TAX PLANNING CASE 6
TAX COMPARISON OF THE FOUR BUSINESS ENTITIES
Description
The "choice of entity" decision is one of the most important decisions facing practitioners
and their clients who own and operate businesses. There are several forms to choose from, each
of which generates different legal and tax consequences. There is no single form of entity that is
appropriate for every type of business owner or entity that a practitioner is likely to encounter.
Choosing the appropriate form of entity in which to operate is a complex decision. It depends
upon many non-tax factors, including the owners' needs and desires and the particular
characteristics and needs of the business in question. The federal tax consequences of each type
of entity also play an important role, especially in closely held entities where the parties'
combined tax liabilities should be analyzed as part of the decision-making process.
This case study includes is an extension of the facts of Davidson Company discussed in
Chapter 12, in that the projected tax results are rolled forward through Year 5, with a liquidation
of the entity occurring at the end of Year 5. The spreadsheet necessary to make these
computations, Case 6- Entities - 2013, is included with this case. These questions involve
manipulations of key input variables for purposes of analyzing the tax consequences associated
with each type of entity.
Learning Objectives
1.
Determine the key tax differences in the treatment of business income for the four major
types of taxable entities.
2.
Distinguish the role of payroll taxes in each of the four types of entities.
3.
Distinguish the treatment of payments to business owners under each of the four types of
entities.
4.
Determine the differing tax effects of liquidations of the business for each of the four
types of entities.
5.
Assess the effects of changes in key input variables on the present value of the total tax
costs associated with each type of business entity.
6.
Assess the relative effects on the results assuming that the 15% preferential rate on
qualifying dividends is no longer available for individual taxpayers; in other words,
dividend income is taxed at ordinary income rates.
TAX PLANNING CASE 6
TAX COMPARISON OF THE FOUR BUSINESS ENTITIES
QUESTIONS
This assignment utilizes an Excel spreadsheet to extend the analysis of the four entities for four
additional years and incorporates the effects of liquidating the entity at the end of Year 5. The
spreadsheet allows for alternative inputs of each of the initial year variables used in Case Study
#1. Instructions for utilizing this spreadsheet are included on the next page.
1. In the original spreadsheet analysis based on the current inputs, the “Reasonable
Compensation” variable (cell D20) is $55,000, and the “Other Payments/ Withdrawals”
variable (cell D21 of the spreadsheet) is $30,000. Redetermine the total taxes paid
under each of the following changes in these two variables, and explain the relative
changes in results:
Total Taxes Paid by Entity
Sole Proprietorship
Partnership
S Corporation
C Corporation
$75,000/$50,000
Comp/Other Pay
$529,949
$529,949
$500,577
$676,787
$100,000/$25,000
Comp/Other Pay
$
$
$
$
$50,000/$75,000
Comp/Other Pay
$
$
$
$
Explanation____________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. In the original analysis, the “Sales/CGS Growth Percentage” variable (cell H7 of the
spreadsheet) is 20%. Redetermine the total taxes paid under each of the following
changes in this growth percentage, and explain the relative changes in the results:
Total Taxes Paid by Entity
Sole Proprietorship
Partnership
S Corporation
C Corporation
20%
Sales/CGS Growth
$529,949
$529,949
$500,577
$676,787
12%
Sales/CGS Growth
$
$
$
$
28%
Sales/CGS Growth
$
$
$
$
Explanation____________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
3. In the original analysis, the “Land/Building Appreciation” variable (cell H27 of the
spreadsheet) is 10%. Redetermine the total taxes paid under each of the following
changes in appreciation rates, and explain the relative changes in the results:
Total Taxes Paid by Entity
Sole Proprietorship
Partnership
S Corporation
C Corporation
10%
Appreciation Rate
$529,949
$529,949
$500,577
$676,787
2%
Appreciation Rate
$
$
$
$
18%
Appreciation Rate
$
$
$
$
Explanation____________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
4. In the original analysis, the dividends received by the individual taxpayers qualified for
a 15% maximum rate. Redetermine the total taxes paid assuming that the preferential
dividend rate sunsets as proposed, and dividends are taxed fully as ordinary income
(change the input for cell H43 to reflect this). Explain the relative changes in results.
