Aspects of Formation – The formation of a sole proprietorship is not a taxable event; the basis of
assets contributed to the business is generally the proprietor’s adjusted basis (unless the fair market
value of converted assets is less than the adjusted basis at contribution).

Taxation as a Separate Entity vs. Pass-Through Entity – The sole proprietorship business and the
owner are treated as a single entity for tax purposes. The net income of the business is determined on
Schedule C, and this amount is included in gross income on the Form 1040. Net losses would
generally be deductible by the sole proprietor unless the hobby loss rules apply. Cash withdrawals
generally have no effect on tax liability. Liquidation of the business by sale or exchange would
involve a single layer of tax, with gains and losses reported on the individual tax return.

Taxation of Owner Compensation – The sole proprietor is always taxed on the net income of the
business (as reflected on Schedule C), regardless of withdrawals. Thus, the designation of a salary as
“reasonable compensation” is meaningless in the sole proprietorship, and any other cash withdrawals
have no effect on the final tax liability. The sole proprietorship is always subject to a single level of
tax at the owner level. As to deferred compensation, a sole proprietor may establish a Keogh (HR-10)
plan that provides benefits similar to corporate plans; immediate deductions for contributions, tax-free
accumulation of income on the trusteed contributions, and deferral of tax until withdrawals
(presumably at retirement). However, employees must be covered under the qualified plan rules.

Ability to Provide Tax-Favored Fringe Benefits – The sole proprietorship entity does not provide a
vehicle for tax-favored fringe benefits. However, in a limited attempt to provide parity with corporate
entities with regards to health insurance coverage, a sole proprietor may deduct for adjusted gross
income 100% of insurance premiums for health coverage for the sole proprietor and his or her family.
12
Figure 12
Partnership Entity - Key Factors Analysis
Non-tax Factors:

Formalities of Existence – A partnership entity generally requires a partnership agreement that
specifies the rights and responsibilities of the partners, including profit and loss sharing ratios. This
agreement would need to be modified each time additional partners are added.

Limited Liability of Owners – General partners (those who participate in the management of the
partnership) have unlimited personal liability. The partnership may also be structured to offer limited
partnership interests, where such partners’ liability is limited to invested capital. However, limited
partners may not actively participate in the management of the business.

Ability to Raise Capital – Partnerships offer increased flexibility as to ability to raise capital when
compared to sole proprietorships. Additional partnership interests may be offered as a means of raising
additional capital; however, this entails changes in the underlying partnership agreement.

Participation in Management – General partners are free to participate actively in managing the
business, but limited partners are prohibited from managing the day to day affairs of the business.
Because of this prohibition, limited partners are likely to be subject to the passive activity limitations.

Transferability of Interests – Transfers of partnership interests can be somewhat complex, as other
partners may have to agree to the transfer and the underlying documents will need to be amended.
Transfers of more than 50% in interests will terminate the partnership for federal tax purposes.
Tax Factors:

Tax Aspects of Formation – The formation of a partnership is generally not a taxable event unless the
interest received is compensation for services or the liabilities assumed by other partners exceed the
adjusted basis of the property to the contributing partner. In general, taxable transfers are less likely to
occur with partnership formation; there is no 80% control requirement. Another positive aspect of a
partnership that a partner’s tax basis includes his or her share of partnership liabilities.

Taxation as a Separate Entity vs. Pass-Through Entity – The partnership is a conduit entity for
federal tax purposes; the single layer of tax is applied at the individual partner level. (The same rules
apply for limited liability entities.) Items of partnership income, deductions, and credits retain their
character and generally flow through to the partners based on profit and loss sharing ratios (this is also
true of losses); however, special allocations having “substantial economic effect” may be made.
Guaranteed payments are deductible in determining partnership ordinary income and are allocated
directly to recipient partners. Distributions need not be pro rata in a partnership entity.

Taxation of Owner Compensation – A partner is always taxed on his or her share of the “ordinary
income” of the business, his or her share of any guaranteed payments, and his or her share of
“separately stated items”. Any cash withdrawals (“other cash payments”) generally have no effect on
the final tax liability. General partners may also establish Keogh accounts for deferred compensation,
and these operate much like the Keogh account of a self-employed individual described above.

