Spilker TBE 15e PPT CH04 Accessible

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Chapter 4
Business Entities Overview
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Learning Objectives
1. Discuss the legal and other nontax characteristics of
different types of legal business entities.
2. Describe the different types of business entities for tax
purposes.
3. Identify fundamental differences in tax characteristics
across business entity types.
© McGraw Hill 2
Entity Legal Classification and Nontax
Characteristics 1
Legal Classification.
• Corporation, limited liability company (LLC), general
partnership (GP), limited partnership (LP), sole
proprietorship.
• Business owners legally form.
• Corporation—file articles of incorporation.
• LLC—file articles of organization.
• GP—written agreement called partnership agreement.
• LP—written agreement and file a certificate of limited
partnership.
• Sole proprietors are not required to formally organize their
businesses with the state.
© McGraw Hill 3
Characteristics 2
Nontax Characteristics.
• Responsibility for Liabilities.
• Corporations and LLCs are solely responsible.
• Partnerships—GPs are ultimately responsible, and LPs are
not responsible.
• Sole proprietorships—Individual owners are responsible
(unless single-member LLC).
• Rights, Responsibilities, and Legal Arrangements among
Owners.
© McGraw Hill 4
Characteristics 3
Exhibit 4-1 Business Types: Legal Entities and Nontax

Characteristics
Nontax General Limited Sole
Corporation LLC
Characteristics Partnership Partnership Proprietorship
Must formally
organize with Yes Yes No Yes No*
state
Responsibility
General General
for liabilities of Entity Entity Owner†
partner(s) partner(s)
business
Legal
arrangement Not flexible Flexible Flexible Flexible Not applicable
among owners
Suitable for
initial public Yes No No No No
offering
© McGraw Hill 5
Characteristics 4
*Sole proprietor must organize with state if she forms a

single-member LLC.
†Owner is not responsible for the liabilities of the business if
sole proprietorship is organized as an LLC. However, owner
is responsible for liabilities stemming from her own
negligence and for any liabilities the owner personally
guarantees.
While it is uncommon, certain limited partnerships are
eligible for IPOs.
© McGraw Hill 6
Entity Tax Classification 1
Business entities classification for tax purposes.

• Check-the-box regulations.
• Taxpaying entities.
• Flow-through entities.
Corporations are C corporations unless shareholders make a

valid S election.
© McGraw Hill 7
Unincorporated entities.
• Taxed as partnerships if they have more than one owner.
• Taxed as sole proprietorships if owned by an individual or
as disregarded entities if held by some other entity.
• May elect to be taxed as C corporations (and,
consequently, S corporations).
• Sole proprietorship is eligible to elect only if legally formed as
a single member LLC.
© McGraw Hill 8
Exhibit 4-2 Determining the Tax Form of a Business Entity

under Check-the-Box Regulations.
Access the text alternative for slide images.
© McGraw Hill 9
Entity Tax Characteristics 1
Taxation of Flow-Through Entity Business Income.

• Income generated by flow-through entities is taxed to entity
owners, not to the entities.
• Income allocated to flow-through entity owners increases owners’
basis in ownership interest.
• Distributions to entity owners are treated as a nontaxable return of
capital to extent of basis in ownership interest.
• C corporations pay entity-level tax.
• Shareholders pay a second level of tax when they.
• Sell stock or
• Receive dividends.
• Entity income and dividend distributions do not affect stock basis.
© McGraw Hill 10
Taxation of Flow-Through Entity Business Entity Income.

• Qualified business income (QBI) deduction potentially available
to flow-through entity owners.
• From AGI deduction but not an itemized deduction.
• 20 percent of QBI, reduced by other deductions attributable to the
trade or business (example, deduction for taxpayer's self-
employment tax, self-employed health insurance, and contributions
to self-employed retirement plans.
• Business income is QBI unless it is from a “specified service”.
• QBI is must be earned in the United States.
• Deduction is subject to wage-based limitation and taxable income
limitation.
© McGraw Hill 11

• Specified trade or business requirement.
• Phases in (deduction phases out) as taxable income before
QBI deduction exceeds threshold (indexed for inflation)
based on filing status.
• If taxable income before QBI is equal to or less than
$182,100 ($364,200 if married filing jointly), specified service
requirement does not apply.
• Specified service requirement phases in pro rata over a $50k
range ($100,000 if MFJ).
© McGraw Hill 12
• QBI Deduction specified service example.
Assume that CCS allocates $50,000 of business income to