Total Taxes Paid by Entity
Sole Proprietorship
Partnership
S Corporation
C Corporation
Current
Preferential Rate
$529,949
$529,949
$500,577
$676,787
No Preference $55,000/$30,000
Comp/Other Pay
$
$
$
$
No Preference $70,000/$15,000
Comp/Other Pay
$
$
$
$
Explanation___________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Spreadsheet Instructions
The spreadsheet Case 6 – Entities - 2013 is included with this case. The first page of the
spreadsheet consists of input information, and the first column of input variables matches the
assumed information in Phase I (with the exception of the detailed business assets information;
in Case Study #1, the total Year 1 MACRS deduction of $35,748 is given). The second column
of inputs reflect the assumed growth rates in business and personal items, the pension plan
contribution percentages, the annual appreciation or depreciation rates in values of business
assets, the present value discount rate used in each analysis, and information on business loans
on the building and the equipment.
The second page of the spreadsheet discloses the projected business income and expense
amounts for the five years (as adjusted by growth rates), the computed MACRS deductions for
each year, and the computation and character of the gains (losses) realized on the sale of all
business assets at liquidation in the fifth year. Note that the estimated amounts realized for each
asset reflects the assumed appreciation/depreciation input rates. The remaining pages summarize
the total taxes paid over the five years for each entity. In each case, it is assumed that the
business assets are sold by the entity for cash, and that any cash remaining (including
accumulations of cash for the five years) is distributed to the owner in final liquidation of the
entity.
In order to provide rough approximations of the double taxation possibility of liquidating
the C corporate entity, it is necessary to estimate the final assets on hand for the corporation (all
converted to cash) immediately prior to liquidation. This estimate is not really needed for the
other three entity types since there is no double taxation at liquidation, i.e., gains or losses on
sales of business assets are taxed at the individual owner level only and no consequences arise
when the net cash is distributed to the owner of the business. On the other hand, all distributions
from a C Corporation, a separate legal entity, have tax consequences.
Any gains and losses on business asset sales are taxable to the C Corporation, a separate
taxable entity. Additionally, after all business assets have been converted to cash, the
distributions to shareholders in liquidation of their shares are taxable events. And these
distributions include not just the proceeds from asset sales but also any assets accumulated over
the life of the business that have not been distributed to shareholders. Thus, to obtain a more
realistic picture of the tax consequences of liquidating a corporation, it is necessary to estimate
the total accumulated (undistributed) corporate assets on hand at the time of liquidation.
This estimate is provided in the spreadsheet by converting each year’s taxable income to
a cash flow figure by adding back noncash flow items (e.g., depreciation) and subtracting
nondeductible cash flow items (e.g., loan principal payments, dividend payments, and federal
income taxes paid). These cash flows are then accumulated across all five years. In each case,
for simplicity it is assumed that the net cash inflows for each year are invested in a tax-exempt
source at the discount rate (which increases the following year’s cash inflows). Note particularly
the cash flow results in the last year: the cash flow adjustments omit the taxable gains on
disposing of business assets and instead substitute the cash realized on such sales. The last year
cash flow is also decreased for the hypothetical payoff of loan balances on the building and the
equipment.
The final cash accumulation at the end of Year 5 is used as an estimate of the total
corporate assets (all converted to cash) that are available to distribute to the shareholders (Dave
Davidson, the sole shareholder in this case). This number is compared to the shareholder’s
adjusted basis in the shares (based on original capital contributions), and any resulting gain or
loss is capital gain and loss upon final liquidation of the corporation, reportable on the
shareholder’s individual tax return.
The following exercise requires changing three key input variables in the spreadsheet
analysis, comparing the projected results with the original spreadsheet results, and analyzing the
results for possible reasons for the differences. In each case, the results for the current iteration
are given in a table. You are to complete the table with changes in a key input variable, and then
explain why the results changed. (In each case, remember to reset the variables to the original
amounts before changing a new variable.)