Ability to Provide Tax-Favored Fringe Benefits – The partnership entity does not provide a vehicle
for tax-favored fringe benefits. However, like a sole proprietor, general partners may deduct 100% of
insurance premiums for health coverage for the sole proprietor and his or her family.
13
Figure 13
S Corporation Entity - Key Factors Analysis
Non-tax Factors:

Formalities of Existence – An S Corporation is a separate entity for purposes other than tax, and as
such, must conform to various legal and/or state requirements for incorporation. Additionally, strict
election requirements must be met for federal tax purposes.

Limited Liability of Owners – Since the S Corporation is a separate legal entity, it offers the regular
corporate advantage of limited liability for its owners. However, this advantage may be somewhat
mitigated by the fact that creditors may require the owners of a startup S Corporation (particularly in
the case of family businesses) to guarantee personally notes for the initial financing of the business.

Ability to Raise Capital – The 100 shareholder limit for S Corporation status may cause some minor
problems in raising capital. However, the company can issue as many shares as it desires, as the limit
is stated in terms of the number of shareholders and not the number of shares.

Participation in Management – Because of the limited number of shareholders in an S, it may be
possible for the owners to participate more in company management than in a regular C Corporation.

Transferability of Interests – Transfers of S Corporation interests are generally easier to accomplish
than transfers of partnership interests, since the S Corporation shareholder can sell his or her shares.
However, care must be taken so that the sale is not to a disqualified shareholder or that the sale causes
problems with the 75 shareholder limit.
Tax Factors:

Tax Aspects of Formation – The formation of an S Corporation involves the same tax consequences
as the formation of a regular C corporation. Thus, nontaxable treatment is assured only if the
shareholder receives no boot, performs no services, does not transfer assets with liabilities exceeding
basis, and most importantly, meets the 80% control requirement. Although liabilities are not added to
a shareholder’s basis, the tax basis any unpaid loans to the S Corporation may be recovered

Taxation as a Separate Entity vs. Pass-Through Entity – The S Corporation is a conduit entity for
federal tax purposes; the single layer of tax is applied at the individual shareholder level. Items of S
Corporation income, deductions, and credits flow through to the shareholders of record at the end of
the tax year and retain their character. Any distributions must be pro rata. Any operating losses would
also flow through to the individual S Corporation shareholders. It is important to note that some states
may not recognize S Corporation status for state income tax purposes.

Taxation of Owner Compensation – The S Corporation shareholder who is also an employee is
treated as an employee of the separate corporate entity. Thus, such owner/employee is taxed on any
compensation received, is subject to the normal FICA withholding rules, and is treated as an employee
for pension plan purposes. Other distributions to an S shareholder/employee are treated as nontaxable
withdrawals (as long as the amounts do not exceed basis).

Ability to Provide Tax-Favored Fringe Benefits – The normal tax-favored treatment of fringe
benefits available to shareholder/employees in regular C Corporations (deduction for the corporation
and exclusion for the employee) is generally not available to shareholder/employees in S Corporations.
The only exception is for those S shareholder/employees who own a 2% or less interest in the S
Corporation. This seldom occurs in most closely-held family businesses.
14
Figure 14
C Corporation Entity - Key Factors Analysis
Nontax Factors:

Formalities of Existence – A C Corporation is a separate entity for tax and non-tax purposes, and as
such, must conform to various specific legal and/or state requirements for incorporation.

Limited Liability of Owners – Since the C Corporation is a separate legal entity, it offers the
advantage of limited liability for its owners. However, as mentioned earlier with S Corporations, this
advantage may be somewhat mitigated by the fact that creditors may require the owners to guarantee
personally any loans used to start the business.

Ability to Raise Capital – The C Corporation offers maximum flexibility in terms of the ability to
raise capital. Different types of stock and securities may be offered as a means to raise such capital;
limitations are not imposed by the Code (other than the possible danger of having some debt
reclassified as stock because the corporation is too “thinly capitalized.”)

Participation in Management –In most cases, the stock of a C Corporation is widely held, which
effectively limits the ability of owners to participate in the management of the company. Most major
decisions of the business are in the hands of an independent Board of Directors.

Transferability of Interests – The C Corporation offers maximum flexibility in transferring interests.
A shareholder may sell his or her shares without any disruption to the ongoing business of the
corporation.
Tax Factors:

Tax Aspects of Formation –Nontaxable treatment in forming a C Corporation is assured only if the
contributing shareholder receives no boot, performs no services, does not transfer assets with liabilities
exceeding basis, and most importantly, meets the 80% control requirement. The strict requirements of
Sec. 351 must be satisfied before the entity formation is tax-free.