Nicole and that the business income is from a specified
service trade or business. Also, assume that Nicole’s
deduction for self-employment taxes paid on the business
allocation included in QBI is $3,532, Nicole is married and
files a joint return with her spouse, and the taxable income
on their joint tax return is $400,000 before the QBI deduction.
All of the taxable income is taxed at ordinary rates except for
$15,000 of qualified dividends. What is Nicole’s QBI
deduction before considering the wage-based limitation but
after considering the taxable income limitation?
© McGraw Hill 13
Description Amount Explanation

1) Qualified business income $ 50,000 From a specified service
2) Self-employment tax deduction Based on self-employment taxes paid on self-
3,535 employment income included in Q BI
3) Base for QBI deduction $ 46,468 (1) − (2)
4) QBI deduction rate 20%
5) QBI deduction before specified service (3) × (4)
requirement $ 9,294
6) Taxable income before QBI deduction 400,000
7) Taxable income threshold for specified service T
or B requirement phase-in 364,200
8) Taxable income over threshold $ 35,800 (6) − (7)
9) Percentage through specified service T or B (8)/100,000
requirement phase-in (deduction phase-out) range
for MFJ tax return 35.8%
10) Deduction phase-out due to specified service (5) × (9)
requirement 3,327
11) QBI deduction before the taxable income limit $ 5,967 (5) − (10)
12) Taxable income limitation 20% × $385,000 [taxable income (before Q BI
deduction) taxed at ordinary rates ($400,000 −
$ 77,000 $15,000)
QBI deduction $ 5,967 Lesser of (11) or (12)
© McGraw Hill 14

• QBI deduction wage-based limitation.
• QBI deduction cannot exceed the greater of
• 50 percent of the wages paid with respect to the qualified trade
or business
• The sum of 25 percent of wages paid with respect to the
qualified trade or business plus 2.5 percent of the unadjusted
basis of all qualified property in the qualified trade or business.
• Wage-based limitation phases in (resulting in less deduction)
as taxable income before QBI deduction exceeds the same
thresholds as used for the specified service requirement
phase in threshold.
© McGraw Hill 15
• QBI deduction wage-based limitation example.

Assume that CCS allocates $50,000 of business income to
Nicole, the business income is not from a specified service
trade or business, and CCS allocated $15,000 of wages to
Nicole for purposes of determining the wage-based limitation
(assume there is no qualified property). Also, assume that
Nicole’s deduction for self-employment taxes paid on the
business allocation included in
QBI is $3,532, Nicole is married and files a joint return with
her spouse, and the taxable income on their joint tax return is
$600,000 before the QBI deduction (all taxable income is
taxed at ordinary rates). What is Nicole’s QBI deduction?
© McGraw Hill 16
• Example
1) Qualified business income $ 50,000 Not from a specified service
2) Self-employment tax 3,532 Based on self-employment taxes paid on self-
deduction employment income included in QBI
3) Base for QBI deduction $ 46,468 (1) − (2)
4) QBI deduction rate 20%
5) QBI deduction before wage $ 9,294 (3) × (4)
limit
6) 50% of wages paid 7,500 $15,000 wages allocated to Nicole × 50%
allocated to Nicole
7) QBI deduction before 7,500 Lesser of (5) or (6)
taxable income limit
8) Taxable income limit $120,000 20% × $600,000[taxable income (before QBI
deduction) taxed at ordinary rates]
QBI deduction $ 7,500 Lesser of (7) or (8)
© McGraw Hill 17

• QBI deduction taxable income limitation.
• QBI deduction cannot exceed 20% of taxable income before
the QBI deduction) taxed at ordinary rates.
• This is taxable income before the QBI deduction minus net
capital gains and qualified dividends (that is, income taxed at
preferential rather than ordinary rates).
• Determine QBI deduction before the taxable income limit and
then compare to taxable income limit to determine the final
amount of the deduction.
© McGraw Hill 18