Taxation as a Separate Entity vs. Pass-Through Entity – The major disadvantage of a C
Corporation is the double taxation possibility, since the corporation is treated as a separate tax entity.
Income is taxed once at the corporate level and then again when distributed to shareholders at a 15%
tax rate (unless in the form of deductible salary, rent, or interest). Also, capital losses and operating
losses may not be passed through to the owners; they remain at the corporate level. If losses are
expected for several years after formation, an S election should be considered if at all possible.

Taxation of Owner Compensation – The C Corporation shareholder/employee is treated as an
employee of the separate corporate entity. Thus, such owner/employee is taxed on any compensation
received, is subject to the normal FICA withholding rules, and is treated as an employee for pension
plan purposes. Other distributions to a C shareholder/employee are treated as taxable dividends (taxed
at a 15% rate) unless payments represent deductible rent or interest paid to the shareholder.

Ability to Provide Tax-Favored Fringe Benefits – The tax-favored treatment of fringe benefits
available to shareholder/employees is a major advantage offered by regular C Corporations. Such
benefits as health and insurance, group-term life insurance, reimbursement plans, meals and lodging,
child care payments, educational benefits, and other items are deductible by the corporation and are
excludable from income by the employee.
15
Figure 15
Choice of Entity – Other Tax Considerations
Choice of Tax Year
Generally, a sole proprietorship and a C corporation are free to choose a calendar or a fiscal year.
On the other hand, partnerships and S corporations are subject to significant restrictions in the choice of a
tax year. A partnership must generally determine its tax year according three tests, each applied
sequentially until the appropriate year is determined: (1) the majority interest rule; (2) the principal
partners rule; or (3) a tax year determined under a “least aggregate deferral” computation. Generally, an S
corporation must use a calendar year unless a special prepayment election under Sec. 444 is made.
Alternative Minimum Tax
Alternative minimum tax (AMT) considerations are somewhat alike for the sole proprietor, the
partnership, and the S corporation, since all items of income, deduction, and credits flow through the
partnership and S corporation directly to the owners and retain their character. The sole proprietor has the
most control over items that may affect the AMT, since he or she makes all tax elections as opposed to
being one of possibly many owners. The regular C Corporation is also subject to an AMT, but only if
average gross receipts for the preceding three years exceed $7.5 million. The corporate AMT rate is only
20% (as opposed to 26% and 28% for individuals); however, the C Corporation has one major adjustment
that does not apply to the other entities: the adjusted current earnings (“ACE”) adjustment. In general,
ACE is a rough surrogate for financial accounting income, and to the extent this “accounting” number
exceeds alternative minimum taxable income, 75% of the excess is reported as an AMT adjustment.
Multi-jurisdictional Operations
As a family business grows, the possibility of expanding beyond state (or national borders) may be
a viable business option. This raises a host of tax issues; for example, has the business in the new
jurisdiction established “nexus” (i.e., are there sufficient operations in the new location to justify that
location imposing a tax for goods and services used in the new jurisdiction)? If the answer is yes, then
some type of apportionment of income may be required. The type of entity in the new jurisdiction will
determine the ultimate tax burden; for example, some states do not recognize the existence of an S
corporation. Also, state tax rates, rules, and “tax holidays” may vary in today’s competitive environment.
Transfer of the Family Business
The owner(s) of a family business must constantly give attention to the possible value of the
business at their deaths, who will receive such interests, and who will eventually control the business.
Depending on the size and complexity of the business, useful tax planning tools could include outright
transfers to survivors or simple buy-sell agreements (where the decedent’s ownership interest is purchased
by surviving owners or is redeemed by the business). Leaving the entire interest to a surviving spouse
eliminates estate tax considerations at death of the first spouse, but may create terrible tax consequences to
the family when the second spouse dies. A popular family transfer planning technique currently used is the
“discounted value transfer”, which eliminates post-transfer appreciation from the decedent’s estate and
limits the original amount subject to the gift or estate transfer. Court decisions have allowed minority
interest and lack of marketability discounts when valuing shares of stock (or partnership interests.
Limited Liability Entities
Since limited liability entities are taxed as partnerships for federal purposes, many of the same tax
and non-tax considerations apply to these entities. However, complying with the various state statutes
permitting limited liability entities may cause administrative problems for multi-state entities.