• Flow-through income taxed at individual marginal tax rate.
• Top individual rate is 37 percent.
• Passive investors also potentially subject to 3.8 percent net
investment income tax.
• Owners of entities taxed as partnerships and sole
proprietorships who are involved in entity’s business activities
are potentially subject to:
• 3.8 to 15.3 percent self-employment tax.
• .9 percent additional Medicare tax.
© McGraw Hill 19

• Self-employment tax base is net earnings from self
employment.
• Net earnings from self employment is Schedule C net
Schedule C income × .9235.
• First $160,200 (2023 Social Security wage base limit) tax
base is taxed at 15.3%.
• Tax basis in excess of $160,200 is taxed at 2.9%.
© McGraw Hill 20

• Self-employment tax example.
Assume that Nicole chooses to form CCS as an S

corporation. In 2023, assume that Nicole is allocated $30,000
of business income from CCS and $20,000 of business
income from a partnership in which Nicole is actively
involved in the business. What are Nicole’s self-employment
tax liability and self-employment tax deduction for the year?
© McGraw Hill 21
• Self-employment tax example.

1) Self-employment income $20,000 $20,000 allocation from partnership
is self-employment income, but
$30,000 allocation from the S
corporation is not.
2) Net earnings from self- 18,470 (1) × 92.35%
employment (SE tax base)
3) Self-employment tax rate 15.3% Rate is 15.3 on first $160,200 of net
earnings from self-employment and
$2.9 % on the amount over
$160,200.
4) Self-employment tax $2,826 (2) × (3)
liability
Self-employment tax $1,413 (4) × 50 percent
deduction
© McGraw Hill 22

• Flow-through income is taxed at individual marginal tax
rate.
• S corporation shareholders are not subject to self-
employment tax or additional Medicare tax on business
income allocations from S corp.
© McGraw Hill 23
Overall Tax Rate of C Corporation Income.

• Corporations pay entity-level tax of 21 percent.
• Second level of tax when after-tax earnings are distributed as
a dividend to shareholders or when shareholders sell stock.
• Individual Shareholders.
• Pay second tax at 0, 15, or 20 percent depending on taxpayer’s
income level.
• May also pay 3.8 net investment income tax, depending on
income level.
© McGraw Hill 24
Overall Tax Rate of C Corporation Income.

• Corporations pay entity-level tax at 21 percent.
• Corporate shareholders.
• Include dividend in income.
• Dividends received deduction of 50 percent, 65 percent, or 100
percent, depending on extent of ownership in distributing
corporation.
• Institutional shareholders.
• Do not pay shareholder-level tax on dividends.
© McGraw Hill 25
Tax-Exempt Organizations.
• Organizations like churches and universities are exempt from
tax on investment income, including dividend income.
• Must file Form 990, “Return of Organization Exempt from Income
Tax”.
• Potentially subject to tax on unrelated business income (21%
rate).
• Must file Form 990-T, “Exempt Organization Business Income Tax
Return” if gross income from unrelated business is more than
$1,000.
Foreign Shareholders.
• May be eligible for reduced rates on dividend income depending
on the tax treaty with the U.S.
© McGraw Hill 26
Corporations can defer second level of tax by not distributing

earnings.
• If retaining earnings for tax avoidance rather than a
business purpose, corporation may owe accumulated
earnings tax or personal holding company tax.
© McGraw Hill 27
Owner Compensation.
• Sole proprietorships—no compensation.
• S corporations and C corporations.
• Employee compensation (wages, salary).
• Subject to FICA (employer and employee portions).
• Deductible by entity.
• Compensation to C corporation shareholder is deductible to extent it is not unreasonably
high. Could be recast as nondeductible dividend to extent it is not reasonable.
• Not eligible for QBI deduction.

• Business income allocation from S corporation to shareholder/employee is not
subject to FICA taxes.
• Incentive to keep salary low to reduce FICA taxes.
• Compensation for S corporation shareholders/employees must not be unreasonably low.
Distributions recast as salary to extent it is unreasonably low.
© McGraw Hill 28
Owner Compensation.
• Owners of entities taxed as partnerships receive
guaranteed payments as compensation.
• Self-employment income.
• Deductible by entity.
• Not eligible for QBI deduction.
© McGraw Hill 29
Deductibility of Entity Losses.

• C corporations with NOL carryovers incurred in tax years
beginning before 2018.
• Carry back 2 years.
• Carry forward 20 years.
• Offset up to 100 percent of taxable income in those years.
© McGraw Hill 30

• C corporations with NOLs incurred in years beginning after
2017 (for years beginning after 2020)and before.
• Carry back 5 years.
• Carry over indefinitely.
• For tax years beginning before 2021, can offset up to
100% of taxable income before the NOL deduction.
• For tax years beginning after 2020, can offset up to 80
percent of taxable income remaining after deducting NO
Ls from tax years beginning before 2018.
© McGraw Hill 31

• C corporations with NOLs incurred in tax years beginning
after 2017 (and remaining after 2020).
• Carry forward indefinitely.
• No carryback.
• Offset up to 80 percent of taxable income remaining after
deducting NOL carryovers from tax years beginning before
2018.
NOL carryovers deducting in FIFO order.

Losses not available to offset owners’ income.
© McGraw Hill 32
Losses generated by flow-through entities are generally

available to offset the owners’ personal income, subject to
certain restrictions.
• Basis.
• At-risk.
• Passive activity.
• Excess business loss.
• $578,000 if married filing jointly, $289,000 otherwise.
© McGraw Hill 33
Tax differences between tax entities.
© McGraw Hill 34
Other differences between entities (see Exhibit 15-4).

• Owner limitations (see Ch. 22).
• Owner contributions of appreciated property to entity (see
Chs. 19, 20, and 22).
• Accounting periods (see Chs. 8, 20, and 22).
• Overall accounting method (see Chs. 8, 16, 20, and 22).
• Allocation of income or loss items to owners (see Chs. 20
and 22).
© McGraw Hill 35
• Share of flow-through entity debt included in basis of

owner’s equity interest (see Chs. 20 and 22).
• Non liquidating distributions of noncash property (see Chs.
18, 21, and 22).
• Liquidating entity (see Chs. 19, 21, and 22).
© McGraw Hill 36
Converting to Other Entity Types.

• C corporations.
• Make election to be taxed as S corporation.
• May not qualify to make S election.
• May liquidate and form as entity taxed as a partnership, but
tax cost of liquidation can be significant.
• Entities taxed as partnerships or sole proprietorships.
• Generally nontaxable to form as a corporation.
• Very common in advance of IPO.
© McGraw Hill 37
Overall Tax Rate Example
Nicole chooses to form her business as a C corporation, and
she makes the following assumptions:
• CCS earns taxable income of $500,000.
• CCS will distribute all of its after-tax earnings annually as a
dividend.
• Her ordinary marginal ordinary tax rate is 37 percent and
her dividend tax rate is 23.8 percent (including the net
investment income tax).
If Nicole organizes CCS as a C corporation, what would be
the overall tax rate on CCS’s income?
© McGraw Hill 38
Overall Tax Rate Example Solution
Answer: 39.8 percent, computed as follows:
1) Taxable income $500,000
2) Corporate tax rate 21% Flat corporate tax rate
3) Corporate-level tax $105,000 (1) × (2) [first level of tax]

4) Income remaining after taxes and
$395,000 (1) − (3)
amount distributed as a dividend
20% dividend rate + 3.8% net
5) Dividend tax rate 23.8%
investment income tax rate
6) Shareholder-level tax on dividend $ 94,010 (4) × (5) [second level of tax]
7) Total tax paid on corporate taxable
$199,010 (3) + (6)
income
Overall tax rate on corporate taxable
39.8% (7)/(1)
income
© McGraw Hill 39
Entity Loss Example 1
Assume that Nicole will organize CCS as a C corporation
and that in spite of her best efforts as CEO of the company,
CCS reports a tax loss of $50,000 in its first year of operation
(2023). Also, recall Nicole’s marginal tax rate is 37 percent
and her spouse’s salary for 2023 is $500,000. Nicole files a
joint tax return with her spouse. How much tax will CCS pay
in 2023 and how much tax will Nicole (and her spouse) pay
on the $500,000 of other taxable income if CCS is organized
as a C corporation?
© McGraw Hill 40
Entity Loss Example 1 Solution
Answer: CCS will pay $0 in taxes because it reports a loss
for tax purposes. Because Nicole may not use the CCS loss
to offset her other income, she (and her spouse) must pay
$185,000 in taxes on the $500,000 of income ($500,000 ×
37%).
© McGraw Hill 41
Suppose CCS is organized as an S corporation and Nicole’s
basis in her CCS stock before the $50,000 2023 loss is
$100,000. How much tax will CCS pay for 2023, and how
much tax will Nicole (and her spouse) pay on the $500,000 of
other income?
© McGraw Hill 42
Answer: CCS pays $0 in taxes (S corporations are not
taxpaying entities) and Nicole (and her spouse) pay
$166,500 in taxes [$450,000 ($500,000 minus $50,000) ×
37%].
© McGraw Hill 43
Entity Loss Examples 1 and 2 Summary
S Corporation
Description C Corporation Explanation
(flow-through)
1) Taxable income (loss) ($50,000) ($50,000)
2) CCS corporate-level tax $0 $ 0 No taxable income.
3) Nicole's other income $500,000 $500,000
4) CCS loss available to $0 if C corp. (1) if
offset Nicole’s other $0 ($50,000) flow-through entity (S
income corporation).
5) Nicole’s other income
$500,000 $450,000 (3) + (4).
reduced by entity loss
6) Nicole’s marginal ordinary
37% 37%
tax rate
Nicole’s tax on other income $185,000 $165,500 (5) × (6).
© McGraw Hill 44
Suppose CCS is organized as an S corporation and Nicole’s
basis before the $50,000 2023 loss is $100,000. Further,
assume that Nicole does not participate in CCS’s business
activities; that is, assume she is a passive investor in the
business entity. How much tax will Nicole (and her spouse)
pay on the $500,000 of other income?
© McGraw Hill 45
Answer: $185,000. Because Nicole is a passive investor,
she is not allowed to deduct the loss allocated to her this
year. She must carry it over and use it in future years (this
assumes neither Nicole nor her spouse have income from
other investments in which they are passive investors).
© McGraw Hill 46
Suppose CCS is organized as an S corporation, and it
incurred a $1,000,000 loss in 2023. Nicole’s basis before the
loss is $600,000. How much of the loss can Nicole deduct for
2023?
© McGraw Hill 47
$578,000. Before considering the excess loss limitation,
Nicole could have deducted $600,000 (her basis in CCS
stock). The excess loss limitation limits her loss to $578,000,
as a married taxpayer filing jointly.
© McGraw Hill 48
Other Tax Characteristics
• For a comparison of tax characteristics across entities.
© McGraw Hill 49
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© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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Because learning changes everything.

Exhibit 4-1 Business Types: Legal Entities and Nontax

*Sole proprietor must organize with state if she forms a

Business entities classification for tax purposes.

Corporations are C corporations unless shareholders make a

Exhibit 4-2 Determining the Tax Form of a Business Entity

Access the text alternative for slide images.

Taxation of Flow-Through Entity Business Income.

Taxation of Flow-Through Entity Business Entity Income.

Taxation of Flow-Through Entity Business Entity Income.

• QBI Deduction specified service example.

Assume that CCS allocates $50,000 of business income to

Description Amount Explanation

Taxation of Flow-Through Entity Business Entity Income.

• QBI deduction wage-based limitation example.

Taxation of Flow-Through Entity Business Entity Income.

Taxation of Flow-Through Entity Business Entity Income.

Taxation of Flow-Through Entity Business Entity Income.

Taxation of Flow-Through Entity Business Entity Income.

Assume that Nicole chooses to form CCS as an S

• Self-employment tax example.

Taxation of Flow-Through Entity Business Entity Income.

Overall Tax Rate of C Corporation Income.

Overall Tax Rate of C Corporation Income.

Corporations can defer second level of tax by not distributing

• Not eligible for QBI deduction.

Deductibility of Entity Losses.

Deductibility of Entity Losses.

Deductibility of Entity Losses.

NOL carryovers deducting in FIFO order.

Losses generated by flow-through entities are generally

Tax differences between tax entities.

Other differences between entities (see Exhibit 15-4).

• Share of flow-through entity debt included in basis of

Converting to Other Entity Types.

Description Amount Explanation

1) Taxable income $500,000

2) Corporate tax rate 21% Flat corporate tax rate

3) Corporate-level tax $105,000 (1) × (2) [first level of tax]